Dr. Martin Regalia

The economy closed 2006 with solid, if not spectacular, growth, improving employment, and slowing inflation-not bad for an economy that, according to the media, was supposed to be slipping into a recession.

The economy grew 2.0% in the third quarter of last year, and growth is expected to improve to about 2.2% for the final quarter of 2006. Job creation in December came in above initial expectations with 167,000 net new jobs, bringing the year's total to more than 1.8 million. Overall inflation moderated as the year wore on with the consumer price index (CPI) and the personal consumption expenditures (PCE) price index declining in November as energy prices dropped significantly below their peaks reached earlier in the year. More important, core inflation (which excludes food and energy) also showed signs of slowing. The core CPI rose only at a 0.6% annual rate in November and only 1.6% over the prior three months, while the core PCE (a measure watched closely by the Fed) increased 0.5% in November and 1.8% over the previous three months. The unemployment rate ended the year at 4.5%.

We expect the economy to continue to improve in 2007, growing at a 2.5%-3.0% rate in the first half of the year and accelerating moderately as the year progresses. While the unemployment rate is projected to inch up toward 5.0%, job and wage growth are expected to be sufficient to ensure continued consumer spending. With inflation expected to slow slightly through 2007, interest rates should remain relatively well behaved and, together with improving demand, should trigger some improvement in investment. The softer dollar and robust growth abroad should continue to reduce the trade deficit and contribute to gross domestic product (GDP) growth.

While the overall economy performed reasonably well last year and is expected to pick up a bit this year, there were certain sectors that were, and continue to be, clear weak spots. For example, the housing market declined sharply in 2006 after years of stellar performance. The drop in housing production was a definite drag on the overall economy, but the feared decline in household wealth and its negative impact on broader consumer spending failed to materialize in part because of the equity market rally in the latter part of last year.

Although we could still see further declines in housing and its ensuing broader ramifications, we don't think that will happen. We believe that the housing market is close to a bottom. And while it may be a protracted bottom and will clearly take some time to work off existing inventories of homes for sale, we believe that stable interest rates and growing incomes will prevent substantial additional drops. We have already seen some positive signs with a small pickup in sales of new and existing homes last November.

At times such as these, when the economy is shifting gears and the top line indicators are less conclusive, we can sometimes get a clearer picture by looking at sector data. One of these underlying sectors is manufacturing. The Institute for Supply Management computes a Purchasing Managers Index (PMI) that is intended to signal whether this sector is expanding or contracting. A reading above 50 indicates growth; a reading below 50 signals contraction. While a brief stint below 50 can occur even in relatively good economic times, a prolonged stay or sharp decline below that level usually means trouble. In November 2006, the PMI dipped slightly below 50 for the first time since April 2003 but quickly rose back above 50 in December. This brief excursion into negative territory is more consistent with below-trend growth rather than an impending recession.

Another indicator of industrial strength is manufacturing new orders, specifically orders of nondefense capital goods excluding aircraft-a number that is less volatile and more reflective of the overall trend in industrial demand. These orders have trended up since 2004 and rose 9.6% year-to-date through November of last year compared with the same period in 2005. Similarly, total durable goods orders rose 7.5% in the same period. 

Like manufacturing, transportation has also proven to be a useful leading indicator of overall economic activity, especially because it includes both domestically produced and imported goods. The American Trucking Associations (ATA) produces an index of truck tonnage, which measures the volume of goods moved by trucks throughout the country. The tonnage index has been trending down since early 2006 and through last November was 2.8% below the same period in 2005. However, the level of the index remains relatively high and is well above that seen during the last recession.

Railroad data also suggest some slowing in the economy. The Association of American Railroads (AAR) publishes statistics on rail activity. In 2006, AAR's total carloadings rose 2.8% over 2005, while intermodal carloadings (which are better correlated with manufacturing activity) gained 5.0%. However, the rate of year-over-year growth in intermodal carloadings has declined noticeably from the nearly 12% pace in late 2004.

Financial indicators are another valuable yardstick to measure economic activity. Growth in the money supply strengthened noticeably after the 2001 recession, running at an annual rate of nearly 6% between 2001 and 2004. Since then, growth has slowed to about 1% as the Fed's monetary policy has become more restrictive. The availability of credit, however, has shown no sign of slowing. Total bank credit has risen at an annual rate of 8.0% in the 2001-2006 period. And while commercial and industrial loan volume dropped off sharply between 2001 and 2004, it has since picked up, growing at an annual rate of 11% between 2004 and 2006.

Even though it appears that both liquidity and credit are readily available, it is a small consolation if businesses and individuals cannot service their debts. Nevertheless, the data suggest that while delinquencies are up slightly since early 2006, they remain well below the peaks seen during the last recession. The industrial sector has actually outperformed the overall spectrum of borrowers, as commercial and industrial loan delinquency rates have declined significantly from the most recent peak of 3.9% in the second quarter of 2002 to 1.3% in the third quarter of 2006.

On balance, these less watched statistics appear to tell the same story as the headline numbers-an economy that while slowing still has plenty of momentum and should continue to grow and create new jobs. Now if we could just get the stock market to recognize that fact!