Housing Slows Economic Growth, Weighs on Equities
The broad U.S. market, as measured by the S&P 500 Index, gained 0.6% during the first quarter, restrained primarily by weakness in the housing and mortgage industries. Economic growth has slowed modestly while core inflation remains obstinately high.

Seven sectors advanced during the first quarter with utilities, materials and telecoms leading the broad gains. Utilities have outperformed due to continued low levels of long-term interest rates and as investors seek a non-cyclical safe haven should the economy slow more than expected.

Materials companies continue to benefit from global supply-demand imbalances, which has been favorable for pricing. Meanwhile, financials under-performed due to weakness in housing, increased subprime-loan delinquencies and the inverted yield curve. Technology stocks were also weak, while consumer discretionary stocks trailed due to fears of a consumer pullback.

Among large-cap stocks, growth and value issues performed in line, each returning 1.2%. Mid-cap stocks outperformed during the quarter, as measured by the Russell Midcap Index which returned 4.4%. Small caps gained 2.0% while large caps advanced 1.2%.

The yield curve remains inverted as interest rates have adjusted little from year-end. The 3-month U.S. Treasury-bill yielded 5.04% at the end of March while the long bond, or the 30-year US T-bond, yielded 4.84%. The 2-year Treasury slipped from 4.80% to 4.58%, while the 10-year T-note was mostly unchanged, slipping from 4.68% to 4.65%.

Oil prices rose modestly from $61 to $66 per barrel.

Economy
Economic growth during the fourth quarter was revised higher to a 2.5% rate from earlier estimates of 2.2%. Housing's downward spiral, lower corporate profits and less business spending restrained the economy from expanding at a faster pace. We expect the economy to expand between 1% and 2% in 2007.

Consumer prices for all items rose at a 2.8% annualized pace as fuel, food and medical care costs rose. The more favorable measure was core-CPI, which excludes volatile food and energy prices and trended modestly lower to a 2.5% year-over-year rate. Despite this early indication of slower price increases, core inflation has remained stubbornly high and increased the odds of a recession. Nevertheless, slower GDP growth and a more pronounced housing slowdown have reduced the likelihood of a future interest rate hike to combat inflation. The U.S. Federal Reserve is expected to keep its target overnight lending rate at 5.25%.

Earnings
Corporate earnings grew at an 11.9% year-over-year rate during the fourth quarter, recording the 14th consecutive quarter of double-digit profit growth. However, that streak is poised to reach its end during the first quarter as consensus estimates are for earnings to rise only 3%. Our research suggests that corporate earnings will be flat this year, particularly due to a precipitous drop in earnings among commodity companies.

As measured by the S&P 500 Index, the stock market is currently trading at 15 times projected 2007 operating earnings. We view the market as being modestly undervalued, given the prospect for low inflation and continued low interest rates.

Outlook
We continue to believe the most likely U.S. economic scenario for 2007 is a mid-cycle slowdown – with 1-2% GDP growth – followed by a reacceleration and several more years of expansion. However, the odds of a recession have risen. Core inflation has remained stubbornly high and may require a prolonged period of slow growth or a recession for it to fall. The labor market remains overheated, and consequently the risk of wage-based inflation exists. In order for core inflation to fall, job growth must slow further, resulting in modestly higher unemployment and ultimately a less overheated labor market.

The second issue affecting economic growth is housing, which has developed into a hard landing. Absent a recession, homebuilding is likely to bottom-out by September, slowing the economy for the next few quarters and reducing the odds of an interest rate hike. The subprime-mortgage meltdown is likely to have at least as significant an impact on economic growth because the economy has yet to absorb any of its worst impacts, such as foreclosures. There will also be a change in lending standards, curbing the number of individuals who can qualify for mortgages and ultimately slowing housing and the economy over the medium-term.

Collectively, these factors increase the odds the economy will tip into recession, but we continue to believe that a mid-cycle slowdown is the more likely scenario. We are optimistic that inflation will ultimately come under control, despite it taking longer than expected. It is also possible that a faster-than-expected slowdown could force the Fed to cut rates, in which case the stock market could surge higher. Fortunately, global economic growth has been so strong that the U.S. is partly cushioned from tipping into recession. Should it become clear that a recession is not necessary and the economic slowdown is merely a mid-cycle correction, the market is likely to shoot higher and we will see multiple expansion again.