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Markets: An Economic U-Turn?
New York: October 02, 2006
By John R. Stephenson

Lately, there has been a lot of concern about an economic slowdown in the United States. Commodity prices slid hard as investors worried that a U.S. housing crash would deflate the economy and take with it the strong global demand that commodities had been enjoying. With as much as 50% of U.S. consumer spending growth in recent years dependent on home equity withdrawals (using your house as an ATM), a crash in house prices would put a serious pinch in the purchasing punch that consumers are able to deliver. With consumption making up some 70 percent of U.S. GDP, falling house prices could create a nightmare scenario for the economy. But is the market right?

Perhaps. The news isn't very good. House prices, which represent some 48.5% of U.S. household wealth, appear to be sliding with no end in sight. In some parts of the country, the inventory of homes for sale (number of homes for sale divided by average monthly sales) is over seven months long. This is translating into lower house prices and poor results for the nation's homebuilders.

Figure 1: With New Home Sales Falling Builder Sentiment Has Plunged

Source: Bloomberg

With U.S. housing starts down some 19.8 percent year over year, builders and investors are beginning to fret. While residential construction only accounts for 5.5 percent of the U.S. GDP, it is the effect on pocketbook economics that has analysts worried. Not only has sentiment turned negative for builders, but also, recent data suggest that the median house price has begun to tumble. With consumption so beholden on borrowing against inflated house prices, can a slowing economy be far behind?

Figure 2: U.S. Leading Economic Indicators Turning Negative

Source: NBER

Signs of a broader economic slowdown are everywhere. Manufacturers are reporting weaker numbers and leading economic indicators (new orders, yield curve, building permits, etc.) have turned negative for the first time in five years. With the U.S. economy decidedly slowing, can a global recession be far behind?

No. For starters, growth in the rest of the world is not nearly as dependent on the U.S. consumer as you might think. China, Russia and much of the Middle East are all growing at a rapid pace. Europe, and even Japan, are starting to show some growth and very little, if any, of it is dependent on the U.S. China, which has been growing at more than 10 percent a year, produced some 6.5 million cars last year without exporting a single car to the U.S. In fact, exports to the U.S. accounted for only 8 percent of China's GDP and American markets mean even less for other rapidly growing economies such as India and Russia. What all this means is that world GDP could clock in at a healthy clip of 4.5 percent even with the U.S. economy wheezing away.

This is good news for commodity players who will see higher base metals and oil and gas prices in the years ahead as global purchasing continues unabated. Commodity pricing is influenced by many factors, but in the end, the only factor that really matters for higher prices is strong demand and struggling supply. In an increasingly global world, demand will come from Asia, not America.

But the news may not be all that bad at home. With a slowdown looming, the U.S. Federal Reserve (U.S. central bank) will have little choice but to cut interest rates to spur growth. That's good news for the stock market and investors alike.

Not only that, but wage gains are up some 8 percent this year, as stock options and bonuses have started to kick in. While consumption is likely to weaken if U.S. house prices continue their slide, it should still keep pace with income growth. If the U.S. dollar weakens in the face of lower interest rates, the competitive positioning of U.S. firms could improve (exports are cheaper) which should improve the balance sheets of corporate America. Much of corporate America cut back drastically on spending after the technology bubble burst and is flush with cash which should allow many companies to weather an eventual economic storm. While the economy is likely to slow in 2007, it may not crash — good news for investors and consumers alike.

Figure 3 - Falling Interest Rates A Boon For Stock Markets

Source: Scotia Capital Inc.

But falling interest rates is great news for stocks, particularly interest rate sensitive stocks. In a declining rate environment, companies that have stable long-term contracts or regulated business models tend to soar. Even in slow economic times, consumers are still going to need heat, food and shelter. Consumer staples, utilities and financials are all likely winners if the faltering U.S. housing market causes the Federal Reserve to slash interest rates to prevent a hard landing for the economy.

Investors looking to profit from a U.S. slowdown should consider allocating a greater proportion of their investment dollars toward utilities and other interest rate sensitive stocks as interest rates are more likely to fall than rise in the months and years ahead. Investors with a longer time horizon can use the current commodity price weakness, particularly in energy, as an opportunity to pick up some great quality oil and gas names that are trading at a discount.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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