Economic Outlook
A Changing Backdrop

The end of the second quarter of 2006 witnessed a rally in both the stock and bond markets for three reasons: first, the markets approach Fed meetings with the same trepidation as we treat a visit from a cranky relative - both of us are just happy to get it over with. Secondly, there was relief that the interest rate hike was 25 basis points, not 50 basis points. And third, the nature of the comments from the Fed was slightly more dovish than expected, and much more dovish than any recent Fed comments. Despite this rally, which helped to bolster the quarter, the S&P 500 Index ended in negative territory, with a -1.45% return and a year-to-date return through June 30, 2006 of +2.69%. The broad bond market, as represented by the Lehman Brothers Aggregate Bond Index, on the other hand, returned -0.08% for the quarter, with a year-to-date return of -0.72%. The Lehman Brothers Intermediate Bond Index fared slightly better, returning +0.21% for the second quarter, with a slightly negative return year-to-date of -0.17%.

Interest rates continue to dominate the psychology of financial markets. Concerns over inflation still have investors anxious about economic growth going forward. Leading economic indicators, the durable goods report, and housing permit activity shows that the US economy is indeed slowing from its brisk first quarter pace. The persistent concern is that the Fed will raise rates so high that it will stunt economic growth and bring the housing market to a harder landing than expected.

US housing market activity, which has been one of the main supports of the economy, continues to weaken, with confidence in the industry at its lowest level since 1995, according to the National Association of Home Builders. The following chart shows the inventory of existing homes for sale in the US, which rose 5.5% at the end of June, and is up 41.0% from one year earlier. These rising inventories reflect the slowdown in the US housing market; however, it is important to remember that the measurements come from a period of an historically frothy housing market, and vary from month to month. In a typical down cycle, housing starts drop to half of their peak value and the share of residential construction in the Gross Domestic Product (GDP) drops by two percentage points. If that were to happen at this point in time, GDP growth could easily dip below 2%.

Despite this weakness in the housing market, consumer sentiment bounced back slightly in June after the index dipped in May, as can be seen from the following chart.

While consumer sentiment improved, consumer expectations about changes in prices took a dip. The single most important contributor to a heightened state of concern in recent weeks has been the release of worse-than-expected US consumer price data. Higher oil and gas prices have been a contributor to accelerating price pressures, given the tight supply/demand balance in global energy markets.

Core CPI, which excludes often volatile food and energy prices, increased 2.4% year-over-year, the highest increase since February 2005.

Potentially adding to inflationary pressures is a weakening US dollar. The dollar is down about 6.0% so far this year versus other major currencies, and many are forecasting further declines, particularly if the Fed stops raising rates while other central banks around the world raise rates. But so far there’s been little sign that exporters overseas are raising prices, which could boost the price of imports.

Currently, consumers are struggling with over $3-per-gallon gasoline. Retail sales in May edged only 0.1% above April. The broader message from sales is that weak consumer spending is going to be a big drag on overall economic growth, although business spending is expected to offset the decline in consumer spending. We feel that the US economy will moderate through the remainder of 2006, with the threat of increasing inflation and persistently high commodity costs.