From the January 01, 2007 issue of Futures Magazine • Subscribe!

2007 Economic outlook

While interest rate forecasts lately seem to change with the wind, there is some consensus coming from economists on this year’s economic outlook. The housing slump seems destined to be the main negative factor for the economy, the Fed will focus very closely on labor and inflation numbers, and many even agree on the economy’s wildcard — the dollar. If foreign investors diversify and sell greenbacks, most analysts agree the U.S. economy definitely will take a hit.

“The wildcard could be the sudden loss of international confidence in the dollar,” says Dr. Dan Seiver, economist with Wizetrade ThinkTank and visiting professor of economics at San Diego State University’s finance department, explaining that if this does occur the impact would be very negative on the economy and the U.S. stock market. What would it take for this to happen? If China and Japan begin to diversify, Seiver says this would lead to weakness in the dollar.

Cary Leahey, senior economist with Decision Economics Inc., explains, “China is holding $1 trillion in U.S. assets in reserve, if they dump these someone else would buy them, but they would buy them at a more favorable price, providing a potential ugly drop in the dollar.” According to Seiver, “We are stuck in a crazy dance with China. And neither of us can stop dancing.”

But while the dollar right now appears to be an unknown for 2007’s economy, the housing market’s effect this year is quite clear to most economists and analysts: the housing market will be a significant drag on the economy.

James O’Sullivan, U.S. economist with UBS Securities LLC, explained late in 2006, “[The housing market] will drag down growth for the next couple of quarters. There will be a decline over the next year.” O’Sullivan is referring to housing prices. He says as a result consumers will have less wealth, less equity, to tap into, which in the end may result in less consumer spending.

Seiver, like most economists, agrees with O’Sullivan, saying the housing sector will hold back this year’s economy. He expects the housing market to stay weak for another year if not longer. Leahey says the earliest he sees the housing market improving would be the third quarter. “It is definitely the 800-pound gorilla on the economy’s back.”

The data supports housing market bears. The National Association of Realtors’ reported on Nov. 28 that the price of existing homes sold in October fell for the third straight month and posted the biggest drop on record. The association said the median price of a home sold in October was $221,000, down 3.5% from October 2005. Data in November also showed a drop to a six-year low in new building starts.

In addition, major builders have seen sales and earnings fall. Barry Ritholtz, chief market strategist for Ritholtz Research & Analytics, says the real estate market is still free falling and the sector is not close to the bottom. “Everything that was real estate affiliated is now problematic, causing a significant impact on the overall economy,” Ritholtz says. He adds real estate is in a recession and the question is whether it will spread to other sectors.

LABOR TAKES THE STAGE

Despite a significantly cooler housing market, which has been accompanied with job losses in this sector, the employment climate is strong. The U.S. unemployment rate dropped to a five-year low of 4.4% in October as employers added 92,000 new jobs. This marked the third month in a row that the jobless rate declined. However, some economists and analysts are not particularly optimistic going forward in regards to labor numbers. “While the United States has not seen a clear, consistent weakening in labor numbers, it is only a matter of time,” O’Sullivan says. He points out unemployment rates will be one of the keys to the Fed’s decision in lowering interest rates. Jim Goulding, fixed income trading coach and analyst at Goldenberg Heymeyer & Co., agrees the Fed will stay keenly focused on the labor market. “I expect to see an increase in volatility in labor numbers in 2007,” he says.

And in late November, Federal Reserve Chairman Ben Bernanke made it quite clear that labor costs are on his radar screen. The chairman is worried that a new source of inflation may be found in rising wages and salaries. Wages and benefits for U.S. workers rose 1% in the third quarter of 2006, the most since 2004. In a Nov. 28 speech before the National Italian American Foundation, Bernanke said, “The more worrisome possibility is that tight product markets might allow firms to pass all or part of their higher labor costs through to prices, adding to inflation pressures.” While no one argues inflation is on the mind of the Fed, some analysts are saying inflation will become tamer. “Inflation is still above the Fed’s comfort zone, Seiver says, “However, I see the tendency for inflation to run out of 2007’s economy.” In late November, the government reported that inflation, using the index that subtracts food and energy from consumer expenditures, rose at a 2.2% annual rate.

So what does a solid job market combined with a falling housing market mean for the economy’s growth? In the third quarter of last year, the economy grew at a much faster rate than originally estimated. Gross domestic product grew at a 2.2% annual rate in the third quarter. However, GDP forecasts from analysts for this year differ rather widely. But most agree the beginning of the year will be the challenging half. “I see an annual GDP of around 3.5%,” Goulding says, explaining that he sees the first quarter of 2007 experiencing the lowest numbers. Ritholtz’s forecast is less rosy. “From a macro environment there are a lot of risks that could hurt the economy. We are looking at a GDP for the first half of the year at or under 1%,” Ritholtz says. Then there are those analysts who are forecasting sub par growth. O’Sullivan, for instance, sees an average of 2% growth throughout the next year. More specifically, his firm’s forecast calls for 1.8% growth in the first quarter, 1.9% growth in the second quarter, 2.3% in the third quarter and the fourth quarter ending on a high with 2.7% growth.

Seiver’s forecast is in line with O’Sullivan’s. He says he would not be surprised if GDP only reaches 2% in 2007. He points out that because of the slow housing market in the first half of 2007, consumers will not be able to refinance their mortgages as inexpensively, which will take a toll on consumer spending. “I do not see consumer spending being able to propel the economy in 2007,” he says. Leahey’s forecast is slightly higher, predicting GDP growth for the year to average around 2.5%.

FUTURE OF INTEREST RATES

With the inflation indicator dipping and economic growth faster than expected, how will interest rates be influenced? After Bernanke’s “worrisome” increase in inflation and his comments indicating the economy seemed rather healthy, some economists starting saying in late November that the Fed may actually raise rates rather than cut rates early this year.

On the other hand, analysts putting a heavy emphasis on housing and manufacturing reports see a slowing economy that could result in rate cuts for early 2007. “We certainly think growth is slowing and the Fed will cut interest rates in 2007,” says O’Sullivan. He expects to see a quarter-point cut in March followed by three more quarter-point cuts in the remainder of the year, bringing the Fed’s fund rate back to 4.25% before the end of 2007. In late November, the Fed funds rate stood at 5.25%, where it has remained for three meetings after raising rates 17 times in two years.

Like O’Sullivan, Ritholtz is calling for a cut in interest rates in the first half of 2007. But Seiver’s view may be the closest to the mainstream press’ most printed view in late November, which was no rate change. “I see interest rates relatively flat in 2007,” Seiver says, adding, “We are likely to go through most of the year leaving interest rates close to where they are.” He says the Fed still sees too many risks and says they will not be ready to cut rates in the first half of the year. Leahey disagrees. “We see an upward slant with a gradual creeping up of interest rates with one more 25 point tightening by the Fed,” Leahey says.

A POSITIVE SIDE?

One thing to keep in mind is even with a cooling housing market and less than glowing GDP predictions, analysts do offer some positives for this year’s economic outlook. O’Sullivan points to business investments and healthy exports. And Leahey notes economies in the G7 countries are averaging around a 2% to 3% GDP, which means there is an equalizing in the growth differential, which is positive for the global economy. “Non-China Asia and Latin America have weathered interest rate hikes quite positively,” Leahey says. In addition, analysts’ immediate responses when asked about the war in Iraq and its effect on the economy are not as dire as they might have been if asked months ago. For instance, Leahey says, “If [the administration takes] money out of Iraq it will go somewhere else.”

Ritholtz says spending on homeland security will continue to go up if we are in Iraq or not.

Maybe the most positive outlook comes with the stock market. With the exception of some indigestion here and there, through late November the stock market has withstood a cooling housing market and other poor economic indicators.

And for those who side with the idea of increased inflation, equities may have even more good fortune in the future, because stocks often perform well in inflationary environments.

Many analysts are predicting 6% to 8% return for this year’s stock market. Goulding, however, sees a positive that may warrant the attention of all active traders. He sees normal volatility from January through June, but says volatility will increase after June and will finish the year very busy. He says this first quarter will offer the most opportunities for traders and that they may want to take advantage of trading bigger sizes during this time.

“Traders should feel confident increasing their size as long as they have money management in place,” Goulding says.

Carla M. Bauch is a freelance writer in Chicago.

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