Economic Outlook
Entering the New Year with Remarkable Resilience
The US economy showed remarkable resilience in 2005. Despite a major natural disaster and an intensified energy shock, growth accelerated from 3.5% in the first half of the year to an estimated 4.2% in the second half of the year. In part, this is a typical reaction to disaster: recovery spending typically offsets the damage to growth almost immediately, and in this case, much has yet to be spent. However, the picture also reflects underlying strength.
As we move into the New Year, a brief review of 2005 performance for the equity and bond markets shows that the S&P 500 Index, a measure for the broad equity market, returned a positive 4.95% for the year. Another widely used measure of the market, the Dow Jones Industrial Average, returned 1.86% for the year. The Lehman Brothers Intermediate Bond Index, a representative measure of the fixed income market, returned 1.58% for 2005.
We expect the US economy to show continued strength into the year 2006, particularly in the first six months of the year, with a slowing in the second six months, with the overall pace more modest then 2005. We forecast that the nation’s gross domestic product (GDP) will grow at an annual rate of 3.3% in 2006, certainly a respectable rate, but falling short of the average of the past two and a half years. Real estate wealth, supporting the economy by providing consumers with cash to buy everything from designer kitchens to second homes, appears to be experiencing what looks like a slow-motion soft landing—as can be seen from the following chart, sales are slowing, with a subsequent building in inventories, with price inflation cooling, but not collapsing.
As interest rates rise, the ingredients of rising home values and consumer cash extraction from refinancing and home equity loans that provided economic growth are being displaced with a new growth mix. Businesses will lead the way with strength in capital spending, inventory rebuilding, supported by post-Katrina government outlays and exports that are expected to pick up the slack from weakened consumer spending and housing.
The economy’s rebound from 2005’s natural disasters and costlier energy have left companies with solid balance sheets and the cash available to afford their capital spending plans and to increase hiring. Even though interest rates will likely continue to rise in the early part of 2006, and labor costs should continue to increase, businesses are sufficiently flush with cash to withstand these pressures. With currently healthy balance sheets and extremely manageable corporate debt, companies are in such good shape that there is a negligible need to borrow to meet the needs for the year’s new buildings, equipment, inventories and payroll. Corporations’ ability to either reduce their borrowing or not borrow at all reduces their interest expense, thereby improving net margins.
Stronger growth in non-US economies will be a plus, as major economies abroad maintain forward momentum. Economic growth abroad leads to solid US export growth, a trend which, along with slower import growth, should stabilize or perhaps even narrow the growing trade deficit. The two major contributors to this foreign economy strength are the Euro zone and Japan, reflected in the new attitudes of both central banks. The European Central Bank lifted rates in December of 2005 for the first time in five years, and the Bank of Japan is contemplating ending its zero-rate policy that had begun in 2001, as it appears that its long hard battle with deflation is ending. The multinational nature of many of the holdings in Oakwood client portfolios will benefit from these improving non-US economies, as well as the healthy effect of an increase in US exports.
The US dollar enjoyed a rally in 2005, primarily due to several factors. US interest rates, higher than non-US counterparts, attracted foreign capital, while the repatriation of billions of dollars in profit by US multinationals added support to the currency. In addition, China’s modest revaluation of the yuan did not spark the broader rally expected in Asian currencies, maintaining the appeal of the US dollar. Despite the current strength of the dollar, many see the present situation as an interruption of a longer-term decline in the dollar. With the US trade deficit growing, many investors say that at some point the dollar must weaken considerably to address this imbalance.
An interesting recent development that could put heavy downward pressure on the dollar is the indication from China during the first week of January 2006 that it could begin to diversify its rapidly growing foreign exchange reserves away from the US dollar and government bonds – a potential shift with significant implications for global financial and commodity markets. Economists estimate that more than 70% of China’s reserves are invested in US dollar assets, which has helped to sustain the recent large US deficits. If China were to stop acquiring such a large proportion of US dollars with its reserves – currently accumulating at about $15 billion a month – the dollar could potentially lose its strength. A fall in the US dollar may heighten inflationary expectations in the US and force the Fed to constrain them. Stronger global growth would put upward pressure on global real interest rates. In addition, it could affect international capital flows, another factor contributing to weakness in the US dollar, particularly if Japan becomes significantly more attractive to global portfolio managers.
A precipitous dropoff in housing activity and home prices and/or a sharp shift in oil prices are the major threats we see to continued US economic growth. So far, the Fed has done its job with controlling rates to allow growth for the economy and keep inflation at bay, with the current Federal Funds rate at 4.25%. An overtightening policy could severely damage housing, and possibly the overall economy. The ups and downs in the price of oil could either be a positive or negative for growth. Any sharp swing out of the range of $45 to $70 a barrel would affect growth and overall inflation.
