Economic Outlook for 2007—The Executives' Club of Chicago

Economic Outlook for 2007 Reveals Pockets of Opportunity + Political Handicapping

The Executives’ Club of Chicago assembled an all-star panel to give Midwest business leaders their guidance for various aspects of the U.S. economy in 2007. Diane Swonk, Chief Economist of Mesirow Financial, Alan Murray, Assistant Managing Editor of The Wall Street Journal and Robert “Bob” Froehlich, Chairman of the Investment Strategy Committee, Deutsche Asset Management broke out their respective crystal balls for 2007, and the audience was not disappointed for lack of insight or wit. The session was scintillatingly moderated by Terry Savage, Financial Columnist of the Chicago Sun-Times.

The consensus was that the U.S. economy would have a relatively benign year in 2007. All panelists predicted a higher Dow, and their predictions concurred with Wall Street’s most accurate ,^) indicator, the Super Bowl Predictor. Little of import will happen on the political front, the U.S. economy will grow at a slower pace, and investment returns will be generally highest outside the U.S. Elsewhere, consumer empowerment reared its head in the executive pay issue, Apple will remain an enigma for investors who don’t understand customer experience, and the U.S. will have to get over itself in order to realize its potential in the Knowledge Economy.

Diane Swonk, Chief Economist, Mesirow Financial

Diane is a widely quoted economist who is sought out for advice worldwide and serving on committees to the Federal Reserve Board and the (U.S.) Congressional Budget Office, among others. Overall, Diane sees smooth sailing for 2007:

• Housing and automotive challenges dissipating: the much ballyhooed housing bust has largely proven to be a paper tiger at the national level, and regional corrections have been orderly and will remain so. Long-term bonds will be at less than 4.5%. The automotive industry has been an engine of the hot U.S. economy until recently. The travails of the Big Three have made headlines, but management has been able to contain the damage, and contract negotiations this summer with the United Auto Workers should provide more relief. These orderly corrections bode well for the economy in 2007.
• Oil prices: 2007 will see increasing stability in crude oil prices. Iran is gaining in political power, both within the Middle East and OPEC. They are pushing for higher oil prices, but Saudi Arabia is targeting lower oil prices. The “fear premium” has been pushing oil prices and will continue to do so unless diplomatic approaches are used with Iran. If oil falls lower than $50, it could decline significantly more. It should remain in the $50-60 range during 2007.
• Consumer spending: has been driving the U.S. economy for the past several years. During 2007, consumers will continue to be price sensitive, but they will continue to spend. 2006 saw record Wall Street bonuses, and the wealthy class continues to grow. The top 1% of earners now account for 20% of the wealth, approximately what we saw in 2000. As one indicator, Rolls Royce has a two-year backlog of orders for its new $406,000 Drophead Coupé. They aren’t in China yet but are considering it.
• Business investment: will be the tailwind of the U.S. economy in 2007. Commercial real estate (office), oil-related infrastructure and hospitality will drive construction, partially dampening the slowdown in residential construction.
• U.S. deficit: the deficit decreased in 2006, and the trend should continue in 2007. Increased revenue has increased tax revenue, and taxes on capital gains and corporate profits are higher than income taxes. U.S. companies have seen 19 consecutive quarters in corporate profits.
• Dynamic shift in trade: U.S. exports have continued to increase, and imports from China decreased in 2006. The improving trade balance will add 1% to growth in 2007. The U.S. economy is slowing, but the rest of the world—notably Japan, Germany and the E.U.—is growing. The relatively low dollar encourages them to buy U.S. products. Continued European infrastructure investments helped to brighten the picture, as well as demand for equipment in developing countries and aircraft. Of late, imports have slowed, helped in part by a warm winter thus far. The Midwest is in the process of decoupling its fortunes from the automotive sector (as its factories turn to equipment exports).
• The Federal Reserve: since Ben Bernanke succeeded Alan Greenspan as Fed Chairman in 2006, the Fed has assumed a less interventionist stance toward monetary policy. In 2007, we should see 2.75-3.00% growth, a veritable “perfection economy” in which growth is solid and steady. The Greenspan Fed was much more aggressive, tending to overshoot and compensate afterward. The Fed will maintain a wait and see approach unless unexpected catastrophic developments unfold in the housing sector, when it would ease. Notably, the bond markets don’t fully appreciate this change.
• Markets: by year end 2007, we should see: The Dow at 13,400, the S&P at 1560, Fed Funds Rate at 5.5% and 5.1% for long-term bond rates.
• If she were a retail investor with $100,000…: she would allocate the investment thus: 50% in international (highlight Japanese stocks), 25% in U.S. stocks and 25% in stocks involved with treating diabetes.

Alan Murray, Assistant Managing Editor, The Wall Street Journal

Alan Murray authors the Business column for The Wall Street Journal and contributes regularly to CNBC. As the former Washington, D.C. bureau chief for both CNBC and The Wall Street Journal, Alan has significant insight into business and politics. He reserved “political handicapping” for the Q&A and spoke about three business trends that will continue to affect markets in 2007.

• The changed role of the public company CEO: recent developments at Home Depot and GE show that there has been a sea change in shareholder attitude toward CEO pay.
  • During the 1990s, CEOs were revered and given much latitude with how they ran their companies. Three CEOs were Time Magazine’s “Person of the Year.” They sat on the top of large hierarchies, and few people questioned it.
  • The stock market crash and Enron was the spark that began to change public expectations. During the Enron and MCI debacles, many publications pointed out that CEOs were vilified and regulation enacted after past stock market plunges, only to have business as usual subsequently return. However, in the most recent case, the change is profound, which Immelt understands (and has been restraining his pay) and Nardelli didn’t. The CEO’s close to absolute power is continuing to unravel.
• The role of private equity has vastly increased: private equity has continued to grow in scale and scope, as holdings amount to hundreds of billions of dollars today.
  • Public companies like GE often sell their underperforming businesses to private equity, which hires new management teams and tries to make the company more valuable.
  • Private equity investors generally want high returns, but they load the acquired company with debt. The open question is, “Can they run the businesses they buy better (than GE)?”
• The world is awash with liquidity: related to the private equity trend is that high liquidity makes many things possible—including many that should not be.
  • There was minimal credit correction in the housing market, and the U.S. government borrows infinitely with no apparent consequences.
  • Will the sea of liquidity go on forever? When it stops, everything will reverse, and something will stop it eventually. Today, stupid business decisions are being made because excess liquidity is chasing returns.
• Politics: the 2006 election was the nastiest yet, and Washington will be in gridlock throughout 2007. The stakes of the 2008 presidential election are huge, and no one will take any chances. Republicans worry that Bush is killing their chances by prolonging the Iraq War.
  • The Republican race will probably be fairly orderly, with the candidate emerging early. He wouldn’t be surprised to see John McCain. Giuliani will not be a factor.
  • Democrats are always more dynamic (Alan may have said “disorganized”), but he wouldn’t be surprised to see Hillary Clinton. Obama will inject dynamism into the race, but he won’t be a serious contender. “The White House isn’t an entry-level job,” he commented wryly. However, he also cited “the Lou Dobbs factor,” concern about the ever-increasing disparity of wealth and stagnating wages. If that issue emerges strong during the campaign, he could see Edwards as the Democratic candidate, as he has a strong middle class message.
• 2007 predictions: continued changes in executive compensation. fewer employment contracts for CEOs; Congress considering changes affecting corporate bylaws.
• If he were a retail investor with $100,000…: he would short Apple in 2007, recounting how he had recommended a buy for 2005 and a sell in 2006 because the stock price was wildly out of line (for my comment, see below). Alan declined to give other investment advice.

Dr. Robert “Bob” Froehlich, Chairman, Investment Strategy Committee, Deutsche Asset Management

Widely quoted on CNBC, CNN, Bloomberg, Fox News and other financial programs, Bob Froehlich boiled his far-reaching comments down to a simple statement for U.S. investors: “invest international.”

• 2007 headwinds will turn out to be tailwinds:
  two supposed challenges for the U.S. economy are the housing bubble and rising interest rates, but they will not have an adverse impact in 2007:
  • The “housing bubble” is a myth that never existed because there is no (national) “housing market.” Markets for housing are local, and certain housing values have seen significant change, but they do not affect each other enough to create a national bubble or bust. They have already corrected themselves.
  • Interest rates will be stable because we no longer have a Greenspan Fed.
• China: while the Dow will be over 14,000 in 2007, that will represent a modest gain. Meanwhile, the Chinese stock market will rise at least 50% in value in 2007. Bob explained the political and economic impact of the 2008 Olympic Games (Beijing) and the 2010 World’s Fair
  (Shanghai):
  • In a message that was especially prescient to the Chicago audience, Bob pointed out that the Olympics provides much less brute economic value to the host city than one would expect. There are huge infrastructure investments, and tourist-related revenues are captured over a short period (say, two weeks). According to this logic, many investors are shorting Chinese stocks because their direct economic impact of the Beijing Olympics will be insignificant.
  • However, the Olympics is the overture, and the three act opera will be the World’s Fair, which will produce tourist-related revenue over a period of 184 days. Every global business will be represented, and huge deals will be done, with no expense spared to facilitate deal making.
• The financial services industry has significant upside in 2007: M&A will set records:
  • The M&A market was interrupted for much of 2006 due to the uncertainty around the Iraq War, and this has produced a backlog of deals. Since investment bankers only get paid when deals are done, the pressure is on to consummate those deals this year.
  • But there’s more: the 2008 presidential election will produce significant uncertainty in the markets, and bankers will point out to their clients that they should do 2008 deals in 2007.
• International investment:
  is the way to go for 2007 (and beyond):
  • If U.S. investors want to maximize their investment returns, they have to get over the longstanding assumption that investing abroad is “un-american.” He pointed out that investment managers who obtain mediocre results from investing in GE won’t be blamed. International investments are held to a different standard, and if they go badly, the manager is blamed.
  • He urged investors to wake up, pointing out that what is *not* U.S.: 98% of the world’s land mass, 94% of the world ‘s population, 93% of the world’s jobs, 72% of the world’s economy and 65% of the world’s resources.
  • “We’re a rounding error,” he quipped. “There’s nothing un-american about making money.”
• Other 2007 Predictions: oil will remain in the $60-65 range.
• If he were a retail investor with $100,000…: he would allocate the investment thus: 60% stocks (67% non-U.S.), 10% bonds, no cash, 15% commodities, 15% real estate—and 90% non-U.S. More specifically, $25,000 in each of the following: China Mobile, China Petroleum (China’s Exxon), Morgan Stanley and the Chicago Mercantile Exchange. The Chinese stocks are available to U.S. investors as ADRs (American Depositary Receipts).

Analysis and Conclusions

• Bob Froehlich’s comments reflected a fundamental weakness among U.S. leaders and citizens: a lack of appreciation for the world “out there.” However, this is by no means a U.S. phenomenon (although the U.S. currently exemplifies it well): any market that is overwhelmingly dominant for a prolonged period will fall prey to it. Markets tend to be customer-focused, and the U.S. has represented an enormous portion of the global economy since the 1950s. Other countries focused on their U.S. customers, and U.S. companies focused on their U.S. customers. The rest of the world was less important. Obviously, that era is a relic: China is rapidly emerging as a huge customer for the world’s products, and it manufacturers a growing portion of the world’s products. It will continue to grow in stature, as will India and other countries that mobilize around the Knowledge Economy.
• International investment is a tremendous opportunity: generally, there is considerable economic dynamism outside the U.S. That said, China specifically presents political risk in that it is not a democracy and could abruptly change its policy toward foreign investors.
• Alan Murray may be even more disappointed in his “sell Apple” advice this year, and he won’t be alone. I agree with him that Apple’s stock is grossly overvalued—when you regard Apple as a hardware and software company. However, most people do not yet understand that Apple is neither a computer company, nor a software company nor a device company. It is a customer experience company. Apple’s DNA has always been design, which is ultimately experience-focused; moreover, (Steve) Jobs’ insights gained from his his role at Pixar and focus on music and film is helping to give the company a real edge. I speculate that the concept behind iLife is “make and share your own life experience” with pictures, music and video. Due to Apple’s creative focus, the vision focuses on customer-creativity and sharing. The U.S. culture is very entertainment-focused, and Apple enables customers to actively create and share entertainment. Therefore, the consumer empowerment experience is a critical part of the value proposition, and the stock can go far higher. It also makes it far more difficult for computer or device companies to compete with Apple on the customer experience terrain.
• The executive compensation issue is even more interesting when examined from a consumer empowerment viewpoint. It is a truism that “information is power,” and we are emerging from an era in which relatively few people were privy to “sensitive” information (say, about compensation). This is the larger issue, and I venture that there is no way back. This will increasingly inconvenience leaders that are accustomed to acting without facing their stakeholders’ visibility into everything.”
• If anyone needs any other reason to be bullish on 2007, consider Wall Street’s most accurate indicator, the Super Bowl Predictor, which has an 80% success rate for predicting the direction for the Dow since the advent of the game in 1967. As reported by The Wall Street Journal, it holds that whenever an “original” National Football League team wins the game, the Dow goes up that year. Since both playoff finalists, the Chicago Bears and the Indianapolis Colts, are original members, there’s your answer!