October 2004

The Federal Reserve - On The Move

The Federal Reserve, in the person of Chairman Alan Greenspan, announced another increase of 25 basis points (1/4 of 1 percent) in the Federal funds rate on September 21st, marking the third increase this year. The quarter-point increase in rates had been expected and was fully reflected in fixed-income and equity markets at the time of the announcement. Consequently, there was no noticeable movement in financial markets when the FOMC announcement was reported. However, the growing sense of uncertainty as to the strength of the U.S. economy is weighing on the market. Job growth remains paltry. Capital spending by corporations continues to be muted. And the war in Iraq keeps the optimistic, entrepreneurial American spirit somewhat in check. On top of all this, the negativity of both political parties, prior to November elections, further undermines consumer confidence.

We do not expect to see any noticeable movement in financial assets until after the November presidential election. A clearer outlook of the course that America will follow in the years ahead is needed, in our opinion, to revive confidence. Some of the secular factors that must be addressed in the years ahead include: global terrorism, probable spread of the war in the middle-east, the bursting of the real estate bubble, the rise of India and China to developed nation status in the next decade, the continued loss of manufacturing jobs to developing nations in southeast Asia and China, and the gradual realization among the middle class that they will experience a drop in their real wealth and standard of living that will be permanent for the most part in the years ahead.

In addition to the above factors and impacting standards of living at home and abroad is the fact that oil consumption has outstripped production and refining capacity. The OPEC nations are currently producing at capacity. The bottom line is that OPEC no longer sets the price of oil – the market does. The price of oil is now set at the margin. Oil consumption in India and China is increasing at rates that far exceed current and projected production increases into the next decade. To the dismay of Americans, further increases in the oil price appear likely. Except for minor downward spikes, the cost of oil and the myriad of products made from petroleum will be increasingly higher. These increased costs will flow through the entire economy and squeeze profits. Attempts to increase prices may become painful and result in lower unit sales and lower revenues for the companies dependent on petroleum.

China, in particular, may be converting some of its billions of dollars in its reserves to non-financial assets in the form of oil, copper, aluminum, iron ore and silver rather than continuing to hold depreciating U.S. dollars.

We expect that natural resources and metals will become more popular as investment vehicles in the next several years, and we’ll gradually shift our investment focus in directions that will more likely participate and benefit from the changing landscape in the coming years.