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2005 1st Quarter GDP up 3.1%
Investment Implications

Geneva, April 28, 2005: At 3.1%, 1Q 2005 economic growth came in below economists' median guess of 3.5%. It also marked a real slowdown from the 3.8% rate achieved in the 4Q 2004. Somewhat bothersome, at least in the short-term, is that the core personal consumption price index rose at a 2.2% annual rate. This is the fastest rate of increase since the 4Q 2001 and good jump from 2004's 4Q rate of 1.7%. We think the apparent pick up in inflation will turn out to be an aberration. One reason is the larger than expected jump in inventories. If economic growth really does turn out to be slower than expected, inventories will not be allowed to accumulate for long. Rather, they will be blown out. This means deep discounting and lower price levels, at least in the short term. The Fed is another factor that causes us to believe inflation will not be a problem this year. We expect the Board Governors will be satisfied with the 3.0% plus growth and will continue to raise rates on a measured basis - 25 basis points per meeting until the Funds Rate hits the 3.25%-3.75% range. This will help keep general price levels in check, at least in the short term.

Importantly, we think this report helps explain why the stock and bond markets appear to be at odds. That is, the stock/bond market valuation equation is out of whack. The S&P 500 is trading at less than 16X. This is below the median P/E of 17X over the last 15 years and looks especially cheap when compared the long-term interest rates. You have to go back to 2002 to find the equity market priced more attractively relative to bonds. Positively, between 2002 and 2004 the S&P 500 Equity Index was up 43%.

If economic growth comes in below expectations for the year and inflation really is under control, then the bond market is right and rates should stay pretty much were they are in the 4.0%-4.5% range for ten-year. This, combined with the fact inventories are accumulating, is a negative for the second half of 2005 earnings outlook and beyond. If the preliminary growth number holds up, it is likely market EPS estimates will be revised down -- slightly in the second half and more for 2006. If this were to happen, all other things being equal, the E component of the P/E ratio will drop causing the overall P/E to rise and bringing the equity/bond market valuation equation back in line. We will know more after next week when the Fed gives its report and in a month after the 1Q GDP numbers are revised.

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