During this edition of our Weekly Market Comment, we would like to take this opportunity to preview our market outlook for 2006. We believe that many of the significant issues that affected the markets this year will bleed over into 2006. On the positive side, we are optimistic that U.S. corporations will continue to post solid earnings gains, although at a slower pace than we’ve had over the past year. Long-term interest rates are likely to remain at historic lows as demand for U.S. treasuries will help to contain any significant spike upwards. Also, the Federal Reserve will continue to raise short-term interest rates into early 2006, further slowing the construction boom, but not far enough as to burst the housing bubble.
We believe a slowing housing and commercial real estate market is the most important factor for the economy in the upcoming year as it directly impacts consumer spending, the stock market, and commodity prices. As many homeowners have taken steps to refinance their mortgages at 2005’s low rates, they have also “cashed out” part of their home equity to finance home improvements, miscellaneous purchases, and to pay down less desirable debt. Now that the refinancing boom has likely run its course, this source of funding has been significantly reduced. We have already seen housing prices begin to slide in several key markets, such as in Phoenix and southern California as speculators have taken steps to reduce their exposure to these hot markets. Where has the money gone? Mainly to the stock market, helping to fuel the late-year rally that we are currently experiencing. As real estate is significantly less liquid than equities, we may continue to see further deterioration in housing prices as investors continue to shift into more timely and less inflated assets, such as equities. We believe the stock market may benefit from this asset allocation shift into 2006. We also believe that a slowing housing market will help to keep inflation in check. Construction is exceptionally commodity intensive, driving higher the price of diesel fuel, plywood, steel, cement, asphalt, etc. If the Federal Reserve is successful in engineering a soft landing for the housing market, the slowing demand in 2006 for basic materials is likely to cause a softening of prices, helping to keep inflation at bay.
As always, there will be challenges. We are already seeing a significant uptick in the number of planned layoffs by U.S. corporations, highlighted by the prospect of significant layoffs in the automotive sector. Both GM and Ford have announced plans to lay off a total of 55,000 workers over the next few years. The trickle down effect (layoffs by parts suppliers, distributors) is likely to compound the effect. In addition, we foresee numerous large corporations abandoning their pension plans to avoid the kinds of issued faced by GM, Ford and other corporations. Just this week, Verizon announced plans to freeze their current pension plan for managers (non union workers), and while it doesn’t effect current union workers and retirees, it will certainly become a bargaining chip when their next round of contract negotiations begins.
Politically, we believe the current environment will continue to be a difficult one in which to tackle significant issues that could impact the markets. Chief among these are adequate measures to reduce government spending. On balance, the pace of Federal spending, while slowing modestly, continues nearly unabated. It appears that tax revenues from 2005’s strong economy will help to offset deficit spending. Also, local and state governments will benefit from the significantly higher property tax base, at least here in Wisconsin. We believe the current level of spending, given higher tax revenue can be sustained given low interest rates, but should be tempered given the prospect for lower property valuations in 2006 (resulting from a slowing housing market).
In closing, the U.S. markets have demonstrated resiliency in the face of higher energy prices, deficit spending, and rising short-term interest rates. These issues are all likely to see some resolution by late 2006. As is always the case, risks will be present. Participation in the U.S. markets is more important than ever, and the need to manage investment risk continues to be an inseparable component of any investment strategy. We stand ready to address all of these issues in the upcoming year, helping our clients achieve their personal investment goals by producing high returns over time while simultaneously managing the risk of uncooperative markets.