Conference Call: Putnam exec says all’s well with the economy

The economy is better than many people realize, and stocks are undervalued.

That was the message David Kelly, senior vice president and economic adviser at Putnam Investments LLC in Boston, delivered to more than 300 financial advisers who attended Mutual Service Corp.’s national conference in Washington late last month.

MSC, which has more than 1,600 registered representatives, is a West Palm Beach, Fla., broker-dealer wholly owned by Pacific Life Insurance Co. of Newport Beach, Calif.

“This economy is growing,” Mr. Kelly said. “It is back on track, and I expect it to stay back on track.”

He said the recession started and ended in 2001.

The economy has grown for six consecutive quarters, Mr. Kelly noted. Last year’s growth rate of 2.9% wasn’t far below the historical average of 3.2%, and the current unemployment rate of 5.8% is only slightly higher than the historical average of 5.7%, he said.

Arguing that stock prices are “too low,” Mr. Kelly said that advisers should look at the earnings yield on stocks, which traditionally tracks the yield of the 10-year Treasury bond. The earnings yield on stocks is 5.5%, compared with 3.95% for the 10-year Treasury.

“It’s the biggest gap we’ve seen between the two yields since 1986,” he said. “By this measure, stocks have been cheaper relative to Treasury bonds [than they’ve been] in 17 years.”

But investors need advisers to keep them disciplined and diversified, Mr. Kelly said.

Consumer spending has been the main source of growth in the American economy, he contended, and spending continues apace. “For over 11 years now, consumers have found a way … to spend more money than in the previous three months,” Mr. Kelly said.

He isn’t worried about declining consumer confidence.

“We are consumer addicts,” Mr. Kelly said. “We spend to celebrate our victories, but we spend just as much to drown our sorrows.”

He cited the economy’s growing 2.7% in the fourth quarter of 2001, just after the Sept. 11 terrorist attacks.

With the U.S. success in the war in Iraq, consumer confidence has risen, and Mr. Kelly predicted that some kind of tax cuts would be enacted retroactive to the start of the year.

Further, the huge amount of mortgage refinancing that has taken place over the last year will boost consumer spending, he said. Forty percent of mortgages are less than a year old, Mr. Kelly noted.

Business spending will also continue to grow, he predicted. Investment spending for equipment dropped for six quarters until the first quarter of 2002.

Since then, it has been increasing. Business spending on inventories also dropped before it started moving up last year, Mr. Kelly added.

In addition, “the federal government is pouring money into this economy,” he said. The $400 billion federal budget deficit expected for fiscal 2003 would be the biggest ever, and figures to cause a huge surge in demand, Mr. Kelly said.

But he said the pace of economic growth isn’t enough to cause unemployment to fall. Productivity increases over the past year will likely result in higher unemployment for the next several months before leveling out, Mr. Kelly said.

Commercial construction also will stay weak, and exports aren’t growing, due to an over-strong dollar, he said. Mr. Kelly expects inflation to stay between 2% and 3%, and he predicted that operating earnings of companies in the Standard & Poor’s 500 stock index will grow about 10% this year.

Company profits have been able to rise because growth for debt costs, depreciation expenses and worker pay is slowing, he said. Firms also continue to increase productivity.

The Federal Reserve will have to start increasing interest rates at some point to compensate for going overboard in lowering rates during the past several years, Mr. Kelly argued. He predicted that the federal funds rate will return to about 5% at some point, which would be at the historic level of 3% above inflation.

Mr. Kelly also thinks the dollar will move lower.

The current U.S. trade deficit of 5.2% of gross domestic product will result in a reduction of the dollar’s value in the range of 10% to 20%, he predicted. That means international investments should be part of a diversified portfolio, Mr. Kelly said.

He expects investors to move money out of short-term cash accounts into stocks. That would push up stock prices.