Market Commentary
learly, the recent performance of the stock market suggests the broad acceptance that the Fed is succeeding in moderating economic growth enough to slow inflation without moving the economy into recession. None of the concerns that could have had a negative impact on the markets materialized in 2006. There were no major terrorist attacks or natural disasters in the US; the slide in value for the dollar did not collapse the market; the housing market concerns did not turn off consumer spending, and the Federal Reserve did not push rates too far, despite their ongoing public comments which reflected downside economic risks and continued worries over inflation.
The facts are, double digit annual growth in corporate profits has continued for 18 quarters, helping the equity markets to rise through a period of rising interest rates and slowing economic growth. The question now is whether corporate profit margin expansions will slow, or even die off with the slowing economy in 2007?
The soft landing that we talked about in prior updates seems to be proceeding nicely. Slower economic growth is reducing inflationary pressures and lower or stable energy prices could further ease core pressures over time. Recent inflation data supports the premise that inflation pressures are easing and the prospect for continued progress is good. Weakness that bears watching is evidenced in some recent same store sales data at casual restaurants and mass retail companies and they suggest the housing slow down has affected consumers. Also worth noting, the pressure on homeowners with adjustable rate mortgages as interest rate payments reset to higher levels. On the positive side, consumers, in general, will receive the equivalent of a sizable tax cut due to lower energy prices.
More broadly, just a short time ago it was considered conventional wisdom that the Fed would lower short term interest rates early in 2007. However, that has changed very quickly in recent weeks. Now the expectation for any rate cuts from the current 5.25% has been pushed out to later in 2007, if any change at all. The shift in consensus has occurred for two reasons. First, it appears the slowdown in growth will not be so severe as to warrant a stronger Fed response. Second, the Fed has been clear their concern remains rising inflation driven by upward wage pressures. We believe the Fed will remain on the sideline and will only move to lower rates if growth slows dramatically and lower core inflation trends continue to decline.
The housing market has received a great deal of attention and concern. While housing is a big drag to economic growth, we do not think it will take a much stronger toll on consumer spending than it has already. This is supported by strong employment trends and the more recent positive trends to wage growth. Also, the 45% increase in December housing starts, along with existing home sales indicates that the housing market might be nearing a bottom. Home prices may continue to ease due to inventory issues, but from a GDP standpoint, the sharpness of the fall looks to be over.
The Fed has done a good job of managing monetary policy and the economy. The key going forward is for inflation to stay near 2%. The current trends are positive, but if inflation picks up, the Fed will raise rates as necessary with economic growth the victim. That said we believe 10 year treasury yields are likely to remain below 5% through 2007. Outside of inflation, the other risks to the economy continue to be potential external shocks related to geo-politics and oil prices. If we avoid the risks of lower inflation combined with slower but still decent economic growth, this will provide a positive environment for the markets. Economic growth has returned to its long term trend of about 3% and a continuation of this trend is critical to our outlook for the markets.
Where then, do we see the markets going forward? We retain a cautious stance similar to early 2006 for the following reasons. While geopolitical issues remain an ongoing concern, positive market returns will either be determined by the health of the economy and corporate profitability or will succumb to the constant media spin of the ‘housing bubble’; a debt-heavy consumer; an economy in slow down mode and a declining dollar. These were essentially the same issues that gained our attention as we began 2006. While we believe it is likely we will see some downside volatility in 2007, we believe that on balance, the markets will produce positive returns for stocks in line with historical trends.
Continued global growth could help offset any weakness in the US, especially aiding US companies that have heavy exposure to foreign markets. We expect corporate profit growth will slow in 2007 to about 8 to 9% as GDP growth slows to about a 3% rate and wage pressures begin to have some negative impact on corporate margins. The markets will have to adjust to these events as the resulting slowdown is logical given moderating economic growth and the very strong comparisons from 2006. The S&P 500 currently tracks at a multiple of about 16. 4 times 2007 earnings compared to an historical average of about 18.6 times during earlier periods of comparable inflation. Corporate earnings and balance sheets are in strong condition, facilitating future growth through acquisitions and capital spending. Earnings growth should be decent and interest rates essentially unchanged but there could be some choppy action over the near term as the excessive optimism of late 2006 gets squeezed out of the markets.
