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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management Company
October 5, 2005

The View from Edgewood

This year’s third quarter was the hurricane quarter. Hurricane Katrina and its aftermath dominated the news unlike any domestic event since the September 11 terrorist attacks. None of us remembers a major American city being evacuated; the last time it happened was after the San Francisco earthquake in 1906. Yet even San Francisco was rebuilt without hesitation; there will be debates for many months about how much of New Orleans should be restored, how it should be done, and how much should be spent. However New Orleans is rebuilt, it will hopefully produce a more secure city with a levee system addressing 21st, not 19th, century problems.

It should be remembered that the large numbers being thrown around, up to $200 billion, are a commitment from the Federal Government that may or may not be spent over a period of many years. Yes it is a large number, but it will not be a one year expenditure. The stimulus to the economy will be over multiple years as well, not all at once, which is good news. A large ($200 billion) expenditure would be a huge fiscal stimulus that the Federal Reserve would doubtless feel compelled to offset with higher interest rates. On top of the spike in energy costs that will be flowing through the economy over the next twelve months this much spending would be another inflationary factor.

For the first time in almost twenty five years the federal government, including the President, is talking about energy conservation. At the beginning of the current Bush administration suggestions that some attention should be paid to conservation were greeted with derision. Now, the lack of attention paid to incremental efficiency increases over the last quarter century, exemplified by the rise of the SUV, are coming back to haunt the country. At a time of increased world demand and no refining capacity, the good news is that there are easy adjustments that most of the economy can make to ride out this spike in energy prices. The dark horse problem in all of this is natural gas. Production of natural gas was severely effected by hurricane Katrina and Rita. Little natural gas is imported and storage is limited. Due to the price spike, it will have a direct impact on consumer spending since over 50% of houses in the U.S. use gas to heat. This would take a lot of stimulus out of the economy quickly and would certainly catch the Federal Reserve’s attention. As we have been saying, the current energy price rise has been acting more as a tax than an inflationary input and will eventually stop the Fed from raising rates. The danger is that the economy slows too much before the Fed stops.

We also still have the “conundrum” that Alan Greenspan commented on earlier in the year. Long term interest rates peaked in the spring and are still lower than they were when the Federal Reserve started raising rates in June 2004. This has prolonged the housing boom and will make the effect on the economy that much more profound when housing prices do cool off.

We still believe the Federal Reserve will stop raising short term rates “sooner” rather than “later.” The global economy is slowing, energy prices are having a braking effect worldwide, and that will keep interest rates in check. As the economy slows consistent growth will get more attention in the stock market and should usher in a period of good performance for growth stocks.


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