Capital Markets Commentary
by Jim Baird
Universal Advisor, 2007 Issue No. 1

For the U.S. economy and capital markets, 2006 was a year of transition. At its outset, strong growth and bubbling inflationary pressures were the dominant themes. In the first quarter, total gross domestic product (GDP) grew at a 5.6% annualized rate. Since that time, quarterly GDP has softened substantially to around 2% annualized. Much of this slowdown can be attributed to the delayed effects of the Federal Reserve’s 17 consecutive interest rate hikes over a two-year period and an overextended housing market.

Although advance estimates of fourth-quarter GDP aren’t yet available as this is written, recent data and comments from the Fed in its most current beige book suggest that the economy likely stabilized in the fourth quarter. Consensus estimates are now even calling for a stronger-than-expected rebound in growth for the quarter to about 3.0% annualized. Strong wage growth, tight labor markets, and a pickup in consumer spending and retail sales throughout the quarter are early indicators that should translate into nominal economic expansion, the first piece of the Real GDP calculation. Inflation, the second portion of the Real GDP equation, is also showing signs of moderation. The Consumer Price Index rose by just 2.5% in 2006, well below its mid-year peak of 4.4% year-over-year and its 3.4% clip for 2005. While the core CPI rate, which excludes food and energy prices, was up slightly over its 2005 level, its fourth quarter annualized rate was a mere 1.4%, further supporting the argument that the cyclical inflation rate has peaked and is headed toward a level more palatable to the Fed.

If current expectations are met, it appears that a “soft landing” will have been achieved. If so, such a result would be about as good as could be hoped for under the circumstances.

While this recent news is good, the housing and manufacturing sectors have struggled of late and serve as a reality check for the overly optimistic. The residential real estate market continued its descent into recession throughout much of 2006. Recent data suggests that housing stabilized a bit late in the year, although it’s far too early to suggest that the market has bottomed. Even so, sales levels remain well below their peaks, and the inventory of unsold homes remains high.

Manufacturing also struggled during the quarter, pulled lower by a slumping auto industry. In November, the Institute for Supply Management reported that its index of manufacturing activity fell to 49.5; a measurement below 50.0 is a sign of contracting factory production. The index rebounded to 51.4 for the month of December, a nominally positive result suggesting at least moderate expansion in factory activity for the month. As with the housing data, this may represent an inflection point in manufacturing as well, but it’s too early to make that determination.

Despite the aching housing and manufacturing sectors, the relative impact of either has thus far been less extensive than initially feared. The full impact of the housing slowdown on employment in that sector remains to be seen, due to the lag that results from builders completing projects in process despite the slowdown in volume. Conversely, the service sector, which now makes up nearly 80% of jobs in the United States, has proven resilient and largely unaffected by that slowdown. A healthy service sector has been the engine for an overall solid job market. Nationally, jobs remained plentiful in the fourth quarter, with the unemployment rate hovering at 4.5% in December. The tight job market has generated an uptick in real wage growth as well. For the year, average hourly earnings are estimated to have grown about 4.2%. With real wages posting solid gains and energy prices coming down significantly from record levels earlier in the year, consumers have maintained their capacity to spend, despite the negative “wealth effect” of declining home prices.

Economists worry that the tight job market and resulting wage appreciation will put additional upward pressure on prices. In our estimation, this is a valid concern. Ideally, wage growth is supportive of GDP growth vis-à-vis consumer spending. Excessive wage growth that generates excessive spending will eventually destabilize prices, however, pushing inflation higher. To date, this cyclical uptick in the rate of wage increases has not been enough to offset declining energy costs and home prices that have taken inflation lower.

Inflection points in the economic cycle present increased difficulty from a forecasting perspective. Conflicting signals are always present, and one can always find statistics to support a pessimistic outlook. The current economic environment is not ideal, most notably in housing and manufacturing. Nonetheless, the actions taken by the Fed over the past few years, coupled with natural market forces, appear to be paying off. While a repeat performance of the strong equity returns of 2006 appears unlikely in the coming year, we remain moderately upbeat about the near-term outlook for the economy and capital markets.