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Entering The New Year With A Head Of Steam


In investing, just knowing the right questions to ask can go a long way toward helping you get the most out of your portfolio. That's especially true when your returns are hostage to the uncertain twists of the economy. To help you understand the crucial issues in the investment climate for 2006, BusinessWeek addresses six key questions on the economic outlook.

We have plenty of help from our panel of 54 forecasters in our annual outlook survey (table, page 74). On average, they expect the economy to grow 3.3% from the end of 2005 to the end of 2006. That's a shade slower than the expected 3.7% pace for 2005, with growth progressively cooling in each quarter. Profit growth will slow to a pace of 7.3%, and inflation will fall as oil prices slip below $55 per barrel. The Federal Reserve will lift its target rate to 4.75% by spring, from 4% now, and the yield on a 10-year Treasury note will drift up to 5%, from about 4.5%. The jobless rate should edge down to 4.9%, from 5%.

On balance, not a bad scenario, assuming all of this comes to pass. Now the urgent questions that both investors and economists are wrestling with:

1. Is the economy more likely to be stronger or weaker than the survey consensus?

The better bet is on the strong side. A slight majority (55%) of the forecasters expect the economy to grow more than the 3.3% average projection. While consumer spending and housing will weaken, strength in capital spending, inventory rebuilding, post-Katrina government outlays, and exports will take up the slack. "Fueling growth will be businesses flush with cash and pristine balance sheets putting their [money] to work investing and hiring," says Mark Zandi at Moody's Economy.com ().

Many of the pessimists expect this general trend, too. But they also anticipate a sizable hit to consumer spending from the predicted housing slowdown. One problem with that scenario, though, is that few forecasters expect the yield on 10-year Treasuries to rise much above 5%, a level translating to 30-year mortgage rates of about 6.5%. Such rates may slow housing activity, but they will not precipitate a collapse.

Moreover, stronger growth overseas will be a plus. "Export growth should be solid in the coming year as major economies abroad retain forward momentum," says Keith Hembre at First American Funds. That trend, along with slower import growth, should stabilize or perhaps narrow the trade deficit.

2. How high will the Fed have to push interest rates in order to contain inflation?

No other question is more important to broad investment decisions than this one. The answer will depend on the strength of the economy and how that affects wages and inflation expectations. The fact that 38% of the forecasters expect the federal funds rate to hit 5% or more suggests a concern that the Fed may tighten more than the consensus expects.

Watch core inflation, which excludes energy and food. Energy prices only have to stabilize at current levels for overall inflation to decline next year. However, most economists expect at least moderate upward pressure on core inflation. If the economy remains as strong as it is now, more companies will pass along current higher costs for energy and labor to their customers. "Pricing power appears to have improved significantly in recent quarters," says John Ryding at Bear Stearns Cos. (). "Coupled with higher costs, we believe this will lead to higher inflation, which will keep the Fed raising rates through spring 2006."

Don't expect a surge in either core inflation or interest rates. The anti-inflation forces of strong productivity and global competition are still at work. Even a 5% fed funds rate is far from draconian.

3. The housing bubble: Slow leak or pop?

The view of most economists, including Fed Chairman Alan Greenspan, is that a national home-price bust is highly unlikely. Clearly, many local markets, mainly on the coasts, are overvalued and will face price declines as interest rates rise.

Still, housing presents the Fed with a delicate balancing act. Rising home values and the cash consumers have extracted from their home equity via refinancing and home-equity loans have fueled both consumer spending and the economy. So the less housing slows, the stronger the economy, and the greater the need for the Fed to raise rates. But overtightening policy could severely damage housing, and possibly the overall economy.

Where do rising mortgage rates fit in? They would have to increase far more than expected to hammer housing. In the past, 30-year fixed rates have approached 8% before monthly payments began to disqualify large numbers of potential buyers. But there are new risks now: The rate level could be lower because of higher home prices. Also, JPMorgan Chase & Co. () estimates that risky subprime loans make up close to 9% of mortgage debt, large enough to make a downturn worse if these loans begin to fail in large numbers. A high concentration of these loans makes California especially vulnerable.

4. Will the profits boom continue for another year?

The short answer is no. Profits in 2005 were surprisingly strong, even outside of energy. Through the third quarter, earnings growth for the Standard & Poor's 500 companies beat expectations for the 10th quarter in a row, according to Thomson Financial. "Pricing power is pretty good with profits at a record share of gross domestic product," says David Wyss at Standard & Poor's (). In 2006 earnings will grow more slowly but will remain well supported by consumer, business, and foreign demand.

It is normal for earnings to slow as a business upswing gets older, partly because productivity gains diminish and labor costs creep up, squeezing margins. That pattern is likely to play out in 2006. Through the first three quarters of 2005, companies were still boosting their efficiency at a good, if slower, clip. To the extent those efforts continue in 2006 -- and the imperative from global competition suggests they will -- profits should post more modest but still healthy gains.

5. What should investors expect from foreign economies?

Growth prospects abroad have improved. "Euro-zone GDP growth will rise from about 1% to 2.5%-3% in 2006, China keeps doing 9%-plus, Japan is back for real, and emerging-market growth remains robust," says James Paulsen at Wells Capital Management.

The two big updrafts will come from the euro zone and Japan, as reflected in the new attitudes of both central banks. The European Central Bank lifted interest rates on Dec. 1 for the first time in five years, and the Bank of Japan is laying the groundwork for ditching its zero-rate policy begun in 2001, now that its long battle with deflation is ending.

Higher interest rates and faster growth abroad will increase the attractiveness of foreign-currency bonds and stocks relative to dollar-based assets. That's one reason economists expect downward pressure on the greenback to resume in 2006. But the U.S. should be able to attract the foreign capital it needs to finance its trade deficit without a dollar crash.

6. What are the wild cards in the outlook that could shake up a portfolio's value?

A sharp dropoff in housing activity and home prices may not be the expected scenario, but it is at the top of most forecasters' worry lists of what could go wrong in the economy in 2006. So is the price of oil. Its ups and downs could be either a positive or a negative for growth. Any sharp swing out of the range of $45 to $70 per barrel would affect growth and overall inflation.

Fed policy is another prime concern, especially if the economy is stronger than expected, fueling more inflation pressures. Mickey Levy at Bank of America Corp. () frets the Fed could overtighten, thereby slowing the economy sharply or creating financial trouble elsewhere in the world. There is also concern about how well soon-to-be Fed chief Ben S. Bernanke will get along with Wall Street. Financial pros think they have a good read on Bernanke, but he lacks the Street savvy of Greenspan. His Fed's behavior in an unexpected financial crisis may be the key test of his rapport with the markets.

Throw in concerns about a possible plunge in the dollar, shrinking foreign capital inflows, and new acts of domestic terrorism, and you have enough in the mix to make any investor queasy. But if the forecasters are right about these six questions, a healthy economy should offer plenty of attractive opportunities to make money.

By James C. Cooper and Kathleen Madigan


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