The following review of economic trends is based on information available as of March 22, 2005.

The first quarter of 2005 found the domestic economy enjoying a serenity that was in short supply throughout much of 2004. The major catalysts for last year's turbulence -- oil prices, the labor situation and instability in the Middle East -- have not totally abated, yet they sprung no ill-timed surprises during the winter months. But that does not mean the economy has a green light for smooth sailing.

A portent of future problems arose in late February upon reports that South Korea's central bank was planning to shift money away from U.S. Treasury securities to securities denominated in currencies other than the dollar. These rumors stoked fears that other Asian central banks, especially those of Japan and China, might follow suit. In response to these reports, the dollar dropped 1.4 percent against both the euro and the Japanese yen, and both domestic and foreign stock markets declined markedly. Gold and oil prices, which tend to move inversely to the dollar, both rose sharply.

A day later, however, these concerns were allayed as South Korean and Japanese officials denied any plans for a dollar selloff. The markets rallied throughout the remainder of the week, regaining the lost value. But the episode emphasized how the fragile dollar can affect many aspects of financial markets. As long as Asian countries finance much of this country's debt, this scenario holds the potential to be repeated, with investors ever sensitive to the havoc that an actual selloff could trigger.

The Federal Reserve (the "Fed") increased its target for short-term interest rates by 50 basis points, bringing the target to 2.5 percent, the sixth such increase since June 2004. The Fed, which has promised to raise rates at a "measured" pace so as to contain inflationary pressures, believes that the economic recovery has firmly taken root and that excess capacity generated during the 2001 recession may soon be used up, as well as the fact that productivity growth has slowed, which suggests that companies will have to add workers, with costs passed on in the form of higher prices.

Indeed, the core Producer Price Index (PPI) rose 0.8 percent in January, the most it has risen in six years, although February's increase was only 0.1 percent. The core PPI, which is determined by the Labor Department and reflects the cost of goods to wholesalers, excludes often-volatile food and energy prices. The core PPI is now up 2.8 percent for the past 12 months, its largest increase since the mid-1990s. The Consumer Price Index, excluding food and energy prices, rose only 0.2 percent for January, suggesting potential upward pressure on retail prices if profit margins are to be maintained.

The economy grew at an annual rate of 3.8 percent in the fourth quarter of 2004, according to data released by the Commerce Department in late February. Although this figure could not match the 4.0 percent growth enjoyed in the previous quarter, the performance was still solid. For all of 2004, the economy grew 4.4 percent, the best showing in five years.

The Conference Board's Index of Leading Indicators rose in three of the last four months, bolstering the idea that the economy has strengthened. The Conference Board also noted that from August 2004 to December 2004 there were significant upward revisions to this gauge that attempts to foretell economic trends. The Conference Board further noted that there has been more widespread strength in the leading indicators in recent months. Lending further credence to the economy's good health is that both the Coincident Index, comprised of components that tend to parallel economic movement, and the Lagging Index, which includes labor data among its components, increased significantly in February.

On the labor scene, solid job growth materialized in the first two months of 2005, with 146,000 jobs added in January and 262,000 in February. Despite this, the unemployment rate rose to 5.4 percent, an occurrence that can be attributed to the addition of the long-term unemployed actively seeking work. Meanwhile, the Conference Board reported that its Help-Wanted Advertising Index increased sharply in January, showing gains in eight of nine regions in the U.S. The Conference Board surveys help-wanted advertising volume in 51 major newspapers across the country each month.

The Conference Board's Consumer Confidence Index dipped in February after two previous increases. The Index, based on a representative sample of 5,000 U.S. households, stands approximately where it did early last summer, but significantly above the level to which it dropped last fall.

Through mid-March, the stock market resumed its sideways, indecisive action seen through all but the last two months of 2004. However, considerable variability in returns was shown among different sectors with Energy advancing almost 18 percent, while Telecom Services was down over 10 percent, representing a spread in returns of more than 2,800 basis points. The explanation: valuations on the market overall remain historically high while profit growth for the overall market is slowing. Investors are looking for the best relative profit growth in this environment and, given rising earnings estimates for energy companies and other commodity-based companies, with flat to falling estimates for most other sectors, equity investment is flowing to oil, oil service, and metals and mining companies.

The bond market has provided a bit more excitement so far in 2005. Using the 10-year Treasury bond as a proxy for interest rate movements, the yield on this instrument began the year at 4.26 percent (ironically, almost the same rate at which it had begun the previous year), dropped to a low of 3.98 percent on February 9, then rose quickly over the next four weeks to 4.54 percent, a level not seen since early July 2004. The initial decline in rates was prompted by an apparent acceptance by bond investors that the Fed had inflation under control, underscored by jobs numbers that did not meet expectations in January. However, January's increase in producer prices, February's strong jobs report, as well as Fed Chairman Greenspan's publicly expressed confusion over why long-term rates remained so low seem to have prompted the quick increase in rates of 50 basis points through mid-March. The key to interest rates will continue to be inflation. High and rising oil prices, a declining dollar, continued Fed short-term rate increases, and a strengthening domestic economy all argue in favor of higher long-term interest rates. That, in turn, suggests headwinds for a fully valued stock market, putting a premium on good stock selection.

FIRST QUARTER INDEX COMPARISONS

Source: The Wall Street Journal

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