However, while this year's stock rally has been even stronger than we expected, it's in line with a normal first-year bull market. The second year of a bull usually trails the first, with gains averaging about 10% rather than the 35% for the year prior. We thus expect the S&P 500 to close 2004 near 1,200 -- still well below the 1,528 high hit in March, 2000.
Looking at the bond market, the yield on the benchmark 10-year Treasury note stabilized near 4.25%. We expect yields to rise as improving capital spending and heavy Treasury borrowing hit the market in 2004. Yields are expected to end 2004 above 5%. We expect them to continue to swing in response to the incoming economic data, as the markets try to guess when the Federal Reserve will tighten interest rates.
GREENBACK WILD CARD. The falling U.S. dollar is creating some nervousness at the long end of the yield curve -- longer-maturity debt issues -- which has also pressured by the U.S. Treasury Dept.'s rising borrowing needs.
The dollar is the wild card for 2004. We continue to expect it to decline, but the exact speed and timing is impossible to forecast. The euro is forecast to hit $1.40, but could do so quickly or slowly, depending on market sentiment. The dollar has been overvalued for the last five years, and history suggests it will become undervalued for the next five. Moreover, the move against the euro is being exaggerated by the unwillingness of the Asian countries to let their currencies appreciate, thus putting the burden of adjustment on the euro.
Money market rates remain near all-time lows, suggesting a lot of cash remains on the sidelines despite recent heavy inflows into mutual funds. Credit spreads -- the difference between interest rates charged to investment-grade and below-investment-grade borrowers -- at the end of 2003 remained at some of the narrowest levels of the year, as the favorable economic outlook and earnings recovery continue to underpin strength.
ON HOLD TIL SUMMER. Although borrowing rates are well above the June bottom, they still remain low on a longer-term historical basis. Such levels should help the economy in the future. The continued slump in mortgage rates is important for the housing market, especially given the drop in home sales in November.
On the monetary-policy front, we expect the Federal Reserve to stay on hold until its June policy meeting. If employment growth materializes, as we expect, the central bank will then begin to raise the benchmark Federal funds rate. If payrolls continue to disappoint, however, the Fed will keep that rate at 1% through the election and perhaps into 2005. The lack of inflation means the Fed is under no immediate pressure to hit the brakes, but it would like to get its foot off the accelerator.
Recent comments from Fed officials continue to suggest no hurry to raise rates. The strength in the economy, labor market, financial markets, and inflation over the next few months will determine whether the Fed complies with market expectations for a rate hike in the second quarter of 2004. We at Standard & Poor's expect an increase in June.
LABOR LAG. Looking at the overall economy, the combined fiscal, monetary, and home-refinancing stimulus kick-started growth in the second half of 2003. Profits and cash flow for U.S. companies continue to improve, which should strengthen capital spending into 2004.
Overcapacity, lack of pricing power (somewhat alleviated by the declining dollar), and corporate efforts to improve liquidity and cash flow, however, will keep capital spending rising more slowly than in the late 1990s. Recent employment trends suggest that the labor market has begun to respond to stronger growth as well -- but with a longer-than-usual lag.
We at S&P expect gross domestic product to rise by 4.7% in 2004, the largest lift in 20 years and up from 2003's annual rate of 3.1%. As for the labor market, we forecast the unemployment rate for full-year 2004 to come in at 5.7%, down from the 6% average for 2003. Payroll employment is expected to rise more quickly than the 101,000 average of the last four months, possibly gaining 3 million jobs in 2004. That would be a major cause for cheer in the new year. Wyss is chief economist for Standard & Poor's