Economic Outlook
Moderating Growth with Room for Opportunity

The US economy is fortunate to have many positive influences affecting it, among them strong employment figures, the ongoing benefits of a period of low interest rates, a relief in gas prices, and a forecast for a relatively mild winter. These influences contributed to a third quarter of 2006 that witnessed decent returns in both the stock and bond markets. The intermediate bond market, as represented by the Lehman Brothers Intermediate Bond Index fared well, returning +3.20% for the third quarter, with a year-to-date return of +3.02%. The broad equity market, as represented by the S&P 500 Index returned +5.66% for the quarter, bringing its year-to-date return to +8.50%. The Russell 1000 Growth Index, consisting of those companies in the Russell 1000 Index with higher than average price-to-book ratios and forecasted growth, returned +3.94% for the quarter, bringing its year-to-date return to +2.97%.

Most economic releases from the third quarter point to continued health in the US economy, with only a moderation in growth. Inflation and housing were prominent stories during much of the quarter.  Recent data show inflationary pressures heading in a favorable direction. Though consumer prices, excluding food and energy, remained elevated, wholesale prices at the core level declined in both July and August, which could suggest some easing in retail inflation in the coming months. Many on Wall Street expect this trend towards moderation to continue, particularly given the pullback in commodity prices.

The verdict is still out on how much the housing market will soften before it’s all said and done, but weaker than expected permit data shows further declines in housing supply on the way. Year-over-year existing home prices declined for the first time in 11 years. With plenty of inventory on the market and buyers hesitant to make moves at the current time, it may still be some time before demand stabilizes. Mortgage rates have been relaxing. This couldn’t come at a better time for the housing market which could desperately use help to lure potential homebuyers back to the bargaining table.

Even though oil prices have more than doubled over the past three to four years, it surprises some that this increase hasn’t caused more damage to the economy. The lack of a more averse reaction is caused by several factors, including:

1. Oil is a smaller share of the economy than it used to be. The US uses half as much energy per dollar of output (constant dollars) as it did in 1970.
   
   
2. Oil is a smaller share of energy (35% compared with 44%) than it was in 1970, diluting the impact of oil prices on growth.

Let’s keep oil prices in perspective. Recently, prices fell below the $60 level, which earlier this year was considered high, and is now considered low. The Organization of Petroleum Exporting Countries (OPEC) is now adjusting production to defend the current price level of around $60 a barrel. A steep drop in oil from current levels may over stimulate the economy and force the Federal Reserve (Fed) into more interest rate tightening. This may not be good for either the stock or the bond market. Though fears surrounding potential supply disruptions have subsided, it doesn’t take much to reignite these concerns. In the meantime, oil’s dip below the $60 per barrel level and prices at the pump falling across the country helped to boost consumer confidence late in the quarter.

In each of the four full years of this economic expansion, a widening trade deficit has subtracted anywhere from 0.3 to 0.7 percentage points from overall growth. Two factors may provide some relief to these perennial downbeat reports. First, growth outside the US is picking up even as domestic growth is moderating, causing real exports to pick up. Second, there has been a broad decline in the dollar, after a period of strengthening last year. The lower dollar represents a de facto rise in the competitiveness of American products in the overseas marketplace. These factors may make 2006 the first year in a decade that the trade deficit stops being a drag on economic growth.

Overall, the US economy seems to be healthy, and is transitioning to a slower, more sustainable growth rate. We are mindful, however, that challenges remain in the months ahead, and are continuously monitoring data from both consumer and business sectors to identify areas of weakness that represent opportunities for our clients.