For investors, 2006 will start a little late this year -- about six months late, in fact. Sure, we'll flip open a new calendar on Jan. 1. But as common as it is to think that a new investing year starts with the New Year, it's especially important to resist that way of thinking as we head into 2006. Truth is, the big make-or-break events of 2006 -- the ones that will determine how different investing in 2006 is from investing in 2005 -- aren't scheduled to hit the calendar until later in the year. What will determine whether the New Year is a happy one or something much less cheerful depends on the way what I call my Five Big Ifs for 2006 play out.
If No. 1: Has the Fed Overdone It?If the Federal Reserve has overdone it with the series of interest-rate increases that began in June 2004, economic growth will be slower than expected or desired. The rate hikes that began when short-term rates were just 1% are now widely expected to end in 2006 with either the Jan. 31 or March 28 meeting of the Federal Open Market Committee. Short-term rates, according to this scenario, will top out at 4.50% or 4.75%. The optimists among investors and economists believe that, at that level, rates will be just right -- high enough to fend off inflation but not high enough to stall the economy. One group of pessimists says the Federal Reserve is raising rates too high for an economy that has derived much of its juice in this recovery from a massive increase in consumer debt and a big bump in housing prices. Take away those stimuli by making it discouragingly expensive to borrow, and the economy will slow down faster than anyone now expects. Other pessimists say the Federal Reserve has moved too late and is too complacent. Inflation is back, they argue, and the Fed should pull its head out of the sand. We should know what the Fed has wrought by July at the earliest, or September at the latest, because it takes about six months for the effects of a Fed rate move to ripple through the economy. A slowdown in economic growth would be bad for the stock market, but it could produce a bond-market rally. A trend toward higher inflation would likely tank both markets.
If No. 2: Potential Pain at the PumpIf gasoline prices spike upward again, consumers will go back into a deep funk and cut back on purchases. Remember how depressed consumer sentiment was this fall when gas passed $3 a gallon? It's not exactly a coincidence that as gas prices peaked in September and October, consumer sentiment in the University of Michigan survey fell to a 13-year low at 74.2. Gasoline prices have backed off. The national average for a gallon of unleaded, according to AAA, stands at $2.14, way, way down from the record high for the national average of $3.06 set on Sept. 5, 2005. Consumer sentiment, meanwhile, has recovered to hit 88.7 in December. The next critical test for the energy-supply system -- everything from tankers to terminals to refineries -- will come next year when the oil industry starts to rev up for the peak driving season. Should gas start to climb back toward or even beyond $3 a gallon, investors can expect another outbreak of consumer depression and endless news coverage about how low-income consumers will stop shopping at Wal-Mart. (I hope reporters have saved their notes and video.) If we sail through the summer driving season relatively unscathed, it will be a huge boost to consumer and investor confidence. Lots and lots of folks will draw the probably erroneous conclusion that there really is no energy-supply squeeze. The crisis of 2005 will get filed away as bad luck. After all, we can't have 26 named hurricanes every year, can we? Predictions for 2006 call for a drop to 17 named storms, a reassuring number unless you know that 10 is the annual average.
If No. 3: Europe and JapanIf economic growth picks up in the European Union and in Japan, it will take pressure off the U.S. trade deficit. Right now, that's the prediction. The Organization for Economic Cooperation and Development sees real GDP growth (that's growth after subtracting the rate of inflation) dropping to a still very healthy 3.5% annually in the U.S. next year, with growth holding solidly positive at 2% in Japan and at 2.1% in the eurozone. That would be good news for profits and jobs at U.S. blue-chip companies, a sector dominated by big multinational exporters. If anything is to go wrong with these economic projections, investors will know by the time June quarterly numbers are reported. The OECD's forecasts show growth rising from the first quarter of 2006 to an annual peak in the second quarter in Japan. In Europe, growth will continue to accelerate to reach a third-quarter high at 2.2%, the OECD predicts. If instead of accelerating, these two global economies slip back in 2006, the disappointment among investors will take hold with those second-quarter numbers.
If No. 4: Influence of China and IndiaIf growth picks up as expected in the developed world and comes in stronger than forecast in China and India, investors can expect a resumption of runaway commodity prices. Right now, the outlook calls for economic growth in both countries to slow next year from 2005. The International Monetary Fund and the Asian Development Bank both peg growth at 8.5% in China in 2006, down from 9.2% in 2005, and at 6.8% in India for 2006, down from 7.1% in 2005. That kind of modestly decelerating growth would be good news for companies competing with China and India for supplies of iron, copper, coal, oil and nickel. But once again, investors are looking at forecasts that project the best of possible worlds: Good growth but not too much growth.
The likelihood of faster growth -- Europe and Japan are both supposed to show stronger economies in 2006, and that would suck up more exports from China and India -- is about balanced with that of a slowdown, because higher oil prices could cut growth in these energy-dependent but energy-inefficient manufacturing economies. As with projections for the developed world, investors won't know if 2006 will be disappointingly different from projections until well into the year.