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In 2005 the economy has been strengthening; however, we perceive some risks that moderate our optimism. At the heart of the economic growth we have seen is a continually improving corporate landscape. GDP grew at 3.8% in the fourth quarter of 2004, and we expect it to grow again by 3.5 - 4% in the first quarter of this year. Growth is increasingly fueled by business investment, which is still experiencing double digit growth thanks to high corporate profit margins and cash rich balance sheets. The American Job Creation Act, passed by Congress last year, will allow U.S. companies with accumulated foreign profits to repatriate some $350 billion at an exceptionally low tax rate in 2005. We believe that this will have a positive impact on the stock market as U.S. corporations experience internal growth through capital spending or external growth through acquisitions.

Other indicators present a more complicated view. Consumer confidence remains quite high despite rising oil prices, the falling dollar, and record trade and current account deficits which widened in the fourth quarter of last year to nearly $188 billion, causing concern that the federal government’s borrowing needs in order to finance the trade deficit may not be sustainable. High oil prices (currently at XX$ per barrel) may act as a brake on the economy, while energy demand continues to outstrip supply worldwide as emerging economies experience rapid growth rates. We continue to favor the energy sector for this reason, but in the words of Treasury Secretary John Snow, "we're not an economy geared to $60 oil." Unemployment, which has been slowly receding and is currently at a level of 5.2%, presents a dilemma in that there is a risk of mounting wage pressure if unemployment continues to fall, which will likely spark inflation. Housing starts recently hit a 21-year high in January and February; until long term interest rates begin to rise significantly the housing sector will likely continue its resilience. The Federal Reserve Board has now raised the federal funds rate seven times since last year to 2.75%, and intends to raise rates further. The risk is that the Fed will begin to accelerate its pace of interest rate hikes beyond what the market expects.

For these reasons we remain cautiously optimistic on the economy. Negative factors continue to be slightly outweighed by positive business and consumer momentum. Until this pattern changes, we believe that the economy should continue on its current course of expansion.

For the first quarter of 2005 the market experienced volatility; the Dow and the S&P both lost 2.6%, and the Nasdaq fell 8.1%.
Grant Rogers Elizabeth Allen

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