As the summer moves into high gear, the economy by most appearances is making forward progress as well. The economy grew at 1.4% for the first quarter of 2003. While 50% below the 3% desired growth trend line, this growth rate is still stronger than anticipated in light of the Iraq war buildup and SARS concerns. We hear frequently that we are experiencing a jobless economic recovery, and we agree that recent employment data has not been encouraging. However, if we review the economic recovery of 1994-1995, that too was considered a jobless recovery. The structural changes facing the manufacturing, travel, and financial industries today have broken the long trend of cyclical hiring, but have not altered the need to enhance productivity and profits. The New York Times recently devoted their Sunday magazine to an economic discussion where they defined the current economy as one of “idiosyncratic volatility.” In this idiosyncratic economy, many individuals are experiencing a great deal of personal disruption and change. However when taken collectively, the labor force translates into a decent economy.

With regard to the “D” words – debt and deflation – we note that bad news sells. While the rise in both individual and national debt should not be ignored, a little context helps us judge the relative magnitude of the current situation. First of all, the Fed has cut interest rates thirteen times in these past three years, thus strongly encouraged borrowing. At the same time, the residential real estate market has provided efficient means for individuals to tap into their home equity, thus encouraging additional borrowing. This trend, combined with the lower interest levels, has allowed for lower payments and accelerated amortization time tables for home loans. With regard to the Federal debt burden, the 1999 surplus of 1.4% of GDP is now a deficit of 4.6% of GDP. This debt burden would look much less foreboding if GDP were trending back toward 3%. Finally there is the looming issue of the weakened state of individual state finances. California – the fifth largest economy in the world – appears on the verge of default.

While we may never know exactly if the Fed needed this last rate decrease, or even if cuts 10 through 13 were effective, the Fed has greased the skids of the economy as never before in modern times. This leads us to our question. What happens when interest rates from the 1950’s meet the productivity of the 21st century? Should we be worried about deflation? We have argued that interest rates have benefited disproportionately from investors chasing performance and running away from the equity market in fear of further losses. Current rates in our view do not speak to a wholesale hedge against deflation. There are certainly industries where deflationary forces are at work (such as telecommunications and technology). However, inflationary pressures are currently evident in the insurance, education, housing and healthcare industries (to name just a few).

On balance, though we maintain a watchful eye on Federal and state debt levels, we are generally positive on the economy and the backdrop that it will create for investing.

Rates

We believe that this continues to be a treacherous time for bond buyers. In the few weeks since the most recent Fed rate cut, we have witnessed a 5% price decline in ten-year US Treasury Bonds. Yes – that that is right – the Fed cut short rates and long term rates went up! However, it is not this recent rising rate trend that seems out of place to us, but rather the magnitude of the preceding rally. Consider the following price/yield changes on the ten-year US Treasury Bond in the last two months:

5/9/2003: Price $99.53125 Yield 3.68%

6/13/2003: Price $104.328125 Yield 3.11% (4.82% price gain while dropping 57 bps)

7/14/2003: Price $99.25 Yield 3.65%

These are extraordinary movements in US Treasury rates. The Government’s borrowing needs should have already provoked a rise in rates to reflect the financing of the growing deficit. In addition, municipal rates do not begin to reflect the credit deterioration in state finances. When might it be safe to buy into the bond market again? Our recent review of historical municipal rates found that good buying trigger points are: ten year municipals with a yield greater than 4.5%, and fifteen year municipals with a yield in excess of 5%. We are currently at 3.44% and 4.2% on 10 and 15 year municipals, respectively. However, it won’t take long to move to higher levels if we see any high profile bankruptcies out of California or other states.

Currencies

The dollar meanwhile has finished its most recent slide in the wake of the last rate increase and has recovered back to levels of early May. We would expect the dollar to trade in a fairly narrow band as there does not seem to be any compelling global trigger for further weakness.

The balance of 2003 may turn out to be a surprisingly good period for the equity investor. The weaker dollar has been a positive for large multinational US corporations. At the same time, the low absolute levels of interest rates have been helpful to small and medium size businesses.

Investor psychology is increasingly more biased toward equity investing. Earning 1% in cash feels better than losing 30% (2000-2002.) However, the equity market is up over 20% since the mid-March lows. A 1% cash return pales in comparison to this relative to this performance.

The new tax legislation also benefits equity investors. The three changes which will have the most direct impact on equity investors are: 1) the 15% tax treatment on dividends; 2) the 15% tax treatment on long term capital gains; and 3) the lowering of the highest tax rate from 38.6% to 35%.

By lowering the tax on capital gains and dividends, Congress is clearly asking individual investors to become long-term investors. The differential between a tax burden of 15% and 35% is significant enough to incent many investors to hold their equities for the minimum one year holding period. We have not seen any wholesale rebalancing of assets out of bonds and into equities but that is likely to come particularly if bond funds start showing significant losses.