Economic Outlook
Not Too Cold, A Little Too Hot?

The first quarter of 2006 ended with all US equity market indices in positive territory. The two major broad equity market indices, the Dow Jones Industrial Average and the S&P 500 Index, both gained 4.2% for the quarter. The Lehman Brothers Intermediate Bond Index, which gauges the overall bond market, returned -0.4% for the quarter, with the Merrill Lynch Government Corporate Bond Index returning -1.0% for the same time period.

A view most widely held by economists, investors and Wall Street pundits is that the US economy is in a “Goldilocks” phase, that is, it is not too hot, not too cold, but just right. To be sure, the Federal Reserve (Fed) has successfully checked any fears of an increase in core inflation, while implementing a remarkably orderly moderation in economic activity. Up to this point, judging Fed policy has been relatively easy. Back in June, 2004, the Fed essentially told the markets it was going to lift its target rate from the highly stimulative 46-year low of 1.0%, to a more neutral level historically consistent with healthy growth and low inflation. The patterns in the economic data, to this point, have played only a small role in the Fed’s actions to raise rates. With the Fed’s target interest rate now at 4.75%, following its fifteenth quarter-point hike in as many meetings, its ability to determine whether the 4.75% rate is high enough to insure that inflation will stay under control has more uncertainty surrounding it, and this uncertainty will translate into more volatility in the coming year.

There are several factors that lead us to think that the economy may be heading to a point where it is a little “too hot”, which we believe will lead to increased inflationary pressures and continuing action from the Fed.

While the fourth quarter GDP measure of 1.7% was the slowest growth in nearly three years, the Fed said that it “reflected temporary or special factors.” To prove this point, despite a meager 0.1% increase in February, inflation-adjusted consumer spending, which accounts for about two-thirds of the GDP, remained on track to grow at a pace of nearly 5.0% annually, a definite snap-back after a slim 0.9% advance in the fourth quarter of 2005.

The Conference Board’s Index of Consumer Confidence jumped to its highest level in nearly four years during March 2006. Over the last ten years, there has been a 66% correlation between the level of consumer confidence and the annual change in real consumer spending. As can be seen in the following chart, the percentage of respondents who viewed jobs as plentiful jumped to 28.4%, the highest since 2001.

If all factors remained status quo, we would agree with the “Goldilocks” view of the economy. However, we see two more rate hikes to ward off inflationary pressures that we see coming from the following areas:

• As we mentioned in the last Oakwood Outlook, we view the surprising uptick in the US dollar in 2005 as an interruption of a longer-term decline in the dollar. The strength of the dollar has been a key ingredient in the easing of inflation. A strong US dollar has the effect of lowering import prices, with the overall pace of nonfuel import prices easing, on average, from 2.7% down to 0.8% in the past twelve months. However, the underpinnings for the stronger dollar are set to fade. The European Central Bank is continuing to sound hawkish and the Bank of Japan is ending its accommodative easing. Global economic activity is expected to accelerate this year even as the US economy settles into a more modest rate of growth. As a result, the demand for the US dollar should wane, eliminating the inflation-dampening effects of lower import prices.
  
  
• Another pressure on prices is the inability of US manufacturers to keep up with orders. Output is already outstripping the growth of new production capacity. This is pushing up operating rates and giving companies more leeway to lift prices.
  
  
• Labor markets are stretched thin, and with ongoing efforts at Gulf Coast rebuilding, we look for a strong rise in payrolls and an unemployment rate around 4.8%.

What we envision for the remainder of 2006 is a market that is glued to the numbers. The Fed and investors alike will be attuned to each new squiggle in the charts to try to identify trends in economic growth and inflation. The upshot of this focus will be that each economic report will take on increased significance for the markets for the balance of the year. Data surprises may pack more punch than they have to date. Our experienced and knowledgeable investment professionals will monitor and interpret the data along with everyone else, but as we outlined in the Word from the Advisor, the main approach at Oakwood is to identify themes that will provide our investors with excellent long-term investment results for the “long haul”.