Worst Case, Best Case, or In Between? Nine Scenarios for the Direction of the US Economy By Ernie Ankrim, Chief Investment Strategist Russell Investment Group November 9, 2005 The following article has been issued by our parent Frank Russell Company in Tacoma, Washington and is referring specifically to the US market unless otherwise stated. Heading into the final stretch of 2005, the Canadian economy continues to remain strong. According to Statistics Canada, the nation's unemployment rate fell to a 30-year-low in October, while year-over-year, gross domestic product growth was a relatively solid 2.7%, pushed by manufacturing, mining, oil-and-gas extraction and exploration. However, whether we like to admit it or not, the Canadian market is significantly tied to the influential US economy. Therefore, it is important to be aware of developments in US economic and monetary policy. The US has had uncertain economic times before, but by any measure today's situation is challenging. Higher energy prices are weighing on consumer spending. Hurricane devastation is still being tallied, and the costs of reconstruction are mounting. Quite naturally, consumer confidence has been on a roller coaster. So how can we even guess at where the market may be heading? We can turn to old-fashioned grid analysis to make a reasonable decision from the alternative scenarios. That's because when we eliminate the factors we don't have a good handle on — such as the limited reliability of post-hurricane data — there are just two key points to consider: How strong is the US economy? And, where is the US Federal Reserve (today or in 2006 when Ben Bernanke is Chairman) taking fed funds rates? Let's first examine each factor individually, and then see what we can deduce when we combine them on a grid. The Good, the Bad and the Ugly When you look at the typical measures on economic strength, you can find data to support just about any conclusion you'd like to reach. On the positive side, US government (federal AND state & local combined) deficits are coming in lower than projected. Inflation expectations remain contained. And corporate profit expectations are still relatively strong. Yet these promising points are countered by:   high levels of mortgage and consumer debt the lowest level of consumer confidence since October 2003 a falloff in the number of favorable company surveys being issued What's more, there are the "ugly" factors of energy costs, natural disasters and corporate bankruptcies. The bottom line is that we don't really know how strong the US economy is. What we do know is that it's weak, normal or strong — so we'll come back to those three possibilities. Figuring Out The US Fed We know that the US Federal Reserve has taken the fed funds rate from 1.00% up to 3.75% — so far. The Bank of Canada has also been active, raising its overnight target rate from 2.75% to 3.00% at its most recent meeting on October 18, 2005. The question on everyone's mind is: when will the Fed be done. Investors know that the Fed won't tell the market they're done until they're certain they've gone far enough. Like economic strength, there are three possible ways the US Fed will proceed: an easy, moderate or tight policy. They could take the easy road and stop where they are at 3.75, or perhaps take a more moderate course at 4.00% — yet if they do and the economy's underlying condition is strong, we could be facing rising inflation and long-term interest rates. However, if they adopt a tight policy and raise the rate to 4.75% or higher, we could be looking at a policy-induced recession if it turns out the economy's underlying strength is weak. Analyzing the Whole Nine Yards Let's put together our grid and see where logic — and a little bit of fearless guesswork — takes us. Our three possibilities for economic strength, and our three possibilities for Fed policy, equal nine possible scenarios: Fed Policy Current Underlying Economic Strength   Weak Moderate Strong Tight       Moderate       Easy       As I see it, we have five possible outcomes for the economy, ranging from negative growth (otherwise known as a recession) to blistering growth (otherwise known as inflation.) Here's how they relate to each combination: Fed Policy Current Underlying Economic Strength   Weak Moderate Strong Tight NEGATIVE GROWTH NO GROWTH MODEST GROWTH Moderate NO GROWTH MODEST GROWTH SOLID GROWTH Easy MODEST GROWTH SOLID GROWTH BLISTERING GROWTH Now what's the likeliest scenario? Here's my assessment: Fed Policy Current Underlying Economic Strength   Weak Moderate Strong Tight AVERAGE LIKELIHOOD HIGH LIKELIHOOD (my guess) HIGH LIKELIHOOD Moderate LOW LIKELIHOOD LOW LIKELIHOOD (my choice) AVERAGE LIKELIHOOD Easy LOW LIKELIHOOD LOW LIKELIHOOD VERY LOW LIKELIHOOD Now here's where I part company with the US Fed. If I were running the show, we'd be done with fed funds rate increases and pursuing a moderate US Fed policy with moderate economic growth — smack dab in the center of possibilities. Which is usually a good place to be. However, my guess is that the US Fed will pursue a tight policy, with additional rate increases; this may substantially slow, but not crater the economy. History shows that the Fed tends to err on the side of over-concern with inflation. If I'm wrong and the Fed overdoes it, bonds are likely to become a better investment than equities. A policy-induced recession is likely to sharply reduce future profits. However, even incorporating the most pessimistic earnings forecasts I can find, equities still appear to offer better opportunities than bonds. We'll see in the next few months whether good times or grid lock are ahead.			related articles Printer friendly version of this page

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