Inflation and more real estate price deterioration lie ahead

Richmond, CA, February 5, 2008--Election-year pressures to lower Fed-funds rates may guarantee inflation in 2008, says Brian Pretti, head of Investment Management for Mechanics Bank, in his first economic forecast of 2008. And, California's inflated real estate values haven't bottomed out yet. But one bright spot may be the state's agricultural industry.

"The upward thrust of economic fortunes in developing economies means the rising ability of global consumers to better afford more broadly defined agricultural products," Pretti says. "Global competition for food products will increase, driving up prices."

Unfortunately, higher food prices also will hit household budgets. There just aren't any easy answers in 2008.

Also driving price increases will be the inflation caused by continued cuts in interest rates as the Fed strives to keep credit available to America's businesses and individuals, Pretti says.

"In virtually every financial crisis or economic slowdown over the past one-and-a-half decades, the Fed response has been to lower interest rates, increase money printing, and encourage credit expansion," said Pretti, who oversees Mechanics Bank's $1.7 billion investment portfolio. "They overdid the job during the last cycle, when the Fed-funds target rate was lowered to 1% and the mortgage credit bubble blew to generational proportion. Today, the economy is choking on the aftermath. But realistically, in an election year they have no choice but to keep lowering rates."

Not that there's any assurance the strategy will be effective; US credit markets and financial institutions, immersed in write-downs, are not in a benevolent mood, Pretti says, and the Fed can't force lenders to lend or borrowers to borrow no matter how low it sets rates.

"That is a function of confidence," Pretti said, "a commodity in very short supply."

Meanwhile, deeper interest rate cuts increase the potential for the dollar to fall relative to foreign currencies--pushing up commodity prices pegged to the U.S. dollar. Oil and gold already have reached all time highs, and wheat and corn are headed there. Even with interest rates down, the US economy faces the real threat of significant inflation, according to Pretti.

Regarding the stock market, "It will be crucial to get sector exposure and geographic specificity correct within the totality of investment portfolios in the coming months," he said. "In 2007, the S&P energy sector produced a 32% return; yet, the S&P financial sector lost 21% of its value. As we move into 2008, there are warning signs that sector selection and specific global geographic exposure will be even more critical to success."

Pretti's specific recommendations echo his advice in 2007: Large capitalization, global blue-chip issues (because their foreign-derived earnings benefit from a weak dollar); precious metals, oil, and commodities (due both to their traditional role as inflation hedges and their continued global appeal); well-managed currencies (as a hedge to the dollar's global decline); and equities in fast-growing regions of the globe. Pretti urges investors to watch global equities carefully, however, given the possibility that a US economic slowdown could have a ripple effect.

Pretti thinks one of the most interesting plays is investing in companies that would benefit from a concerted US effort to address the nation's growing need for infrastructure repair and upgrade.

"Compared with the progressive infrastructure development in many foreign countries, the US is in great need of an infrastructure facelift," he said. "Not only is this a growing physical need, but it also might be an answer to economic malaise, helping support and strengthen US labor markets. As the Fed runs out of effective credit-inducement ammunition, I wouldn’t be surprised to see a modest conceptual return to the New Deal at some point."

Pretti doesn't mince words about how he sees the housing market unfolding.

"Residential real estate is still the single most important issue the US economy will face in 2008. The big question on everyone's mind is, “Now what? For seven years, we've been running not on a business cycle, but rather on a credit cycle — one of generational proportion. Residential housing activity and related consumer spending --both driven by ever-increasing credit availability to households--lifted the economy out of its 2001 slump and drove it for 6 years. But the economy is now paying--and will continue to pay--for the foolhardy way in which that money was lent. Never before in our lifetimes have we seen credit market investors so willing to lend to those least able to pay. Frankly, I hope we'll never see it again."

Pretti believes that financial institutions will be in no hurry to take on any level of risk in the near term, no matter how low the Fed funds rates goes. "In fact, they will be extremely wary in extending credit at all. And credit has been the lifeblood of the US economy this decade," he said.

"2008 starts with sluggish consumer spending and tightening credit — poor indicators for potential growth. It's very likely we'll have recession in 2008. How deep it goes frankly depends on foreign economies. If the global economy can remain very robust, the US export sector should act to underpin the US economy to an extent. Will that be enough? We’ll have to wait and see."

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