May 2007

Editor's note: The following review is based on the most recently available information as of May 11, 2007.

The first quarter of 2007 seems to have delivered the growth slowdown long anticipated by the markets. After raising short-term rates 450 basis points from June 2004 to June 2006, the Federal Reserve (the "Fed") decided last August to pause and observe the unfolding data to see if their tightening actions would have the desired effect of slowing the economic expansion and reigning in an inflation rate that had surpassed their desired limits.

As is usually the case, the data have remained "mixed," meaning contradictory and confusing. Moreover, most economic data is generally revised either up or down in subsequent reports, so there is always a degree of uncertainty about the validity of the information as it is reported. The U.S. Commerce Department report regarding fourth quarter 2006 Gross Domestic Product (4Q'06 GDP) is a case in point. The preliminary number released near the end of January 2007 stated that the U.S. economy had grown a very healthy 3.5% during the last quarter of the prior year, well ahead of the 3.0% expected by many economists. A month later, when the first revision of 4Q'06 GDP was announced, growth had been revised down to 2.2%, more in keeping with a view of an economy that was in a "growth slowdown," and in accord with the goals of the Fed. The final 4Q'06 GDP number, released during the last week of March 2007, was revised up to 2.5%.

The same pattern of strength in January, followed by more sluggish data in February, and a modest firming in March was witnessed in most other data pertaining to output and employment. At the same time, data on consumer spending and incomes have remained firm. The preliminary reading on 1Q'07 GDP came in at 1.3%, the fourth quarter in a row in which economic growth came in at less than what is considered the "full-capacity" rate of 3%, suggesting the Fed has successfully engineered a "mid-cycle slowdown." However, the numbers on inflation have tended to be rising and above expectations. The message the markets are reading is that Fed policy seems to have begun to restrain growth, but not inflation. Such a circumstance potentially puts the Fed in a dilemma: does it raise rates to restrain inflation with the possibility the economy might tip into recession, or does it lower rates to prevent a recession, but risk aggravating inflationary pressures?

Which way will rates go?

Throughout the first quarter of 2007, investors have struggled to determine the direction of the Fed's next rate change. That's another way of saying they have remained confused over the trajectory of the economy. One factor that has raised the odds that recession is more likely than a reacceleration of economic activity is the sudden meltdown in what is commonly referred to as the sub-prime mortgage lending market. Within the last couple of months, the rates of delinquency and default on sub-prime loans (mortgage loans made to people with low credit ratings or even without income documentation, often with no collateral, for an amount often equal to the full purchase price of the house) have risen dramatically. As a consequence, a number of smaller sub-prime mortgage lenders have been forced into bankruptcy, or are on the verge of it, and, consequently, are no longer making loans. Those sub-prime lenders still active are pulling back from the business, and mortgage lenders, in general, are becoming more cautious. With a reduction in lending, home prices, already down on average across the nation, are likely to remain under pressure. Weak home prices undermine the value supporting the mortgages, in some cases forcing more defaults.

That the effect of Fed rate hikes would first be felt in the mortgage market should come as no surprise. In fact, most market commentators have been sounding the warning for years in the face of rapidly escalating home prices and a residential construction boom. Housing was clearly the "bubble" of the current economic expansion. However, the biggest concern was not that housing by itself would cause a recession, but that a major housing downturn, such as we seem to be in, would prompt consumers to begin to curtail their spending in general, and thus precipitate a recession.

So far, that does not seem to be the case. As noted previously, consumer spending remains firm and is being supported by good employment growth, real income gains, and a positive wealth effect as a result of strong financial markets and still relatively high home prices. And consumer confidence measures, while a bit soft over the past couple of months, remain in healthy territory, despite recent increases in the price of oil and gasoline.

Similarly, corporate spending remains firm, although there have been some recent signs of softness. Nevertheless, corporate earnings and cash flows continue to grow, profit margins are at record levels, cash is abundant, and debt in proportion to assets remains historically low. It is true that the rate of earnings and cash flow growth is expected to moderate from double-digit gains over the past 14 quarters to mid- to high single-digit growth over the remainder of the current year. But we expect that, as with the economy, profits should continue to advance, even if at a more modest pace.

The Fed seems to agree with this assessment of the economy given its decision in early May to keep the Fed Funds rate at 5.25%, while reiterating that its primary concern remains inflation.

World growth pumping up U.S. bottom lines

One of the key sources of U.S. corporate profit growth is economic growth outside the U.S. For the first time in years, Europe seems to be building some sustainable economic momentum based on a more unified continent, and a multitude of structural reforms implemented over the past 15 years that are starting to bear fruit. Japan, still the second largest economy in the world, has definitely emerged from its decade-long deflationary funk, and has been putting together a pattern of accelerating growth. Most Asian economies are thriving, and of course, China's emergence as a world economic juggernaut has been, and will continue to be, an engine of global economic growth for the foreseeable future. And then there is India, with its nearly one billion people, being spurred by China's success to reform and open its economy in order to enjoy more of the benefits of being a truly global economic player.

Continued growth of the U.S. economy and U.S. corporate profits is probably a necessary condition for continued advances in U.S. equity markets. And we remain confident that such growth will be maintained in the current year, albeit at a slower rate than in the previous years of this bull market, and at times not without fear that it may dip into negative territory.

But there are other factors besides economic health and profit growth that we believe should, at the very least, provide downside protection to stock prices. First, valuations of domestic equities, especially among larger cap stocks, remain reasonable in the context of the current economic environment and interest rate regime, at least by historical standards. Second, corporations have been aggressively using their cash hoards to repurchase their own stock, thus reducing supply, as well as raising earnings per share and return on equity. In addition, some of this cash is also being used to fuel the current mergers and acquisitions boom, which totaled $439 billion in the U.S. during the first quarter of 2007, up 32% from the first quarter of 2006, and $1.1 trillion globally, up 27% from last year's first quarter. One of the key underlying drivers of this consolidation boom is the bevy of private equity firms that are bidding aggressively to take larger publicly held companies private. These private equity deals ("leveraged buyouts") are funded with cash raised from their own investors, cash from their corporate targets' balance sheets, and, increasingly, from debt funding, which has proven plentiful and cheap.

Shanghai surprise

The first quarter of 2007 did give equity markets a scare. In late February, a one-day, 8% decline in the Shanghai stock market (from extremely overvalued levels, and in response to government suggestions of increasing market regulation) prompted equity markets around the globe to fall precipitously. Since then, most have recovered a significant majority, if not all, of those declines as the relevance of this small and nascent stock market to the global economy and global markets became more apparent to rational minds.

However, the correction did focus attention on a variety of risks about which investors had seemingly become complacent. Here in the U.S., as noted, there had been increasing signs of distress in the sub-prime mortgage markets with relatively little stock price response, even among many of these mortgage lenders. The domestic stock market itself had advanced nearly 20% in a straight line from mid-July 2006 until late February 2007, never declining by more than 1% in the interim. Markets generally do not advance that far so fast with such little volatility. Odds had been rising that the market would correct, and it did.

That said, the basic underlying fundamentals remain solid. On that basis, it is our expectation that the U.S. stock market, as represented by the S&P 500®, can advance about 10-14% for the current year. That forecast depends on a "soft landing," good prospects for a reacceleration of growth beyond the current year, and a modest increase in the Price-to-Earnings ratio the market is willing to pay for earnings and earnings prospects. We also believe that bonds should deliver a return equal to their coupons as rates, represented by the 10-Year Treasury Note, oscillate in a 50 basis-point range between 4.50% and 5.00% in response to a continued flow of mixed economic data, just as they have done over the past year or so.

FIRST QUARTER INDEX COMPARISONS

Source: Wall Street Journal

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The views expressed in this article are subject to change at any time based on market and other conditions, and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.