CLIENT BULLETIN

2005 REVIEW – 2006 OUTLOOK

 

2005 – A Strong Economy and Low Inflation

Our fundamental assumptions for 2005 as outlined in last year’s Review and Outlook called for the economy to slow to the 2-3% range by year-end and for inflation to remain at very modest levels.  As it turned out, our inflation forecast was right on target, however, our growth outlook for the U.S. economy was too pessimistic. 

As of the end of the third quarter 2005, U.S. Gross Domestic Product (GDP) growth had exceeded 3.0% for ten consecutive quarters, the longest string of plus 3.0% increases since the thirteen quarters ending in 1986.  The fourth quarter should also be in solidly positive territory.  It has been a truly remarkable performance, particularly in light of rising interest rates and surging oil prices. 

At the risk of appearing foolishly consistent, we are once again forecasting that 2006 will see slowing economic growth along with stable to lower inflation.  At this stage of the business cycle, GDP growth is coming primarily from consumer spending and not from corporate capital expenditures.  As we describe below, the consumer side of the equation is about to change.  There should be some increases in industrial and technology spending, but not enough to offset a more subdued consumer outlook. 

Housing – Surged in 2005; Weakening in 2006

The greatest appreciation ever in existing home prices over a twelve-month period (up an average 13% nationally) spurred consumers to spend well beyond their means in 2005.  Consumers tapped into the increased value of their homes with Mortgage Equity Withdrawals reaching nearly $800 Billion in 2005.  In the 1960’s and 70’s, these types of loans were virtually zero. 

However, as we begin 2006, nearly every measure of house pricing and activity has slowed.  Tighter regulation of mortgage loans, inventories of existing homes at a 19-year high, and higher energy costs have served to cool off the torrid pace of real estate activity.  The surprising 11% decline in new home sales and the 1.7% drop in existing home sales in November are indicative of what should be a tougher year for the housing market.  This weakness in real estate should quickly translate into slower consumer spending, more subdued GDP growth and the likelihood that the Federal Reserve will begin to lower rates later this year. 

Inflation – The Key to our 2006 Strategy

Inflation trends are the single most important factor in determining our overall asset allocation and bond maturity structure. These trends also effect valuation in the equity markets.  The continuation of low inflation remains the cornerstone of our investment thinking for 2006. 

The transfer of production and some services from high cost regions (Germany, U.S., Japan) to low cost regions (China, India, Russia and certain former communist bloc countries) have lowered overall inflation despite higher prices for oil and other natural resources.  As we have stated in previous Client Bulletins, the forces of global competition, technology and productivity cannot be stopped.  The global glut of labor and capital, which comprise two-thirds of total costs, will serve to keep inflation low for the remainder of the decade. 

Core consumer inflation is up only 1.8% year over year and slowing.  Core Producer Price inflation is up 1.9% and slowing.  Unit labor costs have actually fallen by more than 2.0% in the past two quarters.  As it becomes more evident that higher energy prices have not filtered into the general price structure, inflationary expectations, which began rising last Fall, will recede. Tame inflation will keep interest rates low and this is bullish for both stocks and bonds. 

Fixed-Income – Yield Curve Continues to Flatten

The bond market was buffeted all year by the cross currents of low inflation, strong economic data and persistent increases in short term rates by the Federal Reserve.  Although the benchmark U. S Treasury 10-year Note briefly fell below 4.0% as we expected, the ongoing strength of the U.S. economy prevented a sustainable decline in intermediate and long-term rates.  After much volatility, the 10-year Note, which began 2005 at 4.25%, closed out the year with a small yield increase to 4.35%. 

Considering the increase in short-term rates, higher energy prices, ballooning budget deficits and soaring real estate values, the stable performance of the bond market has been impressive.  The purchase of U.S. debt securities by foreign central banks has clearly helped to keep bond yields lower than would normally be expected.  We did not achieve any capital appreciation in our overall bond positions in 2005.  If our forecast of lower economic growth in 2006 is reasonable, our bond positions should gain in value, in addition to providing a durable stream of interest income. 

Equity Markets – Lackluster at Best

Similar to the bond market, equity returns in 2005 were meager at best.  Virtually all stock market indexes posted low single digit total returns with the Dow Jones Industrial Average recording a gain of less than 2.0% for the year.  This was the smallest change in the DJIA since 1896! 

With corporate profits continuing to grow at double-digit rates and valuations attractive, why were stock returns so lackluster in 2005?  The most reasonable explanation is the relentless increase in interest rates by the Federal Reserve.  Historically, rising short-term rates have been a significant obstacle to stock market returns.  Until investors begin to anticipate an end to the Federal Reserve’s tightening cycle, stock market gains will be limited.  We believed that this anticipation would occur by the end of 2005.  Although we were premature with our forecast, we strongly believe that investor expectations of a more accommodative Federal Reserve will occur in 2006. 

The health of corporate America continues to improve.  Cash as a percentage of assets is the highest since 1962, while balance sheet liabilities are the lowest since 1987.  As a result, we expect further dividend increases, stock buybacks, and more merger and acquisition activity, all of which are positive for stocks.  U.S. stocks have significantly lagged the global markets since October 2002.  With foreign capital now moving into U.S. securities at a rate of $100 Billion per month, we look for U.S. stocks to improve their relative performance over the year ahead. 

One negative factor looming on the horizon is the failure of Congress to extend the dividend and capital gains tax cuts due to expire in 2008.  Hopefully, they will do so this year.  In addition, all financial markets will have to deal with the end of Alan Greenspan’s 18-year tenure at the Fed and the beginning of the Ben Bernanke era.   

Summary and Outlook

Our core assumptions for 2006 focus on an end to Federal Reserve increases in short-term rates, a continuation of only modest inflation pressures, and a slowdown in economic growth led by a softening in real estate markets.  The risks to our forecast are that the global economy stays robust, slower housing doesn’t lead to a consumer slowdown, energy prices spike higher, and/or the Federal Reserve continues to lift short-term rates. We will closely monitor all available data to detect any variance from our fundamental outlook. 

As the yield curve continues to flatten, and short and longer-term rates converge, bond investors seem to believe that the Federal Reserve tightening cycle is nearly over. If this is correct, stocks will encounter a better environment in 2006 and are likely to produce solid positive returns.         

Although we look for bonds to provide some capital appreciation in 2006, our overall view on the economy, inflation and interest rates is even more beneficial for the equity markets.  As we begin 2006, we will bias client accounts toward equities, with below average exposure to fixed-income securities.