U.S. Economic Forecast

The average GDP forecast in the Wall Street Journal’s Economic survey was lowered to 2.3% growth for the first quarter of this year from the previous estimate of 2.5%. Estimates for the rest of 2007 held steady at 2.4% growth for second quarter, 2.7% for the third and 3.0% for the fourth. Our estimate is that GDP growth reaches 3% only if inflation is allowed to approach 3%. Our previous growth estimate of 2.8% in the third and fourth quarter of 2007 seems more realistic with the Fed holding rates constant.
Inflation
The inflation rate is currently below core inflation meaning that the price of food and energy is rising at a slower rate than other consumer products. If food prices driven by increasing corn demand increase at a faster rate, the Fed will need to respond before inflation reaches 3%. As of February, inflation was 2.7% and core inflation was 2.4%.
Employment
Last month unemployment fell to 4.4% down from 4.6% in January. Unemployment has remained between 4.4% and 4.6% since September of 2006. The level of unemployment which produces an acceptable inflation rate according to the Philips curve is called the Non-Accelerating Inflation Rate of Unemployment (NAIRU). Estimates of the NAIRU place it somewhere between 5.5% and 6.5%. Assuming the most optimistic scenario of 5.5% would imply an expected inflation rate of 2.75% which is about where we are today. If we use the long term average NAIRU of 6%, we can expect inflation to rise to 4%. In the current economic expansion, we place more confidence in the lower estimate of NAIRU but feel that the threat of unacceptable inflation remains as long as unemployment remains low.
Fed Funds Rate
The March 21^st Federal Open Market Committee (FOMC) meeting concluded with the Fed keeping the target rate constant at 5.25%. This indicates that the Fed is still concerned about inflation despite so much attention given to Wall Street analysts who predicted that the Fed would cut rates. Many of the writers and consultants who appear in the media have an interest in promoting the idea that the Fed will lower interest rates because it would promote greater investment. This statement is reinforced by the reaction of consumer sentiment immediately following the Fed’s announcement. Consumers have relatively short term memories and had become accustomed to the low interest rate environment just a few years ago. The graph displayed in the Wall Street Journal does not show historic patterns to put recent rate hikes in context and implies that the target rate is at a local maximum. The Fed has an interest in perpetuating this type of analysis because it allows them to affect markets without actually changing the rate. Our previous estimate had the Fed funds rate target increasing to 5.5% by the end of the year and possibly reaching 6% in 2008. We continue to believe that the Fed will not decrease rates, but that an increase to 6% may be unrealistic. We expect the Fed to hold rates steady through the end of 2007 with the potential to increase to 5.5% around the end of 2007 or the beginning of 2008.
Consumer Spending
As discussed earlier, consumer confidence fell on news that the Fed would hold rates constant. The fall from 111.2 in February to 107.2 could also be attributed to the recent volatility experienced in both domestic and global financial markets. Alan Greenspan’s comment that a recession is a possibility also likely impacted consumers’ future expectations. In February, personal income increased by 0.6% and disposable income increased by 0.5%. Both measures are down from January when personal income increased by 1% and disposable income increased by 0.8%.
Energy Costs
Crude oil has made a quick rebound from tumble caused by the winter surpluses. The peaceful conclusion of the British sailor incident in Iran resulted in a stabilization of crude prices at $62.03 as of April 10^th. With the summer driving season quickly approaching, we expect oil prices to stay in the $60 to $70 range into the end of 2007. New York Mercantile Exchange (NYMEX) futures prices confirm this estimate with prices on futures contracts increasing by about $1 per month. Transportation continues to be the largest single factor driving energy demand. Sectors which are transportation intensive will pass on energy costs to the consumer causing a reduction in sales. Industrial electrical prices are expected to show considerable growth prompting investment in utilities and translating to increased manufacturing costs. Consumer discretionary will be less affected because of the relatively flat growth of real residential electrical prices.
Industrial Production
The industrial production index increased by 1% in February indicating that businesses are optimistic about the future and the recent fall in consumer confidence is unlikely to impact the economy to a large extent. Capacity utilization edged up to 82% which is slightly higher than average causing some firms to consider expansion plans in the future. While 82% capacity utilization is above average, businesses still have plenty of time to choose the conditions in which to invest in more capacity.
Bond Yields
The yield curve has become more convex and remains inverted. Historically, the inverted yield curve has been associated with a recession because the Fed is keeping rates higher than the market expectations. Jonathan Wright, a researcher at the Federal Reserve Board, published a paper on the ability of the yield curve to predict a recession based on the spread between the 10 year and the 3 month yields. Utilizing Wright’s Model A and the current curve, there is a 68% chance of a recession occurring within one year. Under Model B which incorporates the current Fed funds target rate, the probability of a recession within four quarters is about 45%.
Housing Market
The sub-prime lending issue has been repeatedly covered in every major news outlet with dire predictions on its effect on the housing market. Meanwhile, in the real world, housing starts were up 9% from January. This is still about 18% below last year’s level, but it indicates that the housing surplus is decreasing and we can expect house prices to begin to recover over 2007. Existing home sales showed the largest single month increase in three years rising 3.9% from January sales. Existing home sales remain 3.4% below last year’s numbers, but the improvement of existing home sales may be a leading indicator for housing starts since used homes are an inferior substitute for new homes.The recovery of the housing construction will reinvigorate the materials sector.

R.I.S.E. VII Symposium

I’ve spent the last few days in Dayton, OH attending the R.I.S.E. Symposium. Over one hundred student run investment funds were represented as well as many industry professionals. The economic session featured:

Dr. James Glassman – Senior Policy Strategist, J.P. Morgan Chase

Dr. Jan Hatzius – Chief Economist, Goldman Sachs

Dr. Myron Scholes – 1997 Nobel Laureate in Economics

Dr. John Silva – Chief Economist, Wachovia

Dr. Silva was outstanding! He discussed how the problems in the sub-prime market should not be helped by government because they were mostly due to both consumer and business stupidity. People who cannot afford a house should not receive government assistance because they decided to get a mortgage rather than renting. Businesses that provide these loans should not be compensated for their greed when it backfires. Dr. Scholes was late and tended to ramble in his comments. The next session focused on the markets. The speakers were:

Robert Doll – Global Chief Investment Officer, Blackrock

Knight Kiplinger – Kiplinger’s Personal Finance

Louis Navellier – Navellier & Associates

Liz Ann Sonders – Chair of Investment Strategy Council, Charles Schwab

Mr. Kiplinger gave a rather lengthy opening comment on personal financial discipline which was valuable but boring. Although it was a valuable session, the markets talk was not quite as good as the economy. Gary Stern (President, Minneapolis Federal Reserve Bank) gave a brief speech but was careful to avoided any substantial predictions or observations other than to focus on long term trends rather than the weekly data releases. The next session covered corporate governance and featured:

Ralph Alvarez – COO, McDonalds

Paul Atkins – SEC Commissioner

Peter Coors – Chairman, Molson Brewing Company

Patrick Dorsey, CFA – Director of Stock Analysis, Morningstar

I had some sympathy for both Mr. Alvarez and Mr. Coors because they were expected to address some difficult issues which could not be adequately answered without disclosing some of the problems their respective companies have faced. Mr Dorsey was very articulate while Commissioner Atkins often tossed out some political jibes at his fellow administration officials. The final session of the day was supposed to be a discussion on public policy. The speakers were:

Dr. Daniel Chiquiar – Research Manger, Banco de Mexico

L’Ubomir Jahnatek – Minister of the Economy, Slovak Republic

Witold Jurek – President, Conference of Rectors of Universities of Economics in Poland

Gintaras Steponavicius – Deputy Speaker of Parliament, Republic of Lithuania

Mr. Jurek never appeared and Mr. Jahnatek refused to utilize his interpreter so his comments were completely unintelligible and seemed to go on forever. The discussion never quite covered any public policy and basically focused on each speaker describing his country’s finance system like a foreign investment commercial.

Our fund presentation was excellent however, we did not win and the decision criteria were never disclosed. During the networking event, I noticed that no other schools came close to matching our risk adjusted return while most of them beat us on total returns. It seems rather absurd to discount risk when evaluating performance but who am I to argue.

Jesse Jackson was the keynote speaker on Friday night at the Air Force Museum. While I admire Mr. Jackson’s oration skills, his speech did not relate to economics, finance, or anything else business related. His message could be summarized as follows: All you rich, educated white kids need to remember the minorities who do not the same opportunities. I was personally rather put off by this since I went to public school and the only reason I have this opportunity is because I joined the military in order to get money for college. There are plenty of minorities in the military with the same educational benefits as me who simply do not utilize them. Here’s a picture landing at Boston’s Logan airport.