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The American Economy
…moderate growth continuing
U.S. economic growth near a 2.5%-2.8% real (inflation adjusted) annual rate seems likely over the balance of the year. Weakness in the housing and automotive sectors should be offset by solid growth in services. We don’t subscribe to the recession view pushed by a noisy few, although odds of a recession have risen.

The Federal Budget
…lesser red ink
Powerful gains in corporate and individual tax receipts reduced the budget deficit for fiscal year (FY) 2006, which ended last September 30, to $248 billion. This compares to the $318 billion shortfall in the prior year. A budget deficit around $200 billion seems on tap for FY2007, while budget issues become more challenging in coming years.

Employment
…tight and tighter
The American economy added nearly seven million net new jobs during 2004 to 2006, a solid rise. The issue of tighter labor availability—especially for skilled workers—will challenge businesses of all shapes and sizes in coming years.

The nation’s unemployment rate averaged 4.6% during 2006 and in early 2007, a five-year low. By comparison, the jobless rate averaged 5.3% in 2004/05 and 5.9% in 2002/03. Monthly job gains have slowed. We expect the unemployment rate to average 4.6%-4.9% in 2007 before moving lower in subsequent years.

Inflation
…tied to oil
Declines in energy prices sharply reduced inflation pressures in 2006’s final months. The Consumer Price Index rose only 2.5% last year, versus 3.4% in 2005, 3.3% in 2004, and 1.9% in 2003. Most forecasters see 2007 consumer inflation near 2.5%-2.8%.

The Federal Reserve
…on the sidelines
The Federal Reserve has now been on the monetary sidelines for nine months, following 17 consecutive 0.25% hikes (to 5.25%) in the critical federal funds rate between June 2004 and June 2006. Prior to that period, the federal funds rate was at a 46-year low of 1.00% for 12 months.

Most forecasters expect the Fed to remain on hold through 2007’s first half, with a possible move or two to the downside during the second half. Subprime lender anxiety could lead the Fed to cut sooner. A vocal minority of economists still expect the Fed to tighten later in the year.

Long-Term Interest Rates
…recently trending lower
Thirty-year fixed-rate mortgages declined to the 6.00%-6.125% level in early to mid-March. I would suggest that mortgage rates have peaked for this cycle, with rates possibly moving to “the very high 5s” by mid-year 2007.

Home Prices
…more realistic pricing
Surging home values on both coasts and in the Southwest during the past five years gave way to a buyers’ market more recently. The simple reason? The average American home rose 55.21% between 2001 and 2006. Florida?…up 106.90%. California?…up 105.80%. Nevada?…up 99.35%. Arizona?…up 96.55%.

Homeowners and “flippers” simply pushed prices too far, requiring the current painful downward adjustment. We expect greater home price strength in the nation’s interior as relative values (compared to the coasts) are attractive.

The Global Economy
…powerful growth continues
Solid global growth is expected in 2007, following impressive growth during the prior four years. Solid growth for 4-5 straight years would be the first such occurrence since the early 1970s. Risks to this view include any major terrorist atrocities (especially on U.S. soil), much higher oil prices, and a worsening of Middle East tensions.

Any discussion of the Pacific Rim must begin with Japan, a nation that still accounts for more than half of all Asian economic output and still ranks as the world’s second largest. Japan returned to modest economic growth during the past 36 months…following “the lost decade” of economic stagnation. Rising exports to China and stronger consumer spending have benefited Japan.

India’s economy continues to perform well, although an infrastructure of two-lane national highways and antiquated airports, sewers, & water systems must be addressed. Most other economies in the Pacific Rim are performing reasonably well (see below for an expanded discussion on China).

The European economy has strengthened, with real growth near 2.5%, the best in six years. Kingpins Germany and France still struggle with jobless rates near 10.0% and 9.0%, respectively. Long-awaited labor reforms bode well for greater European competitiveness in coming years.

The Russian economy continues to take advantage of solid oil prices and high oil production, with Russian oil exports now second only to the Saudis. Moves toward greater governmental control and lesser individual freedoms are worrisome to both the citizenry and Kremlin-watchers around the globe.

The South American economy has slowed somewhat. Oil-rich Venezuela remains a political powder keg, with production now in decline.

Canadian economic growth has slowed, although the energy-rich Western provinces are booming. Recent unemployment rates in the “low 6s” are at a 30-year low. The Mexican economy is growing at a reasonable clip, with national political tensions still at sky-high levels following a bitter Presidential election.

The Bottom Line?
U.S. economic growth during the past 36 months has been solid. Stable growth is likely to continue. In addition, we expect: another 12-digit budget imbalance…slowing employment gains…modest inflation pressures…relative stability in both short- and long-term interest rates…soft coastal housing markets, with more solid interior performance…and an anxious but impressive global marketplace.

China

Chinese economic growth of the past 30 years has been impressive. China is a centrally-planned Communist nation that has strongly embraced its unique version of free enterprise. By most measures, China now ranks as the world’s fourth-largest economy, trailing only the United States, Japan, and Germany. Given its enormous population and vast natural resources, China could challenge Japan for economic leadership in the Pacific Rim by 2020.

Even as economic growth has been impressive, the Chinese face major challenges in coming years. One major issue is the growing income disparity between the newly wealthy and the majority of the population, especially those in rural areas. Tens of millions of Chinese citizens have seen strong economic growth boost their standards of living. However, similar numbers of Chinese have fallen further behind.

At the same time, powerful Chinese economic growth has led to serious issues with environmental damage. Too many cities are covered with clouds of polluted air, while too many rivers have been poisoned with industrial runoff. Greater environmental protection must be factored into the Chinese growth equation in coming years, a move likely to slow future economic gains.

China’s financial system is also fragile, with Chinese banks holding vast amounts of uncollectible loans. Too many loans have been made based on political relationships and cronyism. At the same time, a vast lending network between Chinese citizens exists which bypasses the banking system.

The Labor Issue
China’s rise as a major manufacturing center has been impressive. However, the illusion of limitless and inexpensive labor availability in this nation of more than 1.3 billion people is simply that. Shortages of skilled labor, including managers of all types, are a reality today.

Engineers are in short supply. Such shortfalls of talent will become increasingly apparent as China continues its desired move from being a low-cost producer of apparel, toys, and various commodities to higher-skill, higher-cost output including electronics, steel, furniture, and autos. Land costs have also risen dramatically in recent years.

Substantial pressure remains in place from the United States and other major nations for the Chinese to allow their currency, the yuan, to sharply appreciate as a means of trimming its massive trade surplus with the United States. Critics maintain that the Chinese keep their currency at an artificially low value as a means of flooding the world with exports.

The Chinese have allowed this process of currency appreciation to occur at a modest pace. The Chinese have also made it clear that they will determine the pace of additional yuan appreciation in coming years, and will not have such decisions dictated to them by a U.S. Administration or Congress.

The Dollar Issue
The flipside of China’s massive trade surplus with the United States is their accumulation of hundreds of billions of dollars and dollar-denominated securities. Critics of such a development warn of the threat that the Chinese could, at some future point, decide to sell some or all such dollar holdings, triggering a massive fall in the dollar. In contrast, major dollar ownership is also the reason why the Chinese would not entertain such a move on an elaborate scale.

China’s increasing role as a major global player will require certain changes to occur. The rule of law and copyright protection must be strengthened, while state-owned enterprises should eventually give way to greater private sector participation.

I am asked frequently if the Chinese Communist leadership could stop the powerful entrepreneurial growth underway in recent years. My answer is to picture a powerful thoroughbred flying down the race track. Picture a tiny jockey holding on to the reins for dear life near the tail. The horse is the free enterprise explosion underway in China. As you might assume, the jockey is the Communist leadership.

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