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4th Quarter Economic Review The fourth quarter of 2005 began as the lingering clouds of Hurricanes Katrina and Rita raised many con-cerns about subsequent economic fallout. The cross-currents were accentuated by the prospect of a new Federal Reserve Board Chairman, spiking energy prices, concerns about a housing bubble, and consumer spending. Of course, an historically weak October equity market obliged with a negative return. However, as gasoline prices rose to a peak of $3.22 a gallon in October, other market forces intervened. Very quickly, oil imports were switched to refined products in order to offset some of the impact of lost domestic refinery production. More quickly than initially thought, domestic refining capacity came back on stream and by late-November, the price of gasoline fell back to a $2.20 level. The return of natural gas production disrupted by the storms has been much slower than the return of refinery production. While natural gas storage levels were at high record levels, shifting weather forecasts caused wide trading swings in price. How much would you wager on a long-term weather forecast? Farewell, Mr. Greenspan During November and December, equity prices reacted positively to many other very favorable trends. Speculation concerning Federal Reserve Chairman Alan Greenspan’s successor captured considerable media attention, much of it reflecting widespread approval of his solid, almost legendary, performance as the country’s monetary policy leader for nearly two decades. The nomination of Ben S. Bernanke as Greenspan’s replacement occasioned more speculation about his potential impact on monetary policy. His academic background and past position on the Federal Reserve Board and as Chairman of the Council of Economic Advisors to the President suggest that U.S. monetary policy should continue to be effectively executed. By mid-December the Federal Reserve Board had increased the federal funds rate by 1⁄4% for the 13th consecutive time, bringing the rate to 41⁄4%. Importantly, the Fed’s news release indicated that the period of raising rates was nearing its end. Most people expect at least one more increase on January 31, suggesting that a 41⁄2% to 43⁄4% rate may be the end of tightening. GDP growth continues In late October, the preliminary report on economic activity for the third quarter at 3.8% real GDP growth pleasantly surprised most observers because it outpaced the 3.3% rate in the second quarter despite two damaging hurricanes and soaring energy costs. The November upward revision of that number to 4.3% was an even greater surprise, with an improved productivity number as the catalyst. This marked the fifth successive quarter of GDP growth, at an average of 3.7% — comfortably exceeding the normal 3% rate, during a period of consecutive interest rate increases by the Federal Reserve Board. Continued resilience in consumer spending was one ingredient. Strong wage gains and increased employment more than offset the effects of rising inflation and interest rates. In addition, capital spending maintained its momentum as a driver of economic activity. Housing surge ending? Also encouraging were signs of a slowdown in housing that gave real promise of a soft landing. Mortgage applications, the pending home sales index, University of Michigan Consumer Confidence Survey, a decline in the housing affordability index, a decline in housing starts and building permits all point to an end to the surge in housing. The year-over-year rise in housing prices remained a healthy 14%. However, as the chart above indicates, the rate of increase in condominium prices has declined from a three-year run of 15% to 20% to a 9% rate recently. This is the sector of the housing market that has received the most speculative activity in recent years. While 9% is a healthy normal appreciation factor, it is a rate that does not encourage speculative activity given acquisition, borrowing, and tax costs. An underlying demand for housing at 1.8 million units is down slightly from recent peak levels, but is a healthy sustainable rate. These recent signs of a slowdown in activity to a more sustainable and less speculative rate are a good indication that fear about a housing bubble will quietly fade away. The new year, 2006, should be one of continued growth in personal income and employment which should provide a good base for consumer spending. Capital and infrastructure spending should more than offset slower housing. Growth at an above average 3% to 31⁄2% should allow profits to grow nicely at an 8% pace. Equity returns should better the modest returns of the past two years. * * * Joe Harrison’s keen ability to convert economic trends and data enables him to develop client investment portfolios for long-term growth. If you are not a Midwest Investment Management client, let Joe position your portfolio for growth without undue risk. Contact him at (216) 830-1131 or jah@mimllc.com |
