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Integrity
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There are substantive reasons to hold both views. The housing slump continues to severely crimp residential construction. Virtually every national homebuilder is reporting significant losses and instituting aggressive incentives to unload housing inventories. House prices generally are soft. The National Association of Realtors reported that existing home prices declined 1.3% in February, and there is widespread anecdotal evidence of greater price declines in areas where prices rose dramatically earlier. As if adding a one-two punch to the consumer, energy prices have risen sharply. According to AAA, the average price of a gallon of gasoline rose 28 cents over the last month and is currently higher than the price which prevailed last summer. The surge in gasoline prices is probably the primary cause of the deceleration in the growth of personal spending which has become evident. Weakening employment, higher gasoline prices, and further fallout from housing strongly suggest an anemic outlook for consumer spending in the second quarter. In the huge and complex American economy, however, the story does not end here. Manufacturing has been a significant drag on economic activity, and suffered from an apparent inventory correction in the first quarter. This appears to be changing. While one cannot read too much into one month’s figures, the latest manufacturing report of the Institute for Supply Management showed a strong surge in activity. The gain was driven by a pickup in new orders, production, and manufacturing employment. Construction spending and durable goods orders have also been higher than anticipated, and businesses are showing signs of shaking off their lethargic spending. With the exception of England, which is facing even more severe problems than the U.S., the challenges posed by a deteriorating consumer sector are not matched by overseas economies. Euro area growth is rising, based on broad increases in consumer and business spending. In Asia, China’s growth is even faster than earlier estimates, despite government efforts to rein it in. India and the rest of Asia similarly are enjoying a strong domestic expansion. In the Euro zone and other countries, inflation is intensifying, and efforts to forestall it, by raising interest rates, higher bank reserves on foreign deposits, and other methods, are increasing. In a world of powerful economic and financial linkages, rapid growth overseas is a major benefit to American business. American corporations have significant assets overseas, and foreign earnings are increasing. In addition to our overseas operations, also our exports have been strong, and are augmented by weakness in the dollar. Even allowing for some slowdown overseas, development spending in a major part of the world will remain very strong for many years ahead. We believe the preliminary 1.3% growth rate of GDP in the first quarter will prove to be the low point of the year. Even so, growth will remain below potential, in our judgment. The consumer is clearly affected by the jump in gasoline prices and is influenced by the drumbeat of bad news about housing. It is a mistake, however, to extrapolate a cautious outcome for consumer spending into a severe retrenchment. Consumer fundamentals remain healthy, with near-full employment and rising real incomes. These are effective antidotes to a consumer led recession, as some observers fear. Inflation remains the greatest threat to a benign outcome to current economic conditions. By every measure including the Federal Reserve’s preferred one, inflation is above tolerance levels. Nor has the slowdown in economic activity in the first quarter reduced inflation pressures in any significant way. We believe the Federal Reserve will continue to be cautious until inflation declines comfortably below its 2% limit. While the fragile condition of the housing market probably precludes an increase in the Federal Funds rate, a decline is also unlikely. The likeliest outcome is an extended period of rate stability until the outlook for inflation becomes clear. Investment Policy Committee Alfred A. Lagan, CFA, Chairman Daniel A. Lagan, CFA, President May 9, 2007 This information is intended solely to report on investment strategies and opportunities identified by Congress Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell of any financial instrument. 2 Seaport Lane Boston, MA 02210 www.congressasset.com
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