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<br />
<br />2006 IN REVIEW, F'ORECAST OF' 2007
<br />
<br />What moved markets in 2006...
<br />
<br />This past year witnessed a number of significant
<br />developments in the financial markets, While some of
<br />these were unexpected, many others were eagerly
<br />anticipated, Once again though, the financial markets
<br />proved that even when investors anticipate a
<br />development, accurately predicting its timing,
<br />magnitude, and impact can be extremely difficult. Some
<br />of the most notable developments in 2006 included
<br />
<br />@ The Federal Open Market Committee (FOMC) raised
<br />the Fed Funds Target Rate four times in 2006, from
<br />4,25% to 5.25%. The last interest rate increase
<br />occurred at the June 29th meeting and for the
<br />remainder of the year the FOMC refrained from taking
<br />further action. While the FOMC has maintained a
<br />neutral stance, there has been significant disagreement
<br />in the financial markets as to the future course of
<br />monetary policy and economic growth. While some
<br />market participants believe that the FOMC has merely
<br />paused in its tightening campaign and that there are
<br />more interest rate Increases to come, others believe
<br />that the economy will be influenced by the hOUSing
<br />slowdown and that the next move on interest rates will
<br />be lower. This situation has led to an inverted Yield
<br />curve, as the yields on short term treasuries have been
<br />higher than those for longer dated securities, In the
<br />past this relationship has often forecast the onset of a
<br />recession, but as with many forward-looking economic
<br />indicators its accuracy can only be measured in
<br />hindSight,
<br />
<br />. Following Alan Greenspan's long and successful tenure
<br />as Chairman of the Federal Reserve, Ben Bernanke
<br />assumed the top spot following the January 31st
<br />meeting, Although the transition was relatively
<br />seamless, it took market participants some time to
<br />adjust to the new Chairman's communication style,
<br />Going forward, the FOMC may adopt a more open and
<br />transparent management style, Also, Chairman
<br />Bernanke may support an expliCit inflation target,
<br />which would be an important development If it were to
<br />occur,
<br />
<br />. By many measures, volatility and spreads on risky assets
<br />are at record lows, While thiS contributed to strong
<br />performance for a wide range of financial assets in
<br />2006, a number of Investors are concerned that market
<br />returns no longer reflect the potential downside risk of
<br />certain securities, In the past this situation has
<br />occasionally led to large market movements as
<br />investors suddenly decide to demand higher premiums
<br />for accepting risk,
<br />
<br />. Housing market indicators began to weaken in 2006, In
<br />fact, home prices in some parts of the United States
<br />began to decline for the first time in many years, We
<br />also saw a reduction in new construction for residential
<br />units, as well as increases in inventories of unsold
<br />homes From their peak in January and February 2006,
<br />single family housing starts have fallen 35%, while
<br />existing home sales have fallen 13% since June 2005.
<br />
<br />Housing market weakness has been the topic of much
<br />debate In financial market Circles In fact. market
<br />partiCipants that believe the US economy IS slOWing
<br />often point to thiS as the crucial factor that will prompt a
<br />broader economic slowdown, The continuation of thiS
<br />argument is that the slowdown will then lead to FOMC
<br />interest rate cuts and lower bond yields.
<br />
<br />III Market partiCipants that believe the economy is still
<br />strong and that the FOMC will resume Interest rate
<br />increases often point to inflationary statistics Although it
<br />has begun to moderate during the past several months,
<br />Core CPI has persistently remained above the FOMC's
<br />comfort level throughout 2006, Meanwhile, since
<br />reaching a high for the year of 43% In June, the Overall
<br />Consumer Price Index (CPI) has declined to 2,0%. ThiS
<br />divergence between the two Indicators has led to
<br />uncertainty among market participants as to whether or
<br />not inflation is indeed moderating,
<br />
<br />II> The labor markets continued to enJoy moderate growth
<br />in 2006, For the year, the economy added an average of
<br />153,000 jobs each month, comparable to 2005's
<br />165,000 Jobs per month,
<br />
<br />What to watch for in 2007...
<br />
<br />As is always the case, the year ahead promises to be filled
<br />with unexpected surprises. Nevertheless, there are several
<br />themes that promise to impact the course of financial
<br />markets both in 2007 and beyond, Some of these include:
<br />
<br />. Is the FOMC finished raising rates? Will the next action on
<br />interest rates be a tighten ing or will the FOM C choose to
<br />lower rates? Market partiCipants disagree greatly as to
<br />the future course of FOMC monetary policy, How and
<br />when this issue is resolved is perhaps the most important
<br />factor InfluenCing the fixed income markets in the
<br />coming year.
<br />
<br />. Is US economic growth accelerating, or have we already
<br />reached the peak of the current economic cycle? We
<br />appear to have reached an inflection point In the
<br />economic and interest rate cycles. Which way the
<br />economy and interest rates turn remains to be seen,
<br />
<br />G What effect will the new Congress have on the financial
<br />markets? Most prognosticators foresee little change for
<br />the overall economy, but the new Congress could have a
<br />large impact on certain ind ustries or sectors
<br />
<br />. Will the slowing housing market depress the rest of the
<br />US, economy? Whether housing continues its decline or
<br />rebounds In 2007 will go a long way towards determining
<br />the strength of the overall economy and the future course
<br />of Interest rates.
<br />
<br />CI Will risk premiums remain low, or will they begin to rise in
<br />20017 With premiums on risky assets at historic lows, It
<br />appears that risk premiums must increase at some point
<br />in the future When and how this will occur IS the subject
<br />of great uncertainty
<br />
<br />-Brian Perry, Research Analyst
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<br />C 2007 Chandler Asser Management /nc, A Registered Invesrmen t Adviser
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