Fine Tuning

Investors have gradually moved away from the notion that the Fed is ready to cut interest rates while some think they may be near raising them. The economy has slowed, but will it continue to slow sufficiently to squeeze out inflation? Sure housing and autos are in the basement. Just yesterday, the National Association of Realtors reported that sales of existing homes in 2006 dropped 8.4%, the biggest droop in about a quarter century according to the WSJ. Also yesterday, Ford reported a staggering net loss of $5.8 billion during the fourth quarter, dragging its shortfall for all of 2006 to $12.7 billion.  General Motors said it would delay filing its fourth quarter and 2006 earnings results as it “will restate its financial statements, primarily due to pre-2002 tax accounting adjustments,” according to its statement also in the WSJ.

Against this backdrop, the rest of the economy seems to be doing pretty well. Today the government reported that durable-goods orders climbed during December across the board, with the largest increase coming in commercial aircraft as Boeing received 217 orders in December, compared with 58 in November. Business-equipment spending rebounded from earlier weakness too.

The economy may be near the hoped for “soft landing” scenario of 2-2.5% growth, yet inflation remains higher than the Fed’s stated comfort level. What’s puzzling the Fed and investors is that the job market remains as tight as it was when the economy was ripping along at 4.7%. The concern is that employers will have to pay considerably more as potential new employees become scarce.

On the other hand, it could be that unemployment numbers lag the economy and will increase in the coming weeks and months. Ford and General Motors combined employed about 650,000 people before announcing their latest plans for cutbacks. The layoffs could mean 300,000 people cut from those two companies alone. Add to that the numerous job casualties in housing and you get a large increase in individuals in the job market who aren’t consuming.

But the impact of these issues remains to be seen. The fact is the economy isn’t slowing much below the current rate of growth which is thought to have hit 3% in the fourth quarter. The consensus for first quarter growth of 2.5% is rising. Experts think that housing will remain a drag, but trade and consumer spending, fueled by job growth and lower oil prices, have more than compensated.

If the Fed is right and they have indeed managed a successful “soft landing” that effectively squeezes out inflation without damaging the economy or jobs, then perhaps rates may be coming down soon. If on the other hand, inflation stubbornly remains, more pain may be in store.

We believe the inflation blip had everything to do with the speculative price run-up in oil prices induced by the Gulf Coast hurricanes followed by similar runs on metal commodities. Now that supplies have proven sufficient, prices are coming down to more realistic market-driven levels. As these two influencers return to normal, inflation should retreat to levels more acceptable to the Fed. While wage-driven inflation is still a concern, it has not yet proven to be a significant threat. We think that businesses will continue to invest in productivity enhancing technology to reduce costs while improving output. They must; their competitors in China,India,Korea,Japan, and Europe are doing so at a dramatic pace.

The US, by most reports, should turn in a pretty good year in stocks, while global companies could outshine yet again. And after seven years of underperformance, we think that growth stocks in general and technology in particular will lead the way.