Financial Watch

Steady, but Unspectacular Growth Predicted for U.S. Economy Next Year

Economic growth in the United States is on pace to have expanded at a 3.6% clip during this past year. A resilient consumer and strong government spending are most responsible for powering the U.S. economy onward during the past year. The coming year will prove to be more difficult as consumers pull back somewhat. The big question going into 2006 is whether corporations will pick up some of the slack and keep the economy rolling. Corporate spending should be robust next year, but a disproportioned percentage of the growth may occur overseas in emerging nations to take advantage of lower costs. Financial Watch remains concerned how long the U.S. trade and current account deficits can remain as large as they are before a crisis emerges. In all likelihood, the coming year will present a few surprises, but nothing completely out of the ordinary. With that in mind, here are Financial Watch’s top ten predictions for the 2006.

1) U.S. Economy Will Expand by 3.3% in 2006
The momentum of the past year should help the U.S. economy grow at a fairly robust pace during the first part of the year. Rebuilding from Hurricane Katrina will provide a moderate bounce to growth, but not as much as was initially expected. Congress is much more concerned about preserving tax cuts on investments than it is about providing assistance to those in the Gulf Coast Region devastated by Hurricane Katrina. Our second half forecast currently calls for slightly below average growth. We believe the Federal Reserve will go too far in their campaign to push up interest rates. At the same time, lots of liquidity remains in the financial system. Strong productivity will provide Ben Bernanke leeway to cut interest rates if growth slows to undesirable levels. Strong job growth in the service sector should overcome the negative impact of a slowing consumer and allow the U.S. to turn in another decent year for economic growth.

2) Trade Deficit Sets Another Record
This coming year might be the peak point for the gigantic U.S. trade deficit. We are confident the trade deficit will once again set a record by likely surpassing $800 billion or 7.5% of the nation’s gross domestic product (GDP). Asians nations show very little sign of letting up of their massive accumulation of U.S. dollars. The U.S. economy looks poised to once again outpace most other developed nations. China will once again be most responsible for our nation’s large imbalance. However China is not the only party responsible for our trade deficit. The U.S. holds a trade deficit with just about every foreign country we do business with. On a positive note, the European Union appears set to show some signs of life during the second half of 2006 and this could lead to a pleasant up tick in exports.

3) Dollar Resumes Depreciation Against Major Currencies

The Foreign Repatriation Act and Alan Greenspan gave the greenback a nice lift this past year. The Fed’s tightening cycle and the Repatriation Act will both end early in 2006. Currency traders should then refocus their attention on America’s twin deficits. Much of the U.S. dollar’s appreciation this past year occurred against the Japanese yen and the Euro. A $400 billion void will be left by the expiration of the Repatriation Act. Either foreign money will need to pour into the U.S. dollar in massive amounts or we should expect to see a resumption of the greenback’s steady decline against other major currencies.

4) General Motors Nears Bankruptcy
Barring major concessions for the labor unions it is only a matter of time before General Motors heads into bankruptcy. Rising interest rates, growing pension costs, and slowing demand for Sport Utility Vehicles has forced the company into a position where it would nearly take a miracle for the company to ever regain profitability baring a major restructuring. GM should be able to make it through another year, but investors would be wise to stay away from the company’s stock.

5) China Allows Yuan to Appreciate Modestly
China is content to allow persistently growing trade surpluses to fuel their economic growth, but its leaders are smart enough to realize the political pressure U.S. lawmakers are under to create jobs, particularly in the manufacturing sector that has been devastated by China’s emergence into the global economy. Financial Watch expects a modest appreciation of the Yuan during the upcoming year. The adjustment will likely be in the neighborhood of 5-10%. Such an adjustment would be favorable to both the U.S. and Chinese economies. If China is ever to realize its goal of becoming a major economic power, its businesses must be able to go head to head with firms in developed nations. At this point, most Chinese businesses are far from prepared to compete on a global scale. China will continue to grow strongly into 2006, but at as it grows into a more important economy China must be able to overcome hurdles every industrialized country faces.

6) Residential Real Estate Bubble Bursts in Some Metropolitan Markets
Phenomenal appreciate in coastal markets over the past few years has made it profitable for speculators to flip newly constructed homes. The period for realizing rapid appreciation in real estate ended in late summer, but many speculators continue to hold properties hoping to lock in strong profits once seasonal factors become more favorable in the Spring. Once this excess supply enters the market there will be a glut of unsold homes in some regional markets. Further adding to problems are the homebuilders who continue to build new residential homes despite deteriorating market conditions. It is tough to predict future homes prices a year from now since the Federal Reserve continues to raise interest rates. Should interest rates continues to be pushed higher until reaching 4.75%, as is the consensus on Wall Street, Financial Watch expects to see national real estate prices drop by 2-4% over the coming year. The most vulnerable regional sub markets may realistically see real estate depreciation in the neighborhood of 10%.

7) Stock Market Shows Modest Gains
Financial Watch expects to see the Dow Jones, NASDAQ, and S&P averages to show modest gains during the coming year. January should prove to be a solid month as seasonal factors and anticipation about an end to the Fed’s tightening cycle help to lead the market averages higher. In fact, we expect to see solid gains early into 2006 followed by a mid-year pullback, and another rally to close out the year. Overall, Financial Watch expects to see the Dow Industrials close out 2006 trading between 11,500 and 11,700. The S&P 500 should post similar returns and finish up next year between 1325 and 1350. Industrials, Investment Banks, Health Care and Insurance companies face favorable conditions going into 2006 and should be market leaders next year. Volatility is expected to pick up next creating more opportunities to profit from the markets, but also increasing market risks.

International Stock Markets Turn in Another Stellar Performance
Global stock markets appear set to once again outpace the U.S. markets in 2006. Investors in the United States could also see their returns on international holdings enhanced by a falling U.S. dollar. The importance impact exchange rates have on portfolio returns is evidenced by investors experience in the Japanese stock market over the past year. The Nikkei is up approximately 40% for the year, but returns are reduced by 15% for U.S. investors when currency fluctuations are taken into consideration. Although U.S. investors would have still realized strong returns in the Nikkei in 2005, exchange rates add an element of risk to a portfolio that cause investment returns to fluctuate greatly from year to year.

9) Oil Prices Retreat to More Normal Levels
Economic growth will be slower both in the United States and abroad during the coming year. This should help to ease some of the concerns over a supply crunch. China and India continue to see strong demand growth for oil, but OPEC has been able to meet demand thus far and barring an unforeseen event will have no trouble meeting future demand. Oil traders so far have turned a blind eye to rising U.S. oil inventories during a time of year we typically see inventory outflows. At some point fundamental factors will come back into play. Financial Watch expects oil to slid gradually throughout 2006. Our forecast calls for oil to be priced between $45-50 barrel next December.

10) Interest Rate Yield Curve Remains Flat
For a brief moment last week, the yield between the U.S. 2 and 10 year notes inverted. In most situations this only occurs just prior to a recession and signals to lower short-term interest rates in the near future. However, international monetary forces are exerting strong downward pressures on long maturity U.S. securities. This should not change much next year unless the Chinese Yuan appreciates much more than we expect. Financial Watch expects the U.S. 10 year note to yield just over 5% next December. The interest rate yield curve should remain flat throughout next year. Slower economic growth during the second half of the year may lead the Federal Reserve to consider adjusting to a more accommodative monetary policy, but Financial Watch believes core inflation levels above the Fed’s desirable level should prevent Ben Bernanke from adjusting monetary policy until 2007. Although long-term bonds yields may peak at the time the Federal Reserve pauses in their campaign to cool the economy, Financial Watch continues to recommend that investors stay away from long-term U.S. government securities. The marginally higher yield on long-range securities will not be sufficient to compensate investors for the risks borne in holding those assets.