How '05 predictions look at mid-year

Wednesday, July 20, 2005 at 1:00am

Now that we have passed the halfway point of the year, it seems a good time to revisit the predictions we made at the beginning of 2005 to see how they have played out. Our overall view was that the markets would experience a "muddle through" environment in terms of returns, and so far, that has certainly happened.

Led by a slowdown in consumer spending, U.S. real GDP growth slows to less than 3.5 percent. For gross domestic product (GDP) growth to be less than 3.5 percent, we would need to see a slowdown from the reasonably good growth we saw in the first half of the year. We think that will happen as a result of the year-over-year increase in oil prices, the year-over-year rise in short-term interest rates and the strength of the dollar in 2005.

Every major economy in the world slows, but Asia continues to lead while Europe continues to lag. We believe every major economy will have experienced slower growth by year-end. Clearly, we have been seeing this happen in most parts of the world, particularly in Europe. At the end of the year, we expect to see Asia leading the growth parade, Europe in last place and the United States somewhere in the middle.

Profits advance less than the 10 percent forecast as surprises are no longer positive due to slowing demand and some margin pressure. For this prediction to come true, we will need to see some slowdown in corporate profits for the rest of the year. First-quarter profits were stronger than expected, and with reduced expectations for the second quarter, we would not be surprised to see profits exceed expectations once again. However, with expectations for third- and fourth-quarter growth in the low to middle double digits, we would expect to see disappointments in the second half of the year.

U.S. stocks struggle but outperform bonds and cash for the third consecutive year. For this to happen, we will need to see some combination of stocks performing better than they have so far this year and bonds performing worse. We think the second half of the year will see better performance for stocks. While we have been encouraged by the rally that has occurred over recent weeks, we continue to believe that stocks will muddle through.

Strong balance sheets and high excess cash flow generation create an increase in M&A activity along with dividend increases, stock buy-backs and capital spending. Merger-and-acquisition (M&A) activity started the year at a record pace, and has continued to be strong, driven by high amounts of excess cash and the fact that many companies are experiencing difficulty growing organically. If M&A activity picks up during the second half of the year, as we expect it might, 2005 could be the strongest M&A year in history (2000 currently holds that distinction). At the same time, dividend and share buy-back activity has been strong so far this year, and capital spending has improved recently from a lackluster pace.

Commodities perform well again with oil prices averaging more than $40 per barrel. Most commodities have performed well this year, and at this point it seems certain that oil will average over $40 per barrel. At this point, that hardly seems a daunting task, but it is important to remember that at the beginning of the year, oil was at $41 per barrel and most thought it would be headed lower. Oil prices are up approximately 50 percent so far this year, driven by supply and demand factors, and we don't expect these factors to change, meaning that oil prices will likely remain high.

While significant structural problems remain, the U.S. federal budget deficit, trade deficit and current-account deficit will all improve for the first time in 10 years. This was a rather tenuous prediction when we made it, and although the U.S. federal budget deficit will improve in 2005, the current account deficit has continued to worsen and the trade deficit has flattened out at a very high level.

Against this backdrop, we continue to expect a back-and-forth environment for the markets. For the rest of the year, we expect a slightly more difficult environment for bonds and a slightly better one for equities.

Bob Doll is president and chief investment officer of Merrill Lynch Investment Managers. For more information on MLIM, e-mail mlim_feedback@ml.com.

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