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Worst Case, Best Case, or in Between?

Nine Scenarios for Economic Direction

By Ernie Ankrim, Chief Investment Strategist
Russell Investment Group
Global Leaders in Multi-Manager Investing

November 2, 2005

We've had uncertain economic times before, but by any measure today's situation is challenging. Higher energy prices are weighing on consumer spending. Hurricane devastation is still being tallied, and the costs of reconstruction are mounting. Quite naturally, consumer confidence has been on a roller coaster. So how can we even guess at where the market may be heading?

We can turn to old-fashioned grid analysis to make a reasonable decision from the alternative scenarios. That's because when we eliminate the factors we don't have a good handle on — such as the limited reliability of post-hurricane data — there are just two key points to consider:

How strong is the economy?

And, where is the Federal Reserve (today or in 2006 when Ben Bernanke is Chairman) taking fed funds rates?

Let's first examine each factor individually, and then see what we can deduce when we combine them on a grid.

The Good, the Bad and the Ugly
When you look at the typical measures on economic strength, you can find data to support just about any conclusion you'd like to reach. On the positive side, government (federal AND state & local combined) deficits are coming in lower than projected. Inflation expectations remain contained. And corporate profit expectations are still relatively strong.

Yet these promising points are countered by:

high levels of mortgage and consumer debt
the lowest level of consumer confidence since October 2003
a falloff in the number of favorable company surveys being issued

What's more, there are the "ugly" factors of energy costs, natural disasters and corporate bankruptcies.

The bottom line is that we don't really know how strong the economy is. What we do know is that it's weak, normal or strong — we'll come back to those three possibilities.

Figuring Out The Fed
We know that the Federal Reserve has taken the fed funds rate from 1.00% up to 3.75% — so far. The question on everyone's mind is: when will the Fed be done. Investors know that the Fed won't tell the market they're done until they're certain they've gone far enough.

Like economic strength, there are three possible ways the Fed will proceed: an easy, moderate or tight policy.

They could take the easy road and stop where they are at 3.75, or perhaps take a more moderate course at 4.00% — yet if they do and the economy's underlying condition is strong, we could be facing rising inflation and long-term interest rates. However, if they adopt a tight policy and raise the rate to 4.75% or higher, we could be looking at a policy-induced recession if it turns out the economy's underlying strength is weak.

Analyzing the Whole Nine Yards
Let's put together our grid and see where logic — and a little bit of fearless guesswork — takes us. Our three possibilities for economic strength, and our three possibilities for Fed policy, equal nine possible scenarios:

	Current Underlying Economic Strength	Current Underlying Economic Strength	Current Underlying Economic Strength	Current Underlying Economic Strength
		Weak	Moderate	Strong
Fed Policy	Tight
Fed Policy	Moderate
Fed Policy	Easy

As I see it, we have five possible outcomes for the economy, ranging from negative growth (otherwise known as a recession) to blistering growth (otherwise known as inflation.) Here's how they relate to each combination:

	Current Underlying Economic Strength	Current Underlying Economic Strength	Current Underlying Economic Strength	Current Underlying Economic Strength
		Weak	Moderate	Strong
Fed Policy	Tight	Negative Growth	No Growth	Modest Growth
Fed Policy	Moderate	No Growth	Modest Growth	Solid Growth
Fed Policy	Easy	Modest Growth	Solid Growth	Blistering Growth

Now what's the likeliest scenario? Here's my assessment:

	Current Underlying Economic Strength	Current Underlying Economic Strength	Current Underlying Economic Strength	Current Underlying Economic Strength
		Weak	Moderate	Strong
Fed Policy	Tight	Average Likelihood	Low Likelihood (my guess)	High Likelihood
Fed Policy	Moderate	Low Likelihood	Low Likelihood (my choice)	Average Likelihood
Fed Policy	Easy	Low Likelihood	Low Likelihood	Very Low Likelihood

Now here's where I part company with the Fed. If I were running the show, we'd be done with fed funds rate increases and pursuing a moderate Fed policy with moderate economic growth — smack dab in the center of possibilities. Which is usually a good place to be.

However, my guess is that the Fed will pursue a tight policy, with additional rate increases; this may substantially slow, but not crater the economy. History shows that the Fed tends to err on the side of over-concern with inflation.

If I'm wrong and the Fed overdoes it, bonds are likely to become a better investment than equities. A policy-induced recession is likely to sharply reduce future profits. However, even incorporating the most pessimistic earnings forecasts I can find, equities still appear to offer better opportunities than bonds. We'll see in the next few months whether good times or grid lock are ahead.

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Russell Investment Group is a registered trade name of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide. Frank Russell Company is a subsidiary of The Northwestern Mutual Life Insurance Company.

Bond investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in portfolios that invest primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility.

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Securities distributed through Russell Fund Distributors, Inc., member NASD, part of Russell Investment Group.

RFD 05-5539. First used: November 2005