Wednesday, December 28, 2005

Looking Forward: 2006 Top Economic Stories

by Bill McBride on 12/28/2005 07:10:00 PM

First, here are a few stories that I don't think will be big in 2006:

1) Energy Prices: I expect oil prices to stabilize or decline next year. WTI spot prices closed at $59.96 today. This prediction could be wildly wrong, especially if production falls at Ghawar or the US bombs Iran. This prediction is based on the increased level of investment, the current levels of crude oil stocks and a slowing World economy in 2006.

2) Bush Economic proposals: I think the Bush Administration will be shackled by scandals and Iraq, so I don't expect any major new proposals. I hope I'm wrong about Iraq.

3) Trade Deficit / Current Account Deficit: I could be wildly wrong here too, but I think the trade deficit will stabilize or even decline slightly next year. As the economy slows, I think imports will slow.

4) The Budget Deficit: Although I expect the General Fund deficit to grow to around $600 Billion in 2006, I don't think it will become a huge story until '07 or '08.

So, without trying to predict natural disasters, a pandemic or human stupidity (terrorism, bombing Iran, etc.), I think these are five possible candidates for the top economic stories of 2006:

5) The End of the Greenspan Era

OK. I'll start with a gimme. I think Dr. Bernanke will face a significant challenge in '06, perhaps by one the following top stories - perhaps by something completely unexpected. Stephen Roach recently wrote:

"Alan Greenspan faced a stock-market crash two months after he took over in August 1987. Paul Volcker had to cope with a rout in the bond market three months after he became chairman in August 1979. G. William Miller was challenged immediately by a dollar crisis in the spring of 1978. For Arthur Burns, it was the inflation bogie in the early 1970s."
When the challenge comes, expect investors to pine for their lost love: Alan Greenspan.

4) Housing Slowdown

In my opinion, the Housing Bubble was the top economic story of 2005, but I expect the slowdown to be a form of Chinese water torture. Sales for both existing and new homes will probably fall next year from the records set in 2005. And median prices will probably increase slightly, with declines in the more "heated markets".

3) Pension Blowup / Major Bankruptcy

Of course I am thinking GM, but maybe it will be another major corporation. Bankruptcy has become a tool to break labor agreements and terminate pension plans. This allows companies to "privatize profits and socialize risk" - and companies will increasingly use this tool.

Even "freezing" the pension plan has enormous consequences for many employees, since a large portion of the retirement benefit is accrued in the last few years before retirement. See the USAToday article: Pension problems loom for boomers.

2) Slowing Economy

If the US and the World economies slide into recession, this will be the top story next year. I still think it is too early to call, but I do think economic growth will slow substantially next year.

This slowdown will be partially housing related; as housing slows, real estate related employment will decline and jobs could become an issue in '06. Also, as mortgage equity withdrawal declines, consumer spending will slow.

And my prediction for the Top Story of '06:

1) Interest Rates

Like most investors, I expect the Fed to raise the Fed Funds rate 25 bps at each of the next two meetings to 4.75% in March. See Dr. Altig's graphs: An Inversion Arrives

And like many observers, I expect the Fed to start lowering rates later next year as the economy slows. But here is the surprise, I think long rates will start to rise when the Fed starts cutting the Fed Funds rate.

This will be Bernanke's "conundrum"! As the economy slows, this will reduce the trade deficit and also lower the amount of foreign dollars willing to invest in the US - the start of a possible vicious cycle.

I couldn't resist going out on a limb ... or a couple of limbs. Its fun making predictions - I'm looking forward to the comments.

Best to all. Happy New Year!