Slow Growth in 2007

Over the past ten days we've seen some interesting economic reports. Last week's report on the CPI was surprisingly good - almost unbelievable. This good news was offset earlier this week by the PPI report which was much worse than expected. Today, the final report on third quarter GDP was released. It was down from the last revision to 2.0% vs 2.2% but up from the initially reported 1.7%. And also today, the Conference Board released its Leading Economic Indicators index for November, showing a gain of 0.1% - the third increase in a row - pointing to further growth in the economy.

What should we make of all these mixed reports? Simple. The economy has slowed but is still growing. Inflation is not accelerating out of control. We think that the Fed can stand pat on short term interest rates, perhaps cutting in 2007.

We're expecting more of the same economic action in 2007. That is slow GDP growth, controlled inflation, stable interest rates and rising corporate profits and cash flows. We believe that this will be a favorable environment for stocks and bonds (although our preference is for stocks) and we would tend to focus on companies with solid top line growth, stable/rising margins, and positive free cash flow generation. We expect more M&A activity across a number of sectors of the economy. And, at the risk of sounding like lemmings, our bet is that larger cap stocks will be the better play in 2007.

The risks to our scenario are the same ones we faced this year and include energy supply disruptions, terrorism, a worsening Middle East situation, N. Korea, storms etc. The new unknown is the impact of a Democrat controlled Congress. Watch taxes, particularly the talk on dividends and cap gains - as the impact would be certainly negative for stocks.

All-in-all, we think being cautiously optimistic on the economy and market in 2007 is the correct stance for now. So, don't worry, be happy and have a very. . .

Merry Christmas!

Some better news!

Maybe there will be more than just coal in investors' stockings after some fairly positive news on the economic front today.

Labor Department data released today provided some more evidence that inflation is not spiraling out of control. Unit-labor costs were revised much lower in both the second (from +5.4% to -2.4%) and third quarter (+3.8% to +2.3%). As a result, instead of rising at a 5.3% rate over the last twelve months, unit-labor costs were revised down to a reasonable 2.9% annual gain.

Productivity figures were also revised upward to 0.2% from flat in the third quarter as initially reported. While this result was disappointing to some, we would note that the sharp slump in residential construction may be putting undue pressure on the productivity figure given that home builders either can't or won't reduce employment as fast as the decline in construction activity. We suspect that once homebuilding "normalizes" the solid productivity gains in other sectors of the economy will become more of a positive factor.

This is an important and positive report on inflation which significantly reduces the risk of further Fed rate hikes for the foreseeable future in our view. And stable rates should at least be neutral for the stock market.

On another front, the ISM services index rose to 58.9% from 57.1% in October surprising most economists - who had been expecting the index to slip to 55.8%. This is counter to the fall below 50 for last month's manufacturing figure and should assuage some fears that the economy will fall into recession next year.

Bottom line, these results should offer some comfort and joy to investors.

A Lump of Coal!

Looks like investors received another lump of coal in their stockings with today's release of the Institute of Supply Management's monthly ISM index. This measure of manufacturing activity hit a 2006 high in the spring and has been drifting lower ever since. Today's report that November's number was 49.5 has particular significance for the market when you remember that a reading below 50 is indicative of contracting manufacturing activity.

Not surprisingly, the stock market has begun to slide on concerns that economic growth may slip further than expected and as a result, earnings may fall short of expectations next year.

Before you panic and sell everything, this is the first ISM index number below 50 in a couple of years. Since then the economy has grown strongly. And, this index reflects the manufacturing sector of the economy which is an increasingly less important factor in overall growth. So lets wait for perhaps another month or two of reports below 50 before we panic!

Oh, there's a silver lining to this report. Treasury bonds have strengthened today, pushing interest rates down a bit more. It's going to be tough for the Fed to raise in the face of evidence of a slowing economy and an inverted yield curve.

We believe next week's employment report may be of more help to investors' understanding of the current and future economic picture than to today's ISM.