The economy is losing steam, but still keeps on going. The revised fourth quarter GDP growth rate was 2.5 percent, yielding an annual growth of 3.3 percent for the full year 2006. The preliminary estimate for the first quarter of this year shows GDP growth of only 1.3 percent; although we think it will be revised up possibly to 2.0 percent. The slow growth figure is attributed mainly to further steep declines in residential construction and to a drop in net exports. Consumer spending was relatively robust, particularly expenditures on durable goods. Non-residential investment posted a moderate 2.0 percent growth.

Signs of further economic weakening this year are evident in several areas: first, the residential real estate sector which posted a 17.0 percent drop in its GDP component in the first quarter of this year. Housing is still in the midst of a workout which we think could last another 12 months, with greater price vulnerability in those local markets that have experienced the hottest price appreciation during the past five years – the higher they go, the harder they fall.

A second weakening factor are the spillover effects from the correction in the housing market which could become more pronounced during the second half of this year, when the current pipeline of projects dating back to 2006 reach completion, and much fewer housing are planned. Housing inventories are expected to climb further. The negative linkages from housing to other sectors are evident in the recent weakening of industrial production to a 12 month growth rate of 2.3 percent in March, down from its peak of 6.0 percent in September 2006.

On the plus side, consumer spending will continue to fuel the expansion, buttressed by still low interest rates. Nevertheless, household debt appears to be reaching a peak, with the debt service payment to disposable personal income ratio reaching a record 15 percent and still rising. Even with falling home values, the accumulated equity value is far greater than consumers’ borrowing capacity. We think the likelihood of loan delinquencies poses a greater risk to the economy than the correction to the housing market, and if there is a dramatic rise in foreclosures, housing prices could fall even further.

Despite our sanguine view of inflation and risks to the housing sector, we are a little less pessimistic on the growth outlook for the economy this year. We think GDP will expand at a rate of 2.6 percent.

As we have predicted in previous StratAlerts, inflation made a soft landing but is already taking off again. High energy and other commodity prices accompanied by rising unit labor costs and the cumulative effects of past expansionist policies will fuel the uptick in inflation this year. We expect the year-end CPI inflation rate to reach 4.2 percent this year (December over December), based on an average monthly rate of 0.26 percent, which is conservative considering that inflation averaged 0.5 percent per month during the first quarter of this year. No wonder the Fed is voicing some concerns about inflation.

The long end of the yield curve is starting to move up and appears to be reaching a normal slope, possibly during the second half of this year, which implies that both the 10 and 20 year bond rates will break through the 5.00 percent barrier.

The dollar has been gradually slipping in value particularly with respect to the Euro; and this may help to contain the bulging trade deficit. However, this still leaves the Chinese yuan as the strongest supporter of the dollar, but at the same time, as the principal driver of the U.S. trade deficit. Our long-standing forecast of US$1.5 per Euro may materialize sooner than we think.

At a meeting in Margarita, Venezuela, the South American presidents agreed to create a Union of South American Nations (UNASUR), with the goal of achieving political and economic integration. The new organization would be headquartered in Quito, Ecuador.