We anticipate slow positive economic growth for the US economy. Although industrial and consumer spending is still increasing, the rate of growth is decreasing. On the consumer side, Thanksgiving weekend holiday shopping presented a mixed bag of news as people sought bargains, especially on flat panel and high definition TVs. Thus, retail sales numbers looked strong, but mostly because of cut throat pricing. Many stores, like The Gap, are going to struggle through this holiday season. On the corporate/industrial side, cash coffers are healthy and spending should remain in step with the economy. In addition, Microsoft’s roll out of its new Vista operating system and Apple’s release of its latest operating systems in early 2007 will lead to a swell of consumer spending and IT upgrades that should last well into 2008. Expect stock prices to keep rising and bond spreads to remain tight through next year.

The US Dollar fell to its lowest in a year-and-a-half against the euro on speculation from currency traders that the Fed will lower interest rates in early 2007 from the current 5.25%. In contrast, Europe’s central bank has lifted borrowing costs six times over the last 12 months to 3.5% – most recently at its last meeting on December 7 – and may continue to do so. The narrowing yield premium on dollar-denominated government debt is attracting investors away from the dollar and towards assets in the euro region as well as encouraging foreign central banks to shift more of their reserves to non-US currencies. A stronger euro will undoubtedly hurt exports to the U.S., the region’s largest trading partner. On the other hand, the Japanese Yen has slowly weakened from its strong May levels and is near where it was at the beginning of the year.  Most notable, however, is the strong and continued appreciation of the Chinese Yuan vs. the US dollar, which will increase inflationary pressures on the US.

US Federal Reserve Chairman Ben Bernanke continues to see “uncomfortably high” core inflation as a monetary threat, although he believes it is likely to ease in 2007. “Over the next year or so, the economy appears likely to expand at a moderate rate, close to or modestly below the economy’s long-run sustainable pace,” he said. By noting inflation as a looming threat, Bernanke is trying to dissuade the markets from pricing an imminent rate cut into their forecasts. Rising labor costs along with pricier imports (because of the weakened dollar) will exert upward pressure on inflation while trouble in housing and automobile production will act as inflationary brakes. Expect the Fed to keep interest rates stable at least until March.

The price of existing homes bought in October fell for the third straight month and posted a record drop. Nationally, the median price is $221,000, down from a high of $230,000 in July. Previously we had only seen month-over-month price declines; we are now witnessing year-over-year price drops. Expect the number of homes sold to decline further during the traditionally slow months of November, December and January. If there is a near term bottom or flattening in the housing market, it will probably occur when the Fed lowers rates next year. To date, the decline can largely be attributed to a changing mix of homes purchased as cautious buyers are less likely to buy up into more expensive homes.

Michael Ashley Schulman, CFA
Hollencrest Capital Management