A top broker's ten predictions for 2006
Given the likely backdrop of slowing economic and earnings growth in the US, a Fed that likely will end its tightening cycle and a continued tricky environment for investors, we venture forth with our 10 predictions for 2006.
1. The overall U.S. economy slows to 3% growth as the front end (the consumer) weakens while the back end (capital spending) is relatively strong.
After another good year of economic growth, we believe the U.S. consumer will slow in 2006, causing real growth in the United States to fall to around 3%. We believe consumer spending will grow by between 2% and 2.5% as the cumulative impact of higher interest rates, sharply higher energy prices and a noticeable cooling in the housing market slows the pace of consumption. Conversely, business fixed investment spending should increase at a significantly higher rate. Because consumer spending represents approximately 70% of overall U.S. economic activity, its slowdown will slow overall growth.
2. Earnings fail to meet the consensus expectation of double-digit percentage gains.
Earnings seemed to have defied gravity and surpassed expectations for the third consecutive year in 2005 due to strong revenue growth, excellent productivity and expense management. Our concern is that earnings are unlikely to grow at a double-digit rate for an unprecedented fourth year projected by the consensus. Instead, we believe earnings growth will slow to a more normal range of between 5% and 7% due to a slowdown in revenue growth, some cost pressures and limited pricing flexibility. A slowdown in consumption and the absence of a gargantuan advance in energy profits as occurred in 2005 also will contribute to the slowdown.
3. The U.S. yield curve inverts for the first time since 2000, while the U.S. 10-year Treasury trades with a “four-handle” yield all year.
The yield curve flattened significantly during 2005. We expect that at some point in 2006, the yield curve will invert as the Fed completes its tightening efforts without a commensurate upward move in long-term rates. We also believe that the 10-year Treasury will trade in a reasonably narrow band during 2006, experiencing a “four-handle” yield all year long (meaning that yields will range between 4% and 4.99%).
Factors exerting upward pressure on long-term rates include some increasing cost pressures and slowing productivity gains as well as the effect of the collective deficits. Factors pushing rates down include a slowing economy, continued demand from foreign investors, demand for duration from pension plans and lingering deflationary threats.
4. The U.S. equity market experiences its first 10% correction since 2002, preparing the way for the second half of the bull market.
We believe there is a reasonable probability that the U.S. equity market will experience a significant correction at some point in 2006. Fed tightening campaigns and mid-cycle economic slowdowns often are accompanied by a correction in equity prices as the bull market is interrupted before recovering again (as happened in the 1980s and 1990s). Earnings disappointments are probably a necessary condition for this type of correction. We still believe that, over the long term, equities will experience a total rate of return of about 8% over rolling five-year periods, and we are not necessarily predicting that 2006 itself will see negative returns for stocks.
5. Growth outperforms value and large cap outperforms small cap for the first time since 1999.
After many years of value outperforming growth and small outperforming large, we believe 2005 marked a transition period that will result in growth and large cap outperforming value and small cap. We also believe that the trend of one side dominating the other will moderate significantly in the years to come in contrast to what occurred during the last 10-year period. This prediction is predicated on some notion of mean reversion, but is supported by our analysis of valuation, earnings growth, earnings revisions and free cash flow, all of which suggest that growth and large cap may be poised for outperformance.
6. The U.S. dollar resumes its downtrend.
After an interruption in 2005, we believe the dollar bear market that began in 2002 will resume at some point in 2006. The dollar’s rise in 2005 resulted from higher yields as the Fed raised rates, as well as from stronger economic growth in the United States than in Europe and Japan. We believe the dollar will resume declining as a result of the fundamental misalignment in the world’s trade balances and capital flows, as manifested in the U.S. federal budget deficit, current account deficit, trade deficit and low personal savings rate.
7. Led by Asia, non-U.S. equity markets outperform U.S. equities for the fifth consecutive year.
This outperformance will be especially true for dollar-based investors if the dollar resumes its decline as suggested in the above prediction. Asia is likely to lead the way, highlighted by corporate earnings in Japan continuing to grow at a double-digit pace. Ongoing structural reform throughout Europe also bodes well for stock markets in that region.
8. Strong cash flow leads to another year of high dividend increases, share buybacks and M&A activity.
U.S. corporate balance sheets are in nearly their best shape ever. This is evident in the amount of balance sheet cash (currently over $2 trillion) and the substantial reduction in net long-term debt. Strong excess free cash flow generated in 2006 will only improve the situation, paving the way for continued strong dividend increases, share buybacks and mergers and acquisition activity. Dividends likely will increase by between 8% and 10%, share buybacks by nearly 20% and M&A activity by 10%, after increasing by 50% in 2005.
9. Commodity prices again will be higher in 2006 than they were in 2005.
Following strong gains in 2005, we believe commodity prices in 2006 will average higher than they did in 2005. This is likely to be especially true for industrial commodities, but also for oil and gold as well, despite their huge gains in 2005. Reasonably strong world economic growth, above average growth in commodity-dependent emerging economies, increases in capacity utilization and reasonably short-term fixed supplies for most commodities suggest to us that prices are headed higher.
10. Republicans retain control of Congress, but relinquish some of their advantage in the 2006 election.
Market-friendly legislative progress largely was disappointing in 2005. Historically, the party of a president in his sixth year experiences significant losses in the Congressional elections as the “six-year itch” causes voters to defeat the incumbents. While the administration is challenged with the rate of federal spending growth, the budget deficit, energy policy and pension reform, not to mention Iraq and Supreme Court nominations, we believe the Republican Party will retain its majority in the House and Senate, but that its seat advantage will be trimmed modestly.
By Bob Doll, President and Chief Investment Officer at Merrill Lynch Investment Managers
