The US economy continues to surprise on the upside.  Despite eight interest rate hikes last year, despite oil prices as high as $70 and despite three hurricanes and a national disaster on the Gulf Coast, the US economy has continued to surge, with GDP growth of 4.1% (annual rate) in the 3Q.  Yet the media continue to downplay the robust economic growth.  The Wall Street Journal called it the “Rodney Dangerfield Economy” because it gets no respect in the mainstream media. This week, we will look at some of the under-reported economic accomplishments we saw last year.

In this issue, I also give the results from the latest Wall Street Journal Poll of 56 leading economists, including their estimates for economic growth, interest rates, inflation, the markets, etc.  Overall, the economists are quite optimistic for 2006.  One reason for this optimism is the fact that the Fed has hinted that it is nearing the end of its long rate hiking cycle.  More on that issue as we go along.

There is so much talk about the interest rate “yield curve” inverting in 2006, with short rates rising above long rates, and the implications that could have for the economy.  Historically, an inverted yield curve has led to recessions, and there are many (and not just the gloom-and-doom crowd) who think a recession will unfold in the last half of this year as a result of the yield curve.  I disagree and will discuss this more in the pages which follow.

This week, I will also summarize the latest forecasts for the New Year from The Bank Credit Analyst.  As long-time readers know, I have been a continuous subscriber to BCA for almost 30 years, and I continue to believe that Martin Barnes and his team are among the most astute and accurate forecasters in the world.  Starting on page 5, I will give you BCA’s latest thinking and their specific recommendations for 2006.  (Hint: they remain optimistic about the US economy.)

We cover a lot of ground in this issue of F&T, so let’s get started.

Significant Economic Accomplishments In 2005

I must admit that, like most other forecasters, I predicted a mild slowdown in the economy late last year following one of the worst national disasters in America’s history.  Yet the economy remained resilient despite the hurricanes, soaring oil and gas prices and the meticulous rate hikes by the Fed.  Despite the plunge in consumer confidence last fall, confidence soared in October and November.  Depending on which reports you read, holiday shopping was 5-10% higher than in 2004, despite widespread predictions of a slowdown.  One wonders how strong GDP would have been were it not for the impediments noted above!

In a well-written article on December 30, the editors at the Wall Street Journal (WSJ) addressed some of the many economic accomplishments of 2005.  Here are some excerpts:

“Remember the 2004 debate over the ‘jobless recovery’ and ‘outsourcing’?  Here’s the reality: The great American jobs machine has averaged a net increase of nearly 200,000 new jobs a month this year [2005].  Some 4.5 million more Americans are working today than in May of 2003, before the Bush investment tax cuts. The employment expansion in financial services, software design, medical technology and many other growth industries dwarfs the smaller job losses in the domestic auto industry.  

Even many of the widely publicized lost jobs at Delphi and General Motors are silently offset by the tens of thousands of Americans employed at new domestic plants built by multinational companies like Honda and Toyota of North America. This job growth has been accompanied from 2001 to 2005 with the best rate of labor productivity over any four-year period since the Labor Department started tracking this statistic. This productivity revolution augurs well for higher wages in 2006.

Critics of the U.S economic model charge that income gains for workers still have not caught up with the losses from the 2000-2001 high-tech collapse. Now they have. The Treasury Department reported last week that 'real hourly wages are up 1.1% versus the previous business cycle peak in early 2001.' Workers are now earning more per hour in real terms than they did at the height of the 1990s expansion.  [Emphasis added, GH.]

The real gains for families have been in the value of their assets. In 2005 Americans owned an all-time high level of wealth (mostly housing and stocks), valued at $50 trillion, according to the Federal Reserve. Median household net worth is now estimated at more than $100,000. Rather than being overloaded with credit card bills, the truth is that Americans’ assets are rising in value faster than they are taking on debt.

It’s not just the idle rich who are getting richer. It’s the tens of millions in the middle class who could afford to visit malls this brisk Christmas shopping season and purchase cell phones, DVD players, $2,500 flat-panel HDTVs, $400 Xboxes, digital cameras, pink iPods and laptop computers. Hello? This isn't the buying behavior of people who are feeling poorer.

Next, since the investment tax cuts of 2003 were one of the triggers for the surge in asset values, business investment, and job growth, extending the 15% capital gains and dividend tax rates should be Congress's first order of business. Opponents of those lower rates will moan about ‘the deficit,’ but the truth is that those tax rates corresponded with a record $284 billion increase in tax revenues in Fiscal Year 2005 and a $100 billion decline in the budget deficit. We’d also like to see Republicans begin a campaign for a simplified and pro-growth tax reform, with New Europe's popular flat tax as a potential model.”

You don’t hear much about these accomplishments in the media.  But the truth is, the Bush tax cuts have had a significant positive impact on the economy.  GDP rose only 1.6% in 2002 and 2.6% in 2003, but then leaped ahead by 4.2% in 2004, and GDP for all of 2005 should be close to 4%. 

As noted above, consumer spending during the holidays significantly eclipsed most expectations, many of which were for an actual decline in holiday spending as compared to 2004.  That didn't happen, and consumer spending was in fact robust.  So, we enter 2006 on a strong economic note, and there are no signs of a recession in the near future.  Of course, as always, not everyone agrees as I will discuss below.

Latest Wall Street Journal
Survey Of Leading Economists

On January 3, the WSJ published the results of its year-end survey of 56 leading economists.  Overall, the results were very positive regarding the outlook for 2006, clearly suggesting a fifth consecutive year of economic expansion. 

Perhaps the area with the most consensus was the housing market.  Most of the economists surveyed agreed that the US housing market will cool off in 2006 (in fact, it has already), and on balance, the economists believe this will slow economic growth slightly in the New Year.

However, there was a similar consensus that US businesses will increase capital spending and new investment in plants, equipment and technology, which they believe will offset much of the drag from the slowing housing market.

The consensus estimate of the 56 economists surveyed is that GDP will rise 3.5% in the first half of 2006 and 3.1% in the second half.  While these estimates are more than respectable, they are below the average of 4.1% over the last 2½ years.  Most importantly, few of the economists surveyed believe that a recession will unfold in late 2006. 

On balance, the economists are also optimistic about inflation.  The CPI rose 3.5% in the 12 months ended November.  For 2006, however, the economist consensus estimate was for inflation to cool to a 3.1% rate in the first half of the year and then recede to 2.3% in the second half.  If correct - both on the GDP front and the inflation front - this should assure that the Fed will cease hiking rates soon (more on this below).

On balance, the economists believe that the current economic expansion can continue for several more years. Only 15% of those surveyed believed that a recession will occur in the next couple of years.    This level of optimism assumes, of course, that there is not another huge spike in oil prices; the consensus was that oil prices would stay in a range of $50-$60 per barrel in 2006.  It also assumes that the housing market contracts only modestly, and that there will be no implosion in home prices.

As for interest rates, the consensus was that the Fed will hike two more times, thus putting the Fed Funds rate at 4.75% in March.  The consensus was also that long-term rates would remain generally low.  The consensus forecast suggests that 10-year Treasury Notes will remain below 5% for all of 2006.  This suggests a continued trading range in bonds.

The consensus was that stocks will be higher in 2006.  A plurality of the economists surveyed expects the Dow to end 2006 somewhere between 11,000 and 12,000.  Very few expected the equity markets to be down for 2006.

Fed Hints Of An End In Rate Hikes

At the December FOMC meeting, when the Fed Funds rate was hiked to 4.25%, the Fed hinted that an end to the long rate-hiking cycle may be in sight.  They removed the longstanding policy language that called for additional “measured” rate increases.  Most observers believe that means we will only see either one or two more rate hikes, and then the Fed takes a breather for a while, or maybe longer depending on what the economy does in the New Year.

Interestingly, the 56 economists surveyed by the WSJ voiced great concern that the Fed might go too far in raising rates, thus choking off the economy.  In any event, we will have to wait and see what the Fed does, but the equity and bonds markets are braced for two more increases in the Fed Funds rate.

Fears About The “Inverted Yield Curve”

Investment writers and market analysts are increasingly focusing on the yield curve, especially given that some short-term interest rates edged slightly above certain long-term rates late last week.  As noted above, the FOMC raised the Fed Funds rate to 4.25%.  Most analysts expect the Fed to raise rates at least one more time, which would put the Fed Funds rate at 4.50%  on January 31 and possibly to 4.75% by the end of March.

As of Tuesday, January 3, the yield on the 10-year Treasury Note was at 4.38%.  The concern, of course, is that the Fed goes too far in raising short-term rates, to the point that the Fed Funds rate climbs above the 10-year T-Note.  If the Fed raises rates two more times to 4.75%, and the 10-year Treasury Note stays within its recent trading range, then the yield curve would be slightly inverted.  In fact, a case can be made that the yield curve is already beginning to invert.  On Friday, December 30, the yield on the 2-year Treasury Note was at 4.40% while the 10-year Note was at 4.39%.  Clearly, the yield curve is flattening and may be in the process of inverting modestly.

Many analysts point to the past when recessions have been preceded by an inverted yield curve, and some virtually guarantee that a recession will unfold if the Fed Funds rate rises above the 10-year T-Note later this year.  However, if we look back at the last several recessions, we find that things are much different today.  In the past, the yield curve typically inverted when Fed monetary policy was very tight and inflation was high and rising.  That is not the case today.  Inflation is moderate to low and should remain that way for the coming year at least.  Unlike in past cycles of high inflation, when the Fed had to jack up short rates very aggressively, the Fed has been moving short rates up very slowly, in quarter point increments.  Most importantly, keep in mind that the Fed is merely raising short rates back to a “neutral”  (not stimulative) level.  As I’ve said all along, the Fed is just reloading its weapons for the next recession.

Keep in mind that the Fed is keenly aware of the historical implications of the inverted yield curve.  They are also very mindful of the psychological implications that an inverted yield curve has on investors and traders.  The last thing they want is to choke off the economy or flirt with a recession.  I do not think they will go too far.

It could be that the last rate hike will come in January.  Most Fed watchers agree that if there is another hike in March, it will merely be a token hike to send a message that incoming Fed Chairman Bernard Bernanke is serious about fighting inflation.

The point is, the economic, monetary and inflation environment today is not typical of those in which the yield curve inverted and a recession followed.  Even if the Fed Funds rate were to inch just above the 10-year Note rate in the next 3-6 months, I do not believe that occurrence, by itself, would lead to a recession, especially if short rates do not remain above the 10-year Note for an extended period.

That is the key: 1) that the yield curve doesn’t invert significantly; and 2) it doesn’t remain inverted for a long period of time.  As I will discuss below, BCA happens to agree with my assessment above.  They, too, are not going to get alarmed should the yield curve invert modestly in the next few months.

Nevertheless, with each additional rate hike by the Fed, you are going to hear more analysts wringing their hands about a coming recession based on the yield curve.  I just want to alert you to that fact ahead of time.  For now, ignore these warnings, unless there are some unforeseen surprises in our future over the next several months.  I will keep you posted in the weeks and months ahead.

BCA Remains Optimistic For 2006

In the mid-1990s, BCA predicted that the US economy had entered a multi-year, technology-driven economic “long-wave upturn” which would last for many years, perhaps a decade or longer.  BCA defined their economic long-wave upturn as a period of relatively strong economic growth with only modest recessions along the way.  In short, they predicted that the US economy would surprise on the upside, and it repeatedly has over the last decade. 

In 1995, they also predicted that inflation would trend significantly lower over the next 5-10 years, which it certainly has.  And they predicted that interest rates would decline substantially over the same period of time.  Indeed, we saw interest rates fall to 40-year lows in the last couple of years.

In their bold forecast in 1995, the editors also predicted a spectacular bull market in stocks and bonds at a time when most analysts were bearish.  What followed was the greatest bull markets in stocks of all time, with a similar move up in bonds.

As long-time clients will remember, I questioned BCA’s long-wave forecast at the time as a result of our bulging federal budget deficits, trade deficits and the falling personal savings rate.  I even challenged Martin Barnes in 1995 in an interview that we reproduced and made available free to our clients.  As Barnes pointed out in that interview, BCA was well aware of the many financial imbalances.  He even admitted, readily, that a “day of reckoning” will come at some point in the future.  Nevertheless, Barnes was convinced that the day of reckoning was somewhere well out on the horizon, and BCA has stuck to its optimistic long-term forecast.  They have been correct as usual, and investors who doubted them, and invested for the worst as advised by the gloom-and-doom crowd, missed two of the greatest bull markets in history, and most probably lost a LOT of money over the years.

As for 2006, BCA continues to believe that the US economy is still in the midst of a technology-driven long-wave upturn which could continue for several more years. 

In the short-term, the editors still believe that US economic growth cooled modestly - well below 4% - in the 4Q of last year (although we don’t yet have data to confirm this), and that it will be below the 4% level in GDP again in the 1Q of this year.  But they believe that 2006 will be yet another year of very respectable economic growth (3-3½% in GDP).

BCA’s outlook for 2006 is somewhat the reverse of that offered by the 56 economists surveyed recently by the Wall Street Journal.  On page 3, I stated that the WSJ economists expect GDP growth to be 3.5% in the first half of 2006, and then slow to 3.1% in the second half of the year.  BCA’s view is different in that they expect growth to be slower in the first half of the year, and then accelerate in the second half.  Either way, both groups expect a very respectable year in terms of economic growth.

Most importantly, the centerpiece of BCA’s latest forecast is their belief that inflation will remain low for the next year or longer.  If inflation remains low as they expect, then interest rates should remain low as well, and the economy should deliver solid growth, although probably not another year of 4% GDP.  In short, they expect another year of 3-3½%  growth in GDP and no recession in 2006.

Martin Barnes and his fellow editors readily admit that if they are wrong about their forecast for continued low inflation, then most if not all of their specific market forecasts will be wrong as well.  They clearly recognize that another large spike in energy prices, for example, could cause inflation to rise well above their expectations.  Yet in their most likely scenario, the “core rate” of US inflation stays relatively low for the next several years, interest rates remain low and the US economy continues to grow.

The Problems With BCA's Optimistic Forecast

Having been optimistic about the US economy for over a decade, I suspect that more than a few clients and readers must think that Martin Barnes and his team are eternal optimists and subscribers to the “perma-bull” theory that so pervades Wall Street.  I must admit that it is tempting to doubt BCA’s latest rosy forecasts.

We all know that the federal budget deficits are record large; we all know that the national savings rate fell into negative territory in 2005; we all know that the trade deficit is off the charts; we all know that the only thing supporting the US dollar is massive foreign buying of greenbacks; and we all know that this period of borrow-and-spend prosperity will come to an ugly end at some point.

It is important to note that BCA fully agrees with everything in the paragraph just above.  They simply do not believe that the day of reckoning comes in 2006 and maybe not even in 2007, or even longer.

We all see the national debt piling up, and the fact that neither political party can restrain spending.  The signs continue to mount that the huge bull market in US real estate is leveling-off at best, and the housing boom has been a huge source of liquidity for US consumers, which are driving this economy (and in fact, the global economy).  We all know that foreigners will not continue to hold bulging amounts of US dollars forever.  As noted above, there will be a very ugly end at some point.

BCA simply argues that we are not there yet:

“Current trends in the U.S. trade balance cannot persist indefinitely, but they are likely to be sustained for quite some time.  Even if private capital flows into the dollar fall back from recent high levels, it is virtually certain that Asian central banks will step in to fill the breach, as they did between 2002 and 2004.  It is not in anybody's interest for a dollar crisis to trigger a U.S. recession, and Asia would be especially hard hit.  That is why the region’s central banks are quite prepared to be the dollar buyers of last resort for the foreseeable future… It all comes to an end when it is no longer in the economic and/or political interests of Asian governments to sustain this arrangement.”

The emerging economies around the world, and especially in Asia, are reaping huge benefits by running large trade surpluses with the US.  America, meanwhile, can continue to borrow-and-spend precisely because these foreign countries are willing to be paid in US dollars and are content to hold growing amounts of our greenbacks, which for now remain the world’s “reserve currency.” 

This arrangement will come to an end at some point, and it will not be pretty, but BCA argues that such an end will not happen in 2006, and maybe not for several more years, barring some very negative surprise(s).

No doubt, many of you will disagree, but in the almost 30 years I have read BCA, it has rarely paid to disagree with them.

BCA On The Markets - Good News & Bad

Up to this point, this summary of BCA’s latest forecasts has been quite encouraging - continued economic growth, low inflation and low interest rates.  But that’s where most of the good news ends.  Let’s start with stocks and bonds.

As they have for the last year or so, BCA suggests that US equities are likely to remain in a broad trading range with a mild upward bias in 2006.  BCA’s most encouraging advice is that because the US equity markets lagged many of the international markets in 2005, they are likely to “see some catch-up in the coming year.”

Let’s hope so!  The Dow Jones Industrial Index was actually fractionally lower in 2005; the S&P 500 Index gained only 3% for the year; and the Nasdaq Index was up only 1.4%.  While BCA is slightly more optimistic on equities in 2006, it looks to be another difficult and potentially frustrating year for most equity investors.

If correct, this continues to suggest active management strategies such as sector rotation and traditional market timing.  Several of the professionally managed equity programs I recommend significantly outperformed the major market indices in 2005.  Maybe it’s time you consider them, if you haven’t already.  (Past performance is not necessarily indicative of future results.)

As for bonds, BCA has a similar outlook - a continued trading range.  While the editors expect there to be some minor trends, up and down, in bond yields over the next year or two, they predict that “yields will be relatively modest by the standards of the past few decades.” 

Again, this forecast is based on BCA’s view that inflation will be mild for the next year or longer.  The editors go on to say, “… the conquest of inflation means that bonds have become a relatively boring asset class.”  Within that overall context, the editors believe that US and Australian bonds will perform the best in 2006.

In the area of foreign currencies and the US dollar, BCA has a similar mixed view for the next year.  While the editors continue to believe that the US dollar is in a long-term bear market, they are not compelled to reinstate short positions.  They were correct that the dollar would rebound in 2005.  They are not so certain about the dollar’s path in 2006 (and neither were the economists surveyed by the WSJ).  Here again, it could be another trading range.  For now, BCA’s favorite currencies for 2006 are the  Canadian dollar, which has already advanced significantly, and the Japanese yen.

Next, we move on to the real estate market, which has been a bonanza for many investors in recent years.  As noted earlier, the signs continue to mount that we have seen a peak in real estate prices.  My advice late last year was to take some profits and lighten-up on any speculative real estate you owned, including real estate mutual funds.  I stand by that advice, and it’s not too late to do so.

The big question now is whether real estate prices, including home prices, are in for a steep decline or rather just a modest correction.  BCA suggests the latter.  The editors believe that home prices will fall in the hottest markets, especially the coasts, but they do not see a major plunge in home prices on the national level.  They point to the pattern of home prices in Great Britain, which saw a similar boom but no major implosion in prices.  “House prices in the U.S. are likely to stagnate rather than collapse.”  Let’s hope they are right on this one!

As noted above, all of these forecasts are based on the assumption that no major negative surprises occur in 2006.  Obviously, the threat of terrorism remains a wild card.  Another huge spike in oil prices is also a wild card.  While the editors at BCA remain long-term bullish on oil and energy prices, and recommend buying on dips, they do not expect that energy prices will rise to the point of snuffing out the strong economy in 2006.

BCA’s Most Surprising New Forecast

BCA has not been a big fan of gold since the mid-1970s when inflation was soaring.  In fact, BCA has mostly been bearish on gold since they recommended selling it in late 1979 before gold hit its record high of $850 and then crashed.  However, in December, the BCA editors published a Special Report on gold in which they predicted that gold will rise to near $1,000 per ounce over the next several years.  WOW!

This is one of the most surprising forecasts  I have seen from BCA in years!

Given their outlook for continued low inflation for at least the next several years, it no doubt comes as a surprise to many readers that they have taken such a bullish position on gold.  Most think of a bull market in gold only in the context of rapidly rising inflation.  However, BCA’s latest bullish stance on gold is more in line with their predictions for other commodities over the last year or two.  In other words, they are bullish on gold more for supply and demand reasons than out of concern for inflation.

BCA contends that if you are buying gold largely on fears of much higher inflation, you have it all wrong, since they expect inflation to remain quite low for the next several years.  But BCA believes that the underlying supply-demand fundamentals are quite bullish (after many, many years), and that it will be these forces which propel gold much higher over the next few years.

Frankly, I will be surprised if gold goes to $1,000 or even to the previous record high of $850, but as I said earlier, BCA is much more often right than wrong.  Gold has had a very impressive run over the last year, with prices above $500 (a 25-year high) as this is written.

While BCA is long-term bullish on gold, they caution that the market has been bid up to new highs largely by hedge funds and speculators that have based their purchases on the outlook for much higher inflation.  As a result, BCA expects it will be a wild ride from here on up.  I certainly agree!  Therefore, I would only look to buy on meaningful setbacks.

[EDITORS’ NOTE: As you know, I am in the business of finding professional active money managers in the various market sectors.  For years, we have searched high and low to find an active manager in gold/precious metals.  The only gold trader we found with an impressive record proved unable to trade effectively with a larger base of assets.

The point is, if you know of a successful gold/precious metals trader, with a legitimate and verifiable performance record (no hypotheticals), please let me know and we will check them out.]

Conclusions

There is indeed some very encouraging news on the US economy as discussed on pages 1 and 2, news that you are not likely to hear in the mainstream media.  While BCA predicts that the economy will slow marginally in 2006, to a 3-3½% rate in GDP growth, they see no recession in sight for at least the next year and probably longer.  And they see inflation remaining low for the next several years, which is the centerpiece of their optimistic outlook.

The yield curve is likely to invert slightly over the next 3-6 months, especially if the Fed raises short-term rates two more times.  However, if inflation remains low as BCA expects, they do not believe that a mildly inverted yield curve will lead to a recession as has been the case in the past.  Keep this in mind as you hear much more about the yield curves in the weeks and months ahead.

BCA predicts that equities and bonds will remain in a broad trading range again this year and suggests buying the dips and other active management strategies.  BCA believes that home prices on the national level are likely to slip modestly but not collapse.  The editors continue to believe that energy prices will rise over the next several years, but not by enough to send us into a recession.  Finally, the editors have become long-term bulls on gold.

Lastly, I must remind you that while BCA has been my single best source for economic and financial advice for almost 30 years, they are not perfect.  No one is.  With that said, I recommend BCA very highly. I encourage you to visit their website at: www.bcaresearch.com.                                                                         

In closing, I hope everyone had a great holiday!  I thank you all for your continued confidence and I wish you a Happy & Profitable New Year!!