The Value Line Investment Survey

The Quarterly Economic Review

The moderation in the economy is continuing as 2006 winds down. In some cases—notably housing—the deceleration in economic activity is intensifying. Otherwise, the picture is largely mixed. True, the sequential pattern in the gross domestic product is disturbing, with growth of 5.6%, 2.6%, and 1.6%, respectively, in the first, second, and third quarters of this year. Moreover, the housing slump is deepening and we're seeing softness in manufacturing, auto production, and consumer spending. On the other hand, nonmanufacturing activity is picking up; personal income is on the rise; non-farm payrolls are increasing at a fairly good pace, on average; and the jobless rate is at a five-and-a-half year low.

How serious is the slowdown in business activity likely to become? That is the principal question at this time. Our expectation is that the U.S. economy will remain on a generally slow track in the year ahead, with growth likely to average 2.0%-2.5% in the next few quarters, as the various economic sectors see their outlooks alternately brighten and dim as the business cycle unfolds. Our sense is that we are near the low point in the slowdown, with growth likely to be at the low end of the 2.0%-2.5% range in the current quarter and through the early part of 2007, before climbing back to the top of that range or a little beyond by the second half of the new year. We do not expect a recession to unfold in 2007, unless the housing downturn accelerates, oil resumes its climb, retail spending falters, or the Federal Reserve Board miscalculates on the interest-rate front.

All eyes will be on the Federal Reserve, as the nation's central bank endeavors to maintain a balanced monetary approach. The objective is to keep interest rates low enough to sustain the economic up cycle (even at this modest rate), but high enough to discourage inflationary excesses in labor and raw materials from taking hold. It is a delicate balancing act, to be sure, but one in which the Fed will need to realize success over the next year given the concurrent softness in the economy and the selective uptick in inflation in recent months.

Some attention also will be given to the global situation, where the war in Iraq rages on with no apparent end in sight. The standoffs between the United States and both Iran and North Korea linger on as well, even though the headlines periodically fade. One of the assumptions upon which our forecast of no recession in 2007 is based is that oil prices will hold near, or just modestly above, recent lower levels. Our energy price assumption would clearly have to be revisited if there were another military flareup in the oil-rich Middle East.

As always, there are risks to our forecast. The main risks would seem to be a deterioration in the tenuous global outlook, a runup in oil prices, a misstep by the Federal Reserve, or the enactment of ill-advised spending programs by the new Congress in an effort to jump start the U.S. economy. Such efforts can help the economy in the short run, but often increase the budgetary risks over the longer term.

SOME SPECIFICS

Economic Growth: As we noted, the economy's growth rate continues to moderate (Chart 1). However, we do not think we're yet on the cusp of a recession, as income levels continue to rise, the employment outlook is fairly bright, and nonmanufacturing activity is picking up (Charts 2 and 3). On the other hand, the consumer is being cautious on the spending side. This reticence can be seen in the deepening housing slide (Chart 4), weak auto production numbers, and a softening retail sales trend (Chart 5) as we enter the holiday season.

This deceleration in the economy can be seen in the sequential slowing in quarterly GDP growth in 2006. What's more, reports issued during the current period suggest that growth will not be appreciably better than the lackluster third-quarter level of 1.6%. We also don't expect much change during the first three months of 2007. Thereafter, the cumulative effect of falling oil and gas prices and lower longer-term interest rates could give the economy a shot of adrenaline by the second and third quarters. For there to a more substantial bounce next year, we'll need to see a recovery in the housing market. Such a revival may not get under way in earnest until 2008.

Our sense is that growth will step up a notch in 2008, with continued steady, albeit modest, strides through the end of the decade. GDP growth should average about 3.5% over the long term, with deviations from this average occurring from time to time, as domestic and global conditions change. It is also possible that a recession will develop at some point within our projection period, although the timing is difficult to predict.

Inflation: Inflation has been volatile to say the least this year, with wide month-to-month swings in producer (or wholesale) and consumer prices. The catalyst for this volatility has been energy. Earlier in the year, oil prices soared, with a barrel of crude briefly nearing $80. Since then, the froth has come out of the oil market and crude has fallen about 30%, to $56 a barrel. Whether or not this drop will be sustained is open to argument. Suffice it to say, lower oil and gas prices are a boon to the economy, as they put more cash in the pockets of consumers. Our forecast that the U.S. economy will avoid a recession next year, albeit narrowly, is based in large measure on the expectation that oil prices will be comparatively stable in the months to come.

However, oil isn't the only inflation statistic of note. Expenses for medical care, rents, labor, and raw materials also have been problems from time to time over the past year. The Federal Reserve's reluctance to lower interest rates at this time, notwithstanding the slowing pace of GDP growth, reflects its ongoing inflation concerns.

Going forward, our sense is that the slower pace of business activity will lessen the call for increased labor and raw materials use, thus helping to keep inflationary pressures at bay somewhat (Chart 6).

Interest Rates: The Federal Reserve raised the Federal Funds rate—the interest rate it controls directly—in 17 straight quarter-of-a-percentage-point increments from June 2004 to June 2006. Then, it stopped abruptly, with the past three Federal Open Market Committee meetings producing no change at all. This rate sequence is not as ominous as it sounds, though, as the Fed began tightening when the Fed Funds rate was at a multi-decade low of 1.00%. That probably explains why the economy continues to grow.

The Fed is now at a crossroads. If it resumes raising interest rates in an effort to further lower inflation, then it may risk tipping the economy into a recession. Should it start to reduce borrowing costs prematurely, it could unleash enough pentup buying in the retail, auto, and housing sectors to raise the rate of inflation. Hoping to establish a middle ground, the Fed seems inclined to keep interest rates where they are for now. Should there be a change in Fed policy in 2007, our expectation is that the lead bank will opt to reduce rates, but probably not until well into the new year. The best scenario, given the moderate level of rates at this time, would be for the Fed to maintain a stable rate structure indefinitely. We think the present level of rates is low enough to sustain modest GDP growth in 2007, but high enough to keep inflationary pressures at bay (Chart 7).

Corporate Earnings: Solid economic growth, careful attention to costs, the heavy investment in new plant and equipment and—for the most part—increasing productivity (or labor cost efficiency) have combined to produce a long period of uninterrupted profit improvement for much of Corporate America. Add in favorable news on the energy front (thanks to lower oil prices) and, in addition, moderating commodity cost pressures and it is little wonder that earnings growth continues to be quite impressive.

Now, however, slowing economic growth threatens to change things-at least a little, suggesting that the double-digit percentage profit growth of the past half decade is coming to an end. Now, we don't think earnings are about to reverse course abruptly and tumble. What we expect, instead, is moderation in the rate of profit growth from the 10%-15% range in place for most of the past several years, to a 5%-10% rate in 2007 and over the succeeding few years. This forecast assumes that we can avoid a recession next year. However, should the Federal Reserve not be able to orchestrate a so-called soft landing within the U.S. economy in 2007, our estimates would need to be revised.

THE STOCK MARKET

Sustained economic growth, the absence of a major inflation problem, a manageable level of interest rates, and strong profit growth are clearly a winning combination for investors. So it is not all that surprising the equity market is holding onto respectable gains as we enter the home stretch of 2006. For example, the Dow Jones Industrial Average, underpinned by solid performances by AT&T, Disney, General Motors, and Merck, is ahead by 14%, the Standard and Poor's 500 Index is better by 12%, the small-cap Russell 2000 is in the black by 18%, and the tech-heavy NASDAQ is up by 11%. Moreover, the list of new highs is swamping the list of 52-week lows on most days.

Can the market keep it up? Part of the answer will be supplied by the Federal Reserve and its interest-rate policymakers. Also playing a major role will be corporate earnings, oil prices, and the international outlook. The stock market's generally better showing since July is attributable, we think, to the strong third-quarter profit trends, the sharp decline in oil prices, and a possible cooling in overseas tensions—save for Iraq. Should this less-threatening pattern continue, the stock market might be in a position to rally further in the next several months, aside from some normal profit taking along the way to digest the gains of the past few months.

Conclusion: We think the investment backdrop continues to favor the bulls, given the likely reduction in interest rates next year and the comparatively bright earnings outlook, although we caution that the global realities are not pleasant and the stock market has come a long way in a short time, so some serious profit taking could be in order at any time. Please refer to the inside back cover of Selection & Opinion for our Asset Allocation Model's current reading.