Economic Outlook
The Big Picture

Both the US bond and stock markets ended the year with respectable returns. The US bond market had very strong returns for the quarter, with both the Lehman Brothers Intermediate Index (LB/INT) and the Lehman Brothers Government/Corporate Index (LB/GC) both returning 1.0% for the quarter. The annual return for the LB/INT ended at a respectable +4.1%, with the LB/GC returning +3.8% for the year. Two measures for the equity market, the S&P 500 Index (+6.7%) and the Russell 1000 Growth Index (+5.9%) had robust quarterly returns. For the full year 2006, the S&P 500 Index (+15.7%) outpaced the Russell 1000 Growth Index (+9.1%).

A mild and brief deceleration of global economic growth is anticipated in 2007 due to the lagged effects of tighter global monetary policy and still-high raw materials prices. The slowdown will be most marked in the US. Steady investment and consumption growth in much of Europe, Latin America and Asia, not to mention continuing years of strong growth in the major emerging markets, will ensure that the overall numbers remain healthy.

The US dollar will remain weak and is likely to slide lower. Certainly any weakness in the US economy and the huge US trade deficit won’t help, but the dollar’s slide in 2007 is almost guaranteed by the international interest-rate cycle. The US Federal Reserve (Fed) has stopped raising interest rates for now, but the central banks of Japan, the European Union, India and China are still in rate-increase mode. As these rate increases close the yield gap that currently favors the US dollar, the dollar becomes relatively less attractive to global investors.

Oil prices will remain high by historical standards. We can’t say when or if oil prices will spike back toward $80 a barrel. We can say with reasonable certainty that oil prices will stay high enough in 2007 to keep oil-company exploration and drilling at high throttle and to attract capital to high-cost projects ranging from Alberta’s oil sands to Qatar’s liquefied natural gas plant to windmills in Spain and ethanol plants in Iowa.

Some data suggests slower growth for the US economy, and some data suggests faster growth. For example, factory orders and durable goods orders had recent substantial drops in their numbers, pointing to slower growth. However, numbers from the Institute for Supply Management (ISM) Services Index came in much higher than the consensus expectation, indicating that the service economy is expanding.

The Fed has recently made a concerted effort to convince the financial markets that its next move will be to raise rates again. This is, in large part, due to its focus on the level of US inflation, with the core rate, which removes volatile food and energy prices from the index, now at 2.9%, its highest rate for the decade. We are not convinced and, in fact, our interpretation of all the data leads us to believe that the Fed will hold off until the second half of 2007 and could actually cut rates at that point in time.