PacWest Financial Management Newsletter
4th Quarter 2004

Volume VIII, Issue 4

January 2005

Economic News

The Gross Domestic Product (GDP) rose to 4.0% in the third quarter compared with 3.3% in the second quarter. In the “Semiannual Economic Forecasting Survey” from The Wall Street Journal, a pool of 56 economists expect GDP growth of 3.6% for 2005 and quoted: “Advances slightly below 4% could be just what is needed to strengthen the job market without prompting inflation.” At the end of November the Consumer Price Index (CPI) is 3.5% higher than the previous year. With a rise in GDP and CPI in the past quarter, inflation continues to be a concern. However, the Federal Reserve is closely monitoring it.

At the December 14th meeting, the Federal Open Market Committee (FOMC) raised interest rates another quarter-percent for the fifth time in 2004, to 2.25%. The central bank is widely expected to continue raising rates when the FOMC meets again on February 1st or 2nd. The expectation is for rates to be 3% by June and up to 3.5% in December. The most important factor that may affect these expectations is job growth. Unemployment remained at a steady 5.4% in November 2004. Job growth for December and the coming months will either boost or burden our economy in the coming year.

The dollar sunk to its lowest levels against the euro during the last week of December 2004, but immediately rebounded in the last three days.  How will the weakness in dollar affect our economy?  Our exports will be cheaper and more attractive in the global market, which will help our trade deficit.  However, there will be concerns if the dollar were to plummet any further. This may lead to reduced demand of our government bond from other central banks and further increase our current account deficit.

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Financial Planning - 2005 Numbers

Unchanged from 2004

• Maximum long-term capital gains tax rate: 15%

• Maximum qualified dividend tax rate: 15%

• Maximum education IRA contribution: $2000

• Annual gift tax exclusion amount: $11,000

• Estate tax applicable exclusion amount: $1,500,000

• Lifetime gift tax applicable exclusion amount: $1,000,000

• Generation-skipping transfer tax exemption amount: $1,500,000

Changed from 2005

• Maximum traditional IRA contribution limit: $4000

• Maximum traditional IRA contribution limit, over age 50: $4500

• Maximum annual earnings subject to social security taxes: $90,000

• Full retirement age for social security benefits: 65 years and 6 months

• Standard deduction for married filing jointly: $10,000

• Standard deduction for single filer: $5,000

• Maximum contribution by employees to 401(k): $14,000

• Maximum contribution by employees to 401(k), over age 50: $18,000

• SIMPLE contribution limit is $10,000, over age 50: $12,000

• IRS mileage rates effective 1/1/2005: 40.5 cents for business use, 14 cents for charitable use, 15 cents for medical use, and 15 cents for moving expense use

College Cost Figures

• Four-year public institutions average annual total cost*: $11,354

• Four-year private institutions average annual total cost*: $27,516

*Total cost includes tuition, fees, and room and board

Did you know?

• Social Security beneficiaries will receive a 2.7 percent cost-of-living adjustment, which will be automatically reflected in monthly Social Security benefit checks beginning in January.

• Effective January 1, 2004, the IRS will allow taxpayers to take as an itemized deduction state and local general sales taxes in lieu of the itemized deduction provided for state and local income taxes. For more information, visit: www.irs.gov

Sources: www.forefield.com www.collegeboard.com www.irs.gov

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U.S. Stock Market

As we anticipated and noted in our most recent newsletter, stocks had a strong finish to the year. Stocks began to rise as the presidential picture cleared somewhat at the end of October. Not surprisingly, the improvement in stocks corresponded with a fall in the price of crude oil. Light, sweet crude topped out in the mid-$50s during October.

The S&P 500 rose 8.7% during the fourth quarter to end the year with a 9.0% gain. The advances in the Dow and NASDAQ of 7.0% and 14.7%, respectively, allowed them to make positive returns for the year. However, the biggest surprise to many was the continued outperformance of smallcap stocks. The Russell 2000 was up 13.7% for the quarter, and over 18% for the year.

So, what is on the horizon for U.S. stocks in 2005? It is possible that returns will be below the returns experienced in 2004. Concerns that could squelch higher stock prices include rising interest rates, weakening consumer spending, tepid job growth, and high equity valuations. Bull markets rarely start when stocks are trading at their current valuations. In addition, the broader stock market indices tend to perform poorly in a rising interest rate environment.

The good news is that we have seen signs of improvement in the economy since October. Growth in leading indicators turned positive after declining since February. Additionally, businesses have significant cash positions on their balance sheets that can be used to add shareholder value through dividend increases, share repurchases, or acquisitions.

We see 2005 as a year of stronger performance for larger stocks. Therefore, we will reduce our exposure to smallcap equities in client accounts. We will use the proceeds to purchase larger, mainly dividend-paying stocks.

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Fixed Income Markets

It was definitely a surprising year for the bond market.  As short term rates began rising in June, long term rates began to fall.  The ten-year Treasury bond yield fell from 4.59% on June 30th, the day the Fed began raising rates, to 4.21% at the end of the year.  The Federal Funds rate rose from 1% to the current 2.25%.  The reason for the divergence in short-term and long-term rates can be attributed to the feeling that inflation is under control.  It can also be a sign that investors are expecting the economy to weaken.  Investors will lock into long-term rates now, as they believe they will be lower in the future.  The drop in rates for longer-term debt is also a function of foreign investors buying our treasuries.  Although most investors and economists expected the short-term rate increase, they were caught off guard by the substantial drop in longer-term yields.

  From here, we expect that the Fed will continue to raise rates throughout the year.  The minutes that were released on January 4th from the latest Fed meeting show that they are not finished with their rate hikes.  Economists are predicting that short-term rates will be at 3.5% by the end of the year. It is difficult to say where long-term rates are headed, as they have not reacted as expected.

  We continue to be conservative in our bond portfolios.  Our new purchases will generally be under five years in maturity.  We have added some step-up bonds, which will pay a set coupon for a period of time and then increase the payout over the life of the bond.  Most of our other bond purchases have been short-term government agencies.  The yield spreads on corporate bonds have not justified adding new purchases yet.  In general, it does not make sense to take on too much credit or interest rate risks in the bond portfolios, as there is not enough reward to justify it.

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International Equities

This quarter the fall in the dollar made a big contribution to returns for international equity.  As discussed in previous newsletters, there was a potential for the dollar to weaken further as people grew more concerned with the current account deficit.  During the quarter, the EAFE index rose just over 6.5% in local currency returns, but for U.S. investors this translated into a 15% return.  Over the course of the year, U.S. investors realized a gain of 17.6%.  In local currency returns, it was only 10.2%.

  As is the case with the U.S., most countries’ economies are expected to slow in 2005.  China, which has the second highest GDP to the U.S., is expected to slow from 9% GDP growth to 7.5% growth.  Japan’s economy, which had finally started to improve in the past year, is expected to slow to 2.3% growth.

  We continue to believe a weighting in international stocks is necessary for diversification and performance.  If the dollar should weaken further in 2005 because of the U.S. trade deficit and the economy, these stocks should benefit.  As companies are more global than ever before and the markets tend to move together, the performance of the international equity markets will be much more reliant on currency fluctuations.

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