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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management Company
October 3, 2003

With the books now closed on the third quarter it is clear that the state of the economy is anything but clear. There are many cross currents at the moment and every piece of positive data can be offset with a piece of negative information. For example, on September 30 a survey of corporate CFO’s showed a positive surge in their outlook for the economy, while a measure of consumer confidence declined. This is typical of economic turning points, but after three years of starts and stops in the economy there is increased anxiety for signs of sustained improvement.

The market was strong through the first half of September but spent the second half of the month moving sideways as doubts about an economic recovery resurfaced. The fact that the market was essentially flat in September is in itself good news, as this has historically been the worst month of the year for stocks. After a strong six months of gains some consolidation was to be expected. The earnings pre-announcement season has been more subdued than a year ago, but the market will hold its breath waiting for actual results beginning the week of October 6. As we mentioned in our last letter the breadth of the spring rally was impressive and usually meant the market’s gains could sustain themselves for a while. In fact the results for the third quarter produced the first back-to-back positive quarters in the market since 2000.

The economy is still responding to fiscal and monetary stimulus with the large increases in government spending and the spring tax cuts just beginning to have an effect along with interest rates still at 45 year lows. This is massive stimulus and is a reason for optimism. There are signs of the long awaited pickup in corporate capital spending, which is vital to the next leg of the recovery. By the end of this year we believe a sustainable expansion will be evident, with GDP growth running at a rate of 3.5%. The bigger question as we begin a presidential election year is: can the economy grow fast enough to overcome the growth in productivity and begin to produce jobs? It had better, because there are almost no stimulus tools left to use.

Talk of deflation has subsided as data about a strengthening economy has emerged. We never felt a prolonged decline in prices was possible, but we do believe that levels of inflation as measured by the CPI will stay low even as the economy recovers. China will continue to exert pressure on world markets for manufactured goods and India will continue to grow as a provider of professional labor. These combined forces will minimize the pricing power of corporations and the bargaining power of workers. Price inflation will be low, but so will wage inflation. The Federal Reserve will keep short rates at lower levels than it normally would even through an economic upturn. The long end of the bond market will be more volatile as the economy recovers. Eventually the large deficits the Federal Government is running, even if they shrink in an economic recovery, will put some upward pressure in rates as demand for capital from the private sector increases.

Obviously Iraq is still a major issue confronting our country. The pre-war uncertainty, which probably did suppress economic activity, is over. The largest economic issue is the administration’s request for $87 billion to cover war and reconstruction costs. We have no choice but to start to rebuild the country and see to it that a stable democratic government is put in place. However, unless the situation dramatically worsens Iraq is now a political issue much more than an economic issue.


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