Economic Outlook
Globalization - Here to Stay

The US bond market outpaced the US stock market in the first quarter of 2007 with the Lehman Brothers Intermediate Index returning +1.59%, and the Lehman Brothers Government/Corporate Index returning +1.47%. In contrast, the S&P 500 Index, a broad measure for the US equity market, returned +0.63%, and the Russell 1000 Growth Index, returned +1.19% for the first quarter of 2007. The MSCI Europe Australasia Far East Index (EAFE), which measures the performance of international equity markets, returned +4.08% for the quarter.

The global economy has become increasingly more integrated, intensifying competition and placing downward pressure on prices. We have seen an improved flow of knowledge, capital and goods move more freely between countries. This has enhanced the development and spread of innovation and technology, thereby improving productivity growth. When it comes to keeping inflation in check, productivity is a virtue, no matter where you reside in the world.

Indeed, it appears that US inflation is in check, and inflationary pressures are set to recede later in 2007 as overall economic growth remains below potential. Favored core measures (excluding food and energy) have remained stubbornly above the Federal Reserve’s (Fed) implied comfort zone of 1% to 2%, due in large part to elevated housing prices. However, the markets and the Fed broadly anticipate inflation to moderate going forward.

Analysts and pundits alike are claiming that the recent high-profile failures in the subprime (lower credit quality) mortgage market are in reality a small part of the US economy, and that the “crisis” is manageable. However, we feel that it will not be loan losses that threaten future economic growth, but the tightening of credit conditions that are in part a result of those losses. Lender fears of potential new regulations will begin to restrict additional lending. Tighter lending standards and increased regulations will change the investment outlook for some time to come.

While the Fed must be cognizant of an array of asset prices in addition to housing, the housing market is one of the keys to future economic trends, and therefore fundamental to the outlook for consumption. Consumer spending, the primary driver of US growth, is the most closely watched sector of the economy. Currently, while a low unemployment rate and solid income growth have been underlying supports, consumer spending has slowed in response to higher oil prices, some slowing in the rate of employment growth, and concerns for a slowing US economy.

As in the US, there are indications that growth around the globe may be moderating somewhat, one reason why global inflation trends remain quite favorable. Economies in India, China, and many other emerging markets are still growing robustly. In developed countries, although there are some indications of a slowing in growth, the most recent report by the European Commission shows the Economic Sentiment Indicator (the European Union equivalent of the US Consumer Sentiment Indicator), has the highest reading since January of 2001.

Economic fundamentals continue to support higher oil prices, and Iran’s continued defiance has prompted resurgence in the geopolitical risk premium that is currently priced into oil futures. The combination of raging geopolitical tension, strong motor gasoline demand, weak refiner activity, and the potential for additional supply disruptions far outweigh the downward drag that a potentially slowing US economy is causing on oil’s short term pricing momentum.

In recent years, US consumers and businesses have shelled out more and more dollars to buy Chinese goods and Middle Eastern oil, and most of those dollars came back to the US in the form of stock and bond investments. At first, most of the investment was in Treasury bonds. More recently, the investment has been wide-ranging, from stocks to residential mortgage-backed securities to hard assets like office towers. The US current account deficit is, of course, the mirror image of other nations’ current account surpluses, the source of the so-called global saving glut. With the weaker dollar and stronger global growth now cutting into the US trade and current account shortfalls, fewer dollars will be going overseas, and thus there will be fewer dollars for such investment.

The current consensus continues to reduce 2007 GDP growth expectations, which now fall in the range of 2 to 3%. We believe the range will fall in the 2.0% area, later in the year. Consumption growth will slow as moderating housing prices act as a drag. However, business investment should bounce back from the weak fourth quarter of 2006, and trade should generally be a positive.