The Crystal Ball - 2007

Here are a few thoughts about what I think may drive financial markets in 2007.

Currencies

The free-floating currency system has been relatively stable, but Thailand has been in the news lately with the Government trying to stop the rise in the baht. It sent their markets crashing and sent a shudder through world markets. I think that was a "sneeze." A much darker scenario could materialize in 2007.

What could precipitate the disaster? How about China 'diversifying' its currency holdings out of the US$? The weak dollar (so far) has been perceived as a boon to U.S. exporters - they can sell their products cheaper, meanwhile imports in the US cost more. This drives more consumers to buy from US firms instead. Sounds good, right? The markets have voted with a large rally late this year. But, what happens if the dollar goes into a 'free fall' in 2007?

First, what happens to the value of foreign debt after the lower currency translation? Foreign holders sell to stem losses, driving bond yields higher and stocks lower. US consumers will pull back on spending, and the world economy 'catches a cold.' America's overall debt owned by foreigners totals about $3 trillion, so the effect is not insignificant.

What would precipitate a 'free fall' in the dollar? Here's a laundry list which, if they all hit at the same time, could create a 'perfect storm' of global proportions.

(1) Foreign Governments allow their currencies to rise relative to the dollar. China, for example has already decided to 'diversify' its economy by moving more out of dollars. While Thailand demonstrates that doing the opposite (allowing the home currency to rise and hurt exports) won't sit well with the folks back in Thailand, major emerging economies such as China and India have more latitude to allow their currencies to rise without harming economic growth much.

(2) Slowing US economy - Slower economic growth is predicted for 2007. Helicopter Ben decides to loosen rates, which is normally good for bonds, but bad for the dollar. The lower dollar squeezes export growth in foreign economies, while at the same time offsetting US bond gains for foreign holders of US debt. Critical mass is reached when US rate cuts do not result in bond gains, setting off panic selling in the bond markets, and sending the dollar even lower.

(3) Housing slump - 2007 may be when the real pinch begins. This may be the main culprit for the slower economic growth.

Government

If there is stabilization in Iraq, the spending now going to fund the war would be stopped or reduced. Apart from Iraq, there is rhetoric from the Democrats about fiscal restraint (yeah, right) but since they are barely clinging to power it is not out of the realm of possibilities. These events could add up to a change from the recent recklessness in Government spending - obviously that would be very good for financial markets and very supportive of the dollar.

The Trend to Watch in 2007

2007 may mark the year investors realize how the aging baby boomer demographic impacts stock selection for those massive retirement portfolios. Yes, you guessed it. It's all about income. It won't be all in bonds - a lot will be in income producing stocks.

2006 marked only the beginning of a mega trend (that means it could last 10 years or more) powering dividend-paying blue chip stocks. The quality ones (translation: the ones that are increasing their dividend payouts and buying back stock) already started moving up in 2006.

I predict that over the next ten years that trend will accelerate significantly, and will accelerate so much that investors will have to pay close attention so that payout ratios of these stocks don't get too high.

Many of these companies are defensive in nature, and will have more staying power through either recessionary or inflationary periods. Dividend yields will ensure a higher floor in the event of a major correction or crisis.