It was a great year for investors in 2003. Thanks to lots of liquidity from the Federal Reserve, the war-relief rally that started last March, and the explosive corporate-earnings rally of the fourth quarter, the S&P 500 witnessed a 28.7 percent total return for the year. Select lower-quality corporate bonds, junk bonds, and the average global stock also appreciated approximately 25 percent last year, while most other corporate bonds, municipal bonds, and U.S. Treasuries had a single-digit return but still a very good premium to inflation. Gold rose 19 percent last year and select commodities rose even more — from very depressed levels — as the global economic recovery seemed to take hold. The U.S. dollar came under pressure in 2003, down 14 percent on a trade-weighted basis in part due to unclear rhetoric from the Bush administration as to its stance on the greenback and the growing current-account deficit.
So what’s in store for 2004? Saddam Hussein is in jail and terrorists are on the run. That should make us feel a little bit better. But more important is the state of the global economy and valuations moving forward.
The global economic environment is showing strong gains with the cyclical rebound in the U.S. and Asia. This rebound is having a spill-over effect on Europe and Japan, two very depressed areas to date. Many economists are predicting 4.2 to 4.5 percent global GDP growth for 2004. That is in sharp contrast to the 3.2 percent growth rate of 2003.
The U.S. continues to be the world’s main economic driver with GDP growth forecast at 4.5 percent for 2004 versus 3.1 percent for 2003. Global inflation should remain modest at 2.5 to 3 percent while U.S. inflation should remain under 2 percent barring some unforeseen event.
This forecast obviously bodes well for U.S. corporate profits and continued productivity gains in 2004. Corporate operating profits are expected to rise 12 to 14 percent in 2004 and stock multiples should hold current levels (18 P/Es) with continued modest inflation. Employment levels should improve modestly with slightly better inventory rebuilding and better export growth.
Now for the risks that hopefully will be manageable.
The tension in fiscal and monetary policy between the accommodative U.S. stance and the neutral positions of other world central banks will likely continue. The result so far has been a weak U.S. dollar versus most of our trading partners who are not tied to the dollar.
The dollar is expected to remain weak, especially versus the yen in the first half of 2004. China will continue to experience strong export and import growth and will receive renewed pressure to float their currency in the U.S. presidential-election year. There’s a lot of rhetoric here, but only cautious change is expected by the Chinese government — which possibly includes a wider trading band in 2004.
This year we should (hopefully) see the Federal Reserve slowly adjust its policy from accommodative to neutral. But tightening is not expected at this point in time. Commodity prices should slow their rapid price gains as China attempts to keep its growth rate under control. They should succeed. (China has been growing at an approximate 8 percent rate for some time).
So — barring any unforeseen events — the U.S. and global economic outlook for 2004 is a good one. The financial markets have already recognized most of the positive news and the stock market should experience a more normal return of around 10 percent this year. Bond investors can hopefully earn the coupon return or slightly better than cash returns. Bond investors need to keep in mind that inflation is running at less than 2 percent, so a bond realizing a 4 percent to 6 or 7 percent coupon return on corporate/sovereign debt is very attractive on an historic basis. These securities still belong in a balanced portfolio as good diversification to equities.
The loud rhetoric of a presidential election year has begun, and it’s expected that the stock market will begin to focus more on quality growth securities as well as cyclical/industrial and energy stocks that have value.
Happy hunting and good luck in 2004.
— Patricia A. Small is a partner with KCM Investment Advisors and is Treasurer Emeritus, University of California. She can be reached at pak@kcmadvisors.com