Michael Message-Outlook for 2007

As Spring peeks over the horizon and the days continue to lengthen, this seems a good opportunity to shed some light on the economic outlook for the next year, and on appropriate investment strategies based on that assessment.

Looking ahead is not an idle exercise. It’s the only way to base an investment strategy. Yet, what’s done well in the recent past doesn’t necessarily mean that’s what will work tomorrow.

Given all the uncertainty in the world, looking ahead may seem a difficult task at this particular point in time. From the potential of Iran developing nuclear weapons to global warming; from Iraq to the presidential elections coming next year, the world and the world’s financial futures are fraught with diverse possible outcomes.

This uncertainty is clearly reflected in today’s financial world: while the stock market stays relatively bullish, the bond market says an economic slowdown is looming.

This slow-down prediction is based on the historical relationship between short and long-term interest rates. Historically, when short-term rates are higher than long term rates, the economy goes into recession within six to 18 months. Estrella and Mishkin (Federal Reserve Bank of New York, “Current Issues in Economics and Finance”, June 1996) wrote about the relationship, and our current situation is illustrated in the graph.


An unexpected large slow-down in the economy would make bond prices go up and yields go down. That wouldn’t be good for corporate profits and equities, necessarily, but it would be good for high quality bond holders. So in many ways the stock and bond markets root for opposing outcomes. The one outcome they could all agree on would be a “goldilocks economy” where it’s not too hot and not too cold, and inflation is under control.

From my perspective, the most likely outcome is that the stock market muddles through and does ok for the next year. The same is true for bonds. What’s ok? I see returns of 5 to 8 percent on stocks, and probably 3 to 6 percent on bonds.

So that’s one aspect of the picture. Let’s take a look at some of the issues facing us this year, so that the impact of whatever happens may not throw us too far off our current investment track. One thing to note: the interconnection of many of these world concerns.  

(1) Oil. In the short run, the fact that oil prices have come down will probably encourage the Feds to keep rates higher. Higher oil prices act like a tax, thus slowing consumption. Lower oil prices allow for increased economic activity. So if you take off the drag of higher energy prices, short-term rates are likely to stay higher.

When looked at from an outlook perspective, this strategy tells me that it may be time to look at some oil stocks, now that their prices have come off, because in the long-run global energy demand is not going down.

(2) Iran and the Middle East. I think Iran’s desire to develop nuclear power capability has some pretty profound implications. This is an area of the world worth watching. Because a very large percentage of energy comes out of the region, it is strategically important to the global economy. Imagine if North Korea’s Kim Jong-il had the kind of economic clout that the Middle East has; it would completely change the political balance.

As for Iran, the hope is that if they get that nuclear capability they would act responsibly.

The strategy that would probably most damage the global economy would be a terrorist detonating a nuclear device that contaminates critical middle east oil fields. While not a high probability event, the likely economic outcomes would be: (1) immediate rationing of fuel (2) dramatic and volatile increases in prices, (3) ironically, a possible positive impact on global warming, given the tremendous contraction of energy consumption and resultant global recession.

(3) The Iraq War. The Iraq war has been costly in terms of lives and dollars, but as a percentage of our economy, it hasn’t been that significant. We have on the order of a $12 trillion economy. Although $120 billion a year for Iraq is a big number, it is just 1% in terms of the US economy.

(4) The Presidential elections. If elections have some impact on the financial markets, it’s more because there’s a belief that they do than an underlying economic reality, or economic cause. The election of the president has very little impact on what the economy ultimately does. The economy that presidents take credit, or are blamed, for was put in place years before the election and was mostly beyond the control of politicians.

(5) China. With China’s large trade surplus invested in U. S. Government securities, one question often asked is this: Would China hold the U.S. hostage by threatening to sell their US securities, pushing up interest rates and forcing us into a recession? The answer is no: this would not be in China’s interest. That’s like telling your best customer: I want to put you in a financial bind so you’ll stop buying from me!

That brings up another question: Can we expect China to act rationally? The Chinese view themselves as very rational. Sometimes we believe people are not acting rationally because they are not working with our agenda. China acts very rationally when it comes to its own self interest.

China takes a much longer term view than does the U.S. in terms of policy. It is a country with a 3,000 year history. The transfer of global manufacturing know how to China shouldn’t be taken lightly.

(6) Health care. Many of our health care problems are self-inflicted; a function of diet and lack of exercise. Heart disease, diabetes; many of these things are the cumulative effect of habits over 30, 40, 50 years. From our perspective, given the way we behave, the outlook is good. We own a lot of pharmaceuticals stocks in our portfolios, since we can rely on people’s habits and time to drive demand for their products.

With all of these issues and uncertainties facing us, what do I look at for the next year? The portfolios we have developed for our clients are really structured so that if bad, unexpected things happen, our positions in high quality bonds will perform well as other investors create new opportunities by selling risky assets and by safer investments.

By being properly allocated today, we are in a position where we are ready to act, whether the days ahead are full of sun, or clouded with uncertainty.