Economy is moderate so far, but there are some headwinds on horizon,

Colorado Springs Business Journal, Sep 19, 2008 by Rebecca Tonn

Although he expected a "sluggish and mild environment" during the beginning of the year, Keith Hembre, chief economist and chief investment strategist for FAF Advisors, said that the economy was instead moderate, with stable unemployment and robust corporate earnings.

But that's not all that happened in the economy, he told the audience at U.S. Bank's economic update breakfast at The Antlers Hilton.

"Inflation is a critical variable for the market," Hembre said. "We have a number of headwinds for the domestic market."

While inflation is high, it has likely peaked, and in the near- term, oil will decline. The strength of the dollar will drive down inflation, as will the increasing unemployment rate.

Historically, a rise in unemployment means that, with a lag, inflation will go down, he said.

Hembre predicted that the Federal Reserve is likely to ease interest rates another 50 basis points by mid-2009, or hold steady, but not raise rates.

The European Central Bank recently raised interest rates, despite its slowing economy, but the Fed has to balance the U.S. interest rate with unemployment.

Now, here's one of the "headwinds."

"Even though administrative costs of doing business (making loans) was dropped by the Feds," Hembre said, "banks have continued to tighten standards -- so the availability of credit is substantially restricted."

In other words, monetary policy conditions have eased -- but credit conditions have not.

"There continues to be an enormous overhang in the housing market -- given the homeowner vacancy rate," he said. "Homebuilding activity will have to decline further to reduce oversupply."

Consumers are directly affected by tightened credit conditions, because housing is, "by far," the largest component of a household balance sheet.

The homeowner vacancy rate has risen sharply since 2005, when it was 1.7 percent, to the current rate of 2.8 percent. And loan-to- value ratios are 50 percent, which puts "downward pressure" on homeowners.

Now for news that consumers, small business owners and corporate executives alike don't want to hear -- consumer spending will grow at a slower pace than income growth for the next two to three years. And employment is likely to continue to decline through the first quarter of next year.

No wonder consumer expectation levels are the lowest they've been in 25 years.

The United States has had a "significant positive offset" from gross domestic product, exports and corporate profits. One in three dollars of corporate earnings comes from abroad. And corporate profit shares of GDP remain at an all-time (since 1949) high, Hembre said.

But -- here goes the pin into the balloon -- "we're on the verge of a meaningful slowdown in exports." Ouch.

Non-financial sectors are likely to lag financial sectors in terms of profits, so non-financial sectors should see a modest decline next year.

As for Hembre's recommended asset allocation -- go overweight on bonds. Why? Because inflation is coming down, the economy is continuing to be weak and will grow at a below-trend pace, and the Fed is likely to lower the interest rate, or hold it steady.

"It's hard to get excited about bonds," Hembre said with a laugh, "with only a 3.5 percent yield, but these three factors indicate a coming strong environment for bonds."

And growth stocks tend to be favorable in the current environment.

When the economy starts to recover, then portfolios should be weighted heavier in value stocks.