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February 2007
Soft Landing Ahead for U.S. Economy

By: Joe Hornyak

In 2006, it was a good year to bet against U.S. growth, says Christopher Probyn, chief economist at State Street Global Advisors. The natural maturation of the U.S. business cycle, the lagging effects of the run-up in energy prices, and the inevitable cooling of an unsustainably hot housing market all contributed to some slowing.

The early data suggests that 2007 will also be a good time to bet against the U.S. with the current slowdown likely to persist through the first half of the year, limiting GDP growth to just 2.2 per cent for the year as a whole, he says.

Still, there is good reason not to be pessimistic. Most economists put the prospects of a recession at about 30 per cent, which is not alarming. The jump in energy prices in 2005 and early 2006 proved that this sector alone cannot cripple the economy the way it once could.

As well, business investment remains robust, the drag from international trade is waning, and the spillover from housing to consumer spending should be limited by tight labour markets, solid income growth, and healthy household balance sheets, says Richard Marston, a finance professor at the Wharton School of the University of Pennsylvania.

All of this indicates a mid-cycle ʻsoft-landing,ʼ similar to what occurred in 1995, is far more likely than a recession.

Financial Markets

However, while the U.S. economy slowed in 2006, the financial markets provided some surprises.

To start, the bond market remained remarkably resilient. When the tightening cycle began in mid- 2004, the Fed funds target was one per cent, and the yield on the 10-year Treasury note was around 4.9 per cent. Now the Fed funds target is 5.25 per cent, and the yield on the 10-year note is right around 4.5 per cent. A number of explanations have been put forward to explain this resilience – including pension fund reform, increased central bank credibility on inflation, foreign central bank purchases out of foreign exchange reserves, and parking of petro-dollars.

However, the latest rally may have gone too far, says Probyn. Bonds appear vulnerable at current levels, with investors overly optimistic about the prospects for near-term Fed loosening. Unless growth prospects deteriorate significantly – making rate cuts a real possibility – a reassessment, which takes the 10-year yield back to five per cent, seems likely in 2007, says Probyn.

Meanwhile, stocks behaved much as they did during the 1995 soft-landing. Equity investors once again proved able to shrug off the impending slowdown in economic and, presumably, earnings growth to bid prices higher. As well, based on the 1995 experience, stocks still have a way to run.

Jeremy Siegel, a finance professor at Wharton, looks for the markets to be fairly good. He says U.S. stocks could be up 10 per cent this year.

“I think the biggest positive for the stock market is low interest rates,” says Siegel. “We have good emerging markets growth, decent European growth. Japan is sputtering right now, but itʼs not as bad as it used to be.

”Standard & Poorʼs Equity Research Services sees multiple factors driving the market higher. Including dividends, it predicts a 10 per cent total return for the S&P 500 in 2007.

The primary drivers for the anticipated return will be:

“We believe 2007 will be a good year, not as good as 2006, but one strong enough to provide investors with a 10 percent total return,” says Sam Stovall, chief investment strategist. “In addition to such factors as attractive valuations and the strong potential for an economic soft landing, history shows us that the third year of a presidentʼs term has provided the best annual returns for any in the four-year presidential cycle.”

soft landing U.S. economy

The Dollar

The dollar also surprised with its strength. Most analysts expected the mid-cycle slowdown in the U.S. and the corresponding end of rate hikes to generate dollar weakness, especially given the monetary tightening cycles underway in the eurozone and Japan, as well as the chronic U.S. current account deficit.

However, after selling off over the first five months of the year, the dollar regained its value against the euro and, particularly, the yen. It appears that analysts paid too much attention to the direction of rates, rather than their absolute values. While the interest rate differentials may be narrowing, they remain firmly in favour of the U.S., particularly relative to Japan. However, forecasters say the dollar has to go lower over the intermediate term as part of the process of removing global imbalances.

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