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The Economy: Five Wild Cards For 2005


There's an old saying in economic forecasting: The consensus is always wrong. That's why the key to investing wisely in 2005 may well lie in considering how the economy will stray from expectations. To evaluate the risks and possibilities for 2005, BusinessWeek asked the economists in our annual outlook survey to think outside the box of their basic forecasts by identifying the wild cards that could have a positive or negative impact on the outlook. That's not to say consensus forecasts are useless. Far from it. They provide an important baseline for judging the economy's performance as it plays out. For 2005, the 60 forecasters we surveyed expect, on average, that the economy will grow 3.5% from the end of 2004 to the end of 2005. That's a bit below the 3.8% pace expected for 2004. The consensus view is that profit growth will slow to 6.7%, and inflation will fall, as oil prices slip to $39 per barrel by the end of 2005. The Federal Reserve will keep lifting the federal funds rate, to nearly 3.5% by yearend, from 2.25% now, and the yield on 10-year Treasury bonds will increase from 4.3% to 5.1%. In general, economists see the dollar slipping at a gradual pace of about 10% against major currencies and 5% vs. all currencies. The jobless rate should fall from 5.4% to 5%.

All in all, that's not too shabby. But what could throw the consensus for a loop? Here are five economic wild cards for 2005 that bear close scrutiny as the year progresses. They're especially important because they are interrelated: A surprise in one area could generate unexpected consequences elsewhere. These wild cards are the most credible threats to the general forecast -- and to the value of your portfolio.

WATCH OUT FOR FALLING DOLLARS

A possible crash in the U.S. dollar surpassed even oil prices as the biggest question mark on economists' minds for 2005. "This has been my worst nightmare for some time," says Nicholas S. Perna of Perna Associates in Ridgefield, Conn. The growing concern is America's ability to attract the massive amount of foreign capital it requires to finance both private and public investment. The trouble: A rising federal budget deficit subtracts from the available pool of domestic savings, even as the widening trade deficit adds to the financing needs.

The danger, says Perna, is a loss of confidence in the U.S. economy and those running its economic policy that could play out in a rerun of the 1980s. Early in that decade, the stimulative effects of budget deficits helped to push up the dollar and the trade deficit. But in 1985-87 the dollar plunged 40% vs. major currencies, yields on Treasury bonds jumped two percentage points, and stock prices plunged 30% in October, 1987.

Economists already see some increasing reluctance by both private investors and central banks to hold U.S. Treasury securities. But if the greenback really tanks, "the primary effect will likely be on the U.S. corporate bond market, where overseas investors -- largely Europeans -- account for about half of new-issue buying," says Vincent Boberski at RBC Dain Rauscher in Minneapolis.

Sharply higher interest rates would be especially damaging to a frothy housing market, the stock market, and heavily indebted consumers. More ominously, higher rates would increase the risk of an outright recession.

AVOIDING ANOTHER OIL SLICK

Unlike the dollar, oil is a wild card that could swing either way. On the negative side, another spike in oil prices could slow consumer demand just as it did in 2004. "If oil remained at $50 to $55 per barrel, it would lower gross domestic product growth next year by about one percentage point," says Richard D. Rippe at Prudential Equity Group. Other economists worry that, given the right geopolitical upheavals or supply disruptions, oil could hit $60 or $70, a shock that would further crimp household buying power and pummel corporate profits. "Oil prices at $80 would undermine business and consumer confidence sufficiently to cause a mild recession late next year," says Kurt Karl of reinsurance firm Swiss Re.

But economists see an equal, if not greater, chance that oil prices could fall, perhaps to $25 per barrel. That could be precipitated by several factors, including an expected slowdown in global demand, a mild winter, or an easing of Mideast tensions either in Iraq or between Israel and the Palestinians. Cheaper oil "would spark a period of very strong growth in the U.S. as consumers and companies respond to the cash flow gains generated by the drop, pushing growth towards perhaps 6% for a time," says Ian C. Shepherdson of High Frequency Economics in Valhalla, N.Y. Stock prices would benefit handsomely, and the wealth effect would support consumer spending. However, don't expect falling oil prices to keep rates down. "The Federal Reserve would probably continue to raise interest rates with the economy growing above its potential," says Lynn Reaser at Banc of America (BAC) Capital Management in St. Louis.

INFLATION BREATHES FIRE

Oil and the dollar have one thing in common: the potential to affect inflation. That may well explain why our survey's inflation forecasts vary more than usual, from 1.2% to 4.4%. Consumers and businesses could easily adjust to a return of low inflation after 2004's oil-fueled rise. But if prices pop up 4%, that would send both bond investors and the Fed scrambling. "We believe there is a significant risk that inflation will be higher than expected," says Lynn O. Michaelis at Weyerhaeuser Co. (WY), noting that the dollar's drop and higher commodity prices are just beginning to wend their way into final goods prices. Matters could be worse if China revalues its currency higher. "This would result in revaluations of other Asian currencies and allow U.S. businesses to become more aggressive in their pricing," says Mark Zandi at Economy.com Inc.

Bear in mind that many of the factors that held inflation down during the 1990s are reversing. And it's not just the weaker dollar or costlier energy. First, productivity growth is slowing, as it does when a recovery matures. That, together with a tightening job market, will push up unit labor costs. Second, factories are busier. "The Fed's capacity numbers understate the true capacity utilization rates," asserts Robert Shrouds at DuPont (DD). "Based on the experience at my company, utilization rates are high across a broad range of products." Lastly, monetary policy is still unusually accommodative, with the Fed's target interest rate still close to zero after adjusting for inflation. An inflation surprise would cause the Fed to lift rates more and faster than expected.

POP GOES THE HOUSING BUBBLE

If rates rise faster than the consensus expects, housing is especially vulnerable, say some economists. "Houses that look affordable now would not look so with mortgage rates two percentage points higher," says Nariman Behravesh at Global Insight Inc. in Waltham, Mass. If mortgages rise to 8%, many buyers would have to scale back their aspirations, and some homebuyers would be priced out of the markets, causing a downshift in home demand.

More important, a weaker housing market would prick any bubble in prices, deflating household wealth. Consumers would have to save more and shop less. And with mortgage rates up, refinancing would dry up, also crimping spending.

AS THE WORLD CHURNS

Another wild card foremost in our economists' minds is a sharp slowdown in global growth. "The euro area is weighed down by currency appreciation and the absence of any domestic demand dynamic," says Bruce Kasman at JPMorgan Chase & Co. (JPM), "and Japan's recovery could prove disappointing." If China's efforts to cool off its economy rip its fragile financial fabric, that could have global repercussions. The risk is that weak demand would cut into U.S. exports, thwarting the chances for a lower dollar to help stabilize the trade deficit.

Not surprisingly, the threat of terrorism looms over all. "A terrorist strike in the U.S. or marked escalation of the conflict in the Middle East could result in an attendant drop in business confidence that would undermine the expected recovery in investment and employment," says Tim O'Neill at BM Financial Group/Harris Bank in Toronto. Another attack could hasten the dollar's decline, roil the financial markets, and harm the economy.

The problem is that terrorist attacks are impossible to forecast. But that only illustrates how one day's events can derail a yearlong consensus forecast. If all goes according to the forecasters' plans, 2005 should be a decent year for both the economy and a well-balanced portfolio. But investors should heed the lesson of recent years: Expect the unexpected.

By James C. Cooper & Kathleen Madigan


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