PacWest Financial Management Newsletter
2nd Quarter 2004

Volume VIII, Issue 2

July 2004

This country was founded and built by people with great dreams and the courage to take great risks. ~ Ronald Reagan

Economic News

In the economic corner, the topics of note for this issue are the recent slowdown in economic indicators and the hike in interest rates. Job growth has been advancing quite nicely for the past few months. The June numbers, however, have come in considerably lower than expected. The Institute for Supply Management (ISM) also reported that manufacturing activity was down to 61.1 from 62.8, but still above the relatively high level of 60.

Since the beginning of the job recovery in September 2003, the U.S. has added 1.5 million jobs, of which 1.3 million were generated this year. The job growth numbers for June were expected to come in at around 250,000 jobs. Instead, only 112,000 jobs were added during the month.

Many economists have been biting their nails, waiting for the rates to increase, especially as they relate to inflation. On June 30, 2004, the Federal Reserve raised short-term interest rates from 1%, the lowest level since 1958, to 1.25%. This is the first increase since May 2000. The real rate of interest, which is the fed funds rate less the annual inflation rate, has been negative for 20 months in a row. Fed Chairman Alan Greenspan still believes that inflationary pressures are not too big of a concern for the near future, due to the slack nature of the economy. In addition, consumer debt is high, so a small increase in interest rates can put pressure on economic growth while controlling the rise of inflation.

Economists anticipate another rate increase in August. The Fed has mentioned the possibility of maintaining the 0.25% incremental increases, but may go to 0.50% if inflation accelerates. Based on the Wall Street Journal’s Economic Forecast Survey, the consensus estimate is for the fed funds rate to reach 2% by the end of the year and a GDP decline from 4.2% in the second half of 2004 to 3.7% in the first half of 2005.

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What is probate and why do I want to avoid it?
You have probably heard that living trusts avoid probate whereas wills do not, but you may have wondered, what is probate? Probate is the legal process that occurs after someone dies. It involves paperwork and court appearances by lawyers whose fees are paid from the estate’s property. Probate can take as little as three months or as long as two years or more. According to one AARP study, 4-6% of an estate’s assets are used up in the probate process – assets that would have otherwise gone to the beneficiaries of the estate.

During probate, the executor has to prove the validity of the will, which is usually straightforward, provided there is a will. The executor then presents the court with a list of the deceased’s property and its appraised value, a list of the deceased’s debts and creditors, and a list of the deceased’s estate’s beneficiaries. The executor then pays the debts and taxes of the estate, notifies relatives and creditors of the deceased’s death and distributes the assets according to the will or, if no will exists, according to state intestate laws.

How do I avoid probate?
In Arizona, you can pass up to $50,000 of property without probate. If your assets exceed this level, here are ways to avoid probate:

• Create a trust.

• Open a payable-on-death bank account: You retain all rights to the bank account while you are alive. At death, the beneficiary goes to the bank, identifies themselves, presents a death certificate and collects the funds in the account.

• Designate a beneficiary on your retirement account.

• Hold your property as joint tenants with right of survivorship. This method works well when married couples acquire assets together. However, if your spouse is your joint tenant, you may not be maximizing the estate tax credit exemption. If you enter into a joint tenancy with someone other than your spouse and you are giving up partial control of the assets, you may incur gift tax from an unintentional gift.

Please be advised that each of these methods have advantages and disadvantages. If you have any questions about these methods, please contact us.

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U.S. Stock Market

The second quarter of 2004 will be remembered more for the passing of President Ronald Reagan than how stocks fared. The following equity summary pales in comparison to this significant event. Nonetheless, stocks did not make much headway during Q2. While the economy was strong and earnings were moving higher, outside influences held stocks back. Also, interest rate fears and crude oil prices played a role in the sideways market of the second quarter.

The S&P 500 gained 1.3%, while the NASDAQ was up 2.7%. The Dow did not do as well, advancing 0.75% during the quarter. The small cap Russell 2000 trailed the larger indices, gaining less than 0.5%.

Going forward, we see stocks ending 2004 higher than they started the year. Although interest rates are up, they are still at historically low levels. Also, the Fed seems determined to raise rates at a fairly slow pace. Additionally, the price of crude oil appears to be abating. As long as it remains in the mid-to-low-30s price range, consumers and businesses should not be significantly impacted.

Moreover, earnings and cash flows of companies are rising, while stock prices have basically remained flat. This leads to lower valuation multiples such as price to earnings and price to sales, as well as discounts to intrinsic values. However, the improving fundamentals have been somewhat offset by higher interest rates.

From a geopolitical standpoint, the relatively smooth transition of sovereignty back to the Iraqi people is certainly a positive. Although the market will not be overly impressed until our troops no longer occupy the country, this is a step in the right direction.

As always, there are risks to the preceding forecast. Valuations are getting better, but are still slightly above historical levels. Additionally, the Presidential election is making the market quite nervous. As stated last quarter, President Bush is seen as being friendlier to equity holders. A Bush/Cheney loss could cause turbulence in the stock market.

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There is no pleasant way to describe the bond market in the second quarter. It was painful. After the March jobs report came out, bonds sank quickly as investors realized that the tide had finally turned and higher rates were on their way. Inflation picked up slightly.

The fierceness of the move in bonds can partially be attributed to what is called the carry trade, which is when investors borrow short-term to buy longer-term bonds. To undo this they have to sell their longer term bonds causing prices to drop rapidly. The ten year T-note yield rose to 4.59% from 3.85%, providing the bond market with one of the worst performances since early 1994.

There has been little doubt that the Federal Reserve was slowly unwinding their accommodative monetary policy. And unwind they did. With a quarter point increase at the June 30 meeting, the federal funds rate now stands at 1.25%. Bond prices yawned at the news and yields even dropped slightly, as the Fed delivered just as expected.

The important question is how will this impact fixed income investments from here? At the end of the quarter, bonds had already priced in a federal funds rate of 2.25% by the end of the year and 3.5% by the end of next year. As long as the economy expands slowly, inflation remains subdued and the Federal Reserve continues their measured pace, short term bonds should still offer higher rewards than cash and more safety than stocks.

Our strategy has been to keep maturities fairly short as rates move upward. We’ve used government agency step-up bonds and corporate bonds indexed to inflation. These bonds offer coupons that adjust upward on a periodic basis or when CPI moves up. This will help protect against any unexpected increase in rates.

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International markets basically ended the quarter flat, although certainly not without excitement. Concerns over China’s move to slow their economy and rising U.S. interest rates caused quite a swoon in April and May.

China has been counted on to be a big global growth driver in the coming years. Their GDP growth in the first quarter was 11%. In late April, the government pledged to slow growth down to 7% by reducing lending. This caused international markets to drop. Some emerging markets, which are more volatile, plunged by double digits in a matter of weeks.

Other areas, such as Europe, are showing somewhat sluggish growth. The U.K. is expected to grow at a respectable 3.5% this year, but this lags other countries which have been experiencing much more rapid growth.

The dollar remained relatively stable this quarter and did not add return to dollar-based investors. However, the widening current account deficit, reaching 5% of GDP, has many, including Warren Buffet and George Soros, betting on a weakening dollar. While this has not been the case so far, it deserves attention. A weaker dollar from this point would certainly boost international returns for U.S. investors, but does not necessarily guarantee a strong foreign stock market.

We continue to add international exposure to client accounts. This will provide added diversification and opportunities for increased returns. A weakening dollar might not give us the same boost we saw last year, but it could provide opportunities to enhance returns.

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