The global economy was generally healthy and continued to grow in the first quarter of 2004. In spite of record high profits, companies have been wary of adding more workers. Retail sales have been much better than consumer confidence or the employment reports would suggest, and housing demand and sales remained at historically high levels.  Overseas, China’s growth continues to boost the global economy, and Japan is recovering without fiscal stimulus for the first time in a decade as healthier Japanese companies integrate with China .

According to data released during the first quarter, the global economic expansion remained on track, and the hoped for rebound in business investment is now a reality.  In the U.S., consumer spending was reported to have stayed strong, despite the volatility of consumer sentiment. The durability of consumer activity remained tied to accommodative fiscal and monetary policies, namely, lower interest rates and higher after-tax income. The pace of retail sales, excluding autos, through the first two months of 2004 was more than 7% ahead of the same period in 2003.  In April, the U.S. Labor Department reported a gain of 308,000 jobs in March 2004, with unemployment at 5.7% relatively unchanged during the month. On average the U.S. added just over 170,000 jobs per month during the quarter, short of the recovery related benchmark of 200,000-250,000.  Housing starts rose, and the outlook for capital expenditures (“capex”) improved. Businesses had lowered inventories to the point where inventory-to-sales ratios in some industries were at record lows.

In spite of strong U.S. economic growth (4.3% in 2003 and nearly the same estimated for 2004),  some analysts and economists are hypothesizing that the traditional relationship between job growth (particularly in manufacturing) and growth in corporate earnings is changing. As a result, there may be both continued weakness in the labor market and record high levels of corporate profitability. The underlying conditions behind this phenomenon of overall economic growth and continued weakness in the U.S. labor market include increased globalization and enhanced productivity of the U.S. work force.  The shrinking labor market is indicative of a global, highly productive capitalism that does not see job creation as an end unto itself.

Demand from abroad, particularly from many of the developing regions (China, Latin America, Eastern Europe, etc.) has fed into this cycling up of global economic growth. China’s contribution to growth is tied to its currency peg with the U.S. dollar.  The peg forces China to follow the Fed’s reflationary policy, fueling a boom in investment for domestic infrastructure.  This investment will promote growth in Asia and elsewhere as China imports commodities and components to build its infrastructure.  Many believe China will eventually succumb to pressure and revalue its currency, but its currency peg will be sustained for the next year because the peg serves Chinese and U.S. interests.  China will retain competitive pricing in dollar terms for its exports.  It will use the dollars it earns to help finance the U.S. trade deficit, thereby stemming a freefall in the dollar and mitigating the rise in U.S. interest rates.  Parenthetically, Japan is motivated to hold record amount of U.S. dollars for the same reasons.

 Price inflation has been limited to select cyclical industries such as oil, metals, and chemicals. Thus, consumers have been relatively sheltered from measurable inflation in most goods and services. The statement following the mid-March Federal Open Market Committee was a good synopsis: “The evidence accumulated over the intermeeting period indicates that output is continuing to expand at a solid pace. Although job losses have slowed, new hiring has lagged. Increases in core consumer prices are muted and expected to remain low”.

Though the first quarter ended with a rally, the consensus was that the U.S. market was fully valued, that prices had factored in strong earnings for the first quarter of 2004, and that stocks had reached their targets. It is not surprising to see a relative pause in the market after the extreme gains experienced in the last quarters of 2003.  This slowdown of price appreciation has, to a degree, allowed corporate earnings to catch up with prices so that markets are trading at somewhat lower levels (i.e., price to earnings ratios) than six months ago.  Further, the bull market that began in Spring 2003 is only about one year old, which is considerably shorter than the average length of market upswings historically.

* Thanks go to the Managers, Alger, and PIMCO Funds for their reviews of global  economic presented here