Financial forecast.

• Author: Boquist, John A.

The past three years have been tough on investors with declining stock market returns and low interest rates. Furthermore, notable companies such as Enron, Worldcom, and United Airlines have gone bankrupt, wiping out the entire stock valuations of these companies. Add to this mix the ethical lapses of some managers and investment advisors, as well as the lack of responsible corporate governance at many companies, and it is easy to see why financial markets are now on edge with investors wondering whom they can trust.

Not all the news is bad: housing demand remains strong and families who own their own homes have seen rapid increases in value in many markets. Low interest rates have helped stimulate the real estate market, allowing homeowners to refinance at low rates and fuel their urges to consume. Since we forecast many of these trends will continue next year, financial markets are exhibiting a new reality.

Interest rates

Interest rates have generally fallen during the past twenty years, due in large part to wringing inflation out of the economy. Since short-term rates have fallen much more than the long-term rates, the yield curve is the steepest that we have seen since the early 1990s. Historically, the spread between short- and long-term rates is a precursor to economic activity--the currently observed high spread is generally followed by an expansion and rising interest rates. Thus, we expect to see a slight rise in interest rates over the next year, with the short-term Fed Funds rate in the 1.75 percent to 2.00 percent range and long-term treasury bond yields in the 5 percent to 6 percent range by the end of 2004. Corporate interest rates will also exhibit small increases next year. Mortgage interest rates bottomed out at about 5.25 percent in early summer and have since increased to approximately 6 percent. We expect mortgage rates to also rise over the next year to a level of 6.5 percent. The prime rate will be near 5 percent by the end of the year.

Corporate Profits

Corporate profits are expected to rise about 9 percent next year as the economy continues to grow and recover from the recession. In fact, third quarter earnings this year are expected to be 20 percent above the level of last year. Corporate profits and cash flows continue to be adversely affected by employee health insurance premiums, which rose 14.8 percent last year, and under-funded pension plans, which stand at a $216 billion deficit for the S&P 500 companies...