GLOBAL ECONOMICS

Bear, Stearns & Co. Inc. - U.S. Equity Research January 6, 2007

2007 Outlook: Durable Global Expansion

We emphasize the deep underestimate of the U.S. economy. We expect more growth and profits than the consensus, supporting equities, but also more inflation and rate hikes, hurting stocks and bonds. Despite the pervasive talk of an economic slowdown, U.S. real GDP growth will turn out to have been faster in 2006 than in 2005. This parallels the 2006 acceleration in the global economy. Monetary policy remains stimulative worldwide. We expect the global expansion to remain strong in 2007 despite interest rate hikes by most major central banks. We think the biggest 2007 economic risk is from inflation, particularly in the U.S. We expect rate hikes by all the major central banks as they grapple with the excess liquidity from low interest rates earlier in the decade.

We emphasize the deep underestimate of the U.S. economy. We expect more growth and profits than the consensus, supporting equities, but also more inflation and rate hikes, hurting stocks and bonds.

Unemployment ended the year at 4.5% with fast growth in the labor force. The fourthquarter payroll gains totaled 407,000 despite the expected weakness in construction, manufacturing and retailing. The household survey showed even stronger fourth-quarter job gains of 1.02 million. We think theres a healthy transition in the economy from the extreme pace of home-building in 2004 and 2005 to more sustainable gains in global service industries. Wages rose 4.2% in 2006, versus CPI inflation of 2.0% in the 12 months through November. The real wage gains in October/November were the largest since 1998.

Real Wage Growth (inflation measured by headline CPI)

3%
Economists David Malpass Sandy Batten
212-272-4293 DMALPASS@bear.com 212-272-8428 sbatten@bear.com

2% 1% y/y % change 0% -1% -2% -3% Jan-88

Jan-91

Jan-94

Jan-97

Jan-00

Jan-03

Jan-06

Source: Haver; Bear, Stearns & Co. Inc.

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We expect the strong labor environment to continue contributing to consumer resilience. We disagree with the view that weakness in housing and mortgage equity withdrawals will cause weak growth in consumption. We note also the big increases in U.S. financial savings and disagree with the view that the low savings rate will cause weakness in consumption.

Real Personal Consumption Expenditure

8200 Q3 ave Q2 ave 8000 Q1 ave

8100 $ 2000 billions

7900

7800

7700 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06

Source: Haver; Bear, Stearns & Co. Inc.

Despite the pervasive talk of an economic slowdown, U.S. real GDP growth will turn out to have been faster in 2006 than in 2005 (see table). This parallels the 2006 acceleration in the global economy. Outlook for Real GDP
2003 U.S. Q4/Q4 Yr ave/Yr ave World Yr ave/Yr ave 3.7% 2.5% 2004 3.4% 3.9% 2005 3.1% 3.2% 2006(e) 3.2% 3.3% 2007(f) 3.0% 2.8%

2.5%

3.7%

3.4%

3.8%

3.3%

Source: Haver; Bear, Stearns & Co. Inc. estimates.

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Second- and third-quarter growth (2.6% and 2.0%) were below average due to the contraction in residential investment and came on top of the first quarters 5.6% surge. Were now assuming 2.7% growth in the fourth quarter based on the strength in hours worked and consumption. Growth in Hours Worked
7.5% 5.0% Q/Q % change, SAAR 2.5% 0.0% -2.5% -5.0% Mar-88 Mar-90 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06
Source: Haver; Bear, Stearns & Co. Inc.

Excluding residential investment, which bulged in 2004 and 2005 and then reverted in 2006, GDP growth has been remarkably stable.

Real GDP Growth Excluding Residential Investment

8 6 q/q % change, AR 4 2 0 -2 -4 Mar-89

Sep-91

Mar-94

Sep-96

Mar-99

Sep-01

Mar-04

Sep-06

Source: Haver; Bear, Stearns & Co. Inc.

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Monetary policy remains stimulative worldwide. Japans real interest rates are practically zero, undoing the deflation of the 1990s. U.S. real interest rates are low by the standards of previous expansions. Not only was extra liquidity injected into the global economy in 2003-2005 but monetary policy is still not at the point of reducing it. Real Federal Funds Rate (inflation measured by core PCE deflator)
8 7 6 5 4 3 2 1 0 -1 -2 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 %

Source: Haver; Bear, Stearns & Co. Inc.

We disagree with the view that money supply is a useful indicator of monetary policy accommodation under current circumstances. We note wide swings in the value of currencies and in the velocity of money. We think slow growth in U.S. and Japanese money supply is a response to rising velocity, with no implications for future economic growth.

U.S. Monetary Base Velocity

22

20 GDP/M0

18

16

14 Mar-70

Mar-75

Mar-80

Mar-85

Mar-90

Mar-95

Mar-00

Mar-05

Source: Haver; Bear, Stearns & Co. Inc.

From the standpoint of a business or potential homebuyer, real interest rates are particularly low given the mild inversion of the yield curve. Real five-year interest rates are much lower than in the robust expansions of the 1980s and 1990s.

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Real Yield on 5-Year Treasury Note (inflation measured by core PCE deflator)
10 8 6 % 4 2 0 Jan-80

Jan-83

Jan-86

Jan-89

Jan-92

Jan-95

Jan-98

Jan-01

Jan-04

Source: Haver; Bear, Stearns & Co. Inc.

Good 2007 Global Prospects We expect the global expansion to remain strong in 2007 despite interest rate hikes by most major central banks.

Job growth in Europe and Japan is running above expectations, a powerful stimulus to output and consumption.

Japanese and Eurozone Unemployment Rates

10.5 10.0 9.5 % 9.0 8.5 8.0 7.5 7.0 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06
Source: Haver; Bear, Stearns & Co. Inc.

6.0 Japan (rhs) 5.5 5.0 % 4.5 Eurozone (lhs) 4.0 3.5 3.0

The U.S. digested most of the housing and Big-3 auto corrections in 2006, setting up better prospects for 2007 (see Better Economic Outlook on November 20, 2006). Overall growth should continue in the 3% range of recent years in the first part of 2007. We expect quarterly real GDP growth rates of 3.0%, 3.1%, 3.0%, 2.9%, though second-half growth may be weaker if inflation and rate hikes exceed our expectations (core staying below 3% and two Fed rate hikes). We note confirmation of the strong growth outlook from equity prices, credit spreads, and profit growth.

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U.S. Corporate Profits

8 7 log of $ billions 6 5 4 3 Mar-47

Mar-54

Mar-61

Mar-68

Mar-75

Mar-82

Mar-89

Mar-96

Mar-03

log scale: 3=$20 billion; 5=$148 billion; 7=$1,096 billion

Source: Haver; Bear, Stearns & Co. Inc.

We discount the slowdown signal from low Treasury bond yields. We think it reflects plentiful liquidity, a backward-looking fear of deflation, and an underestimate of the growth and inflation outlook. We note that Treasury bond returns were poor in 2003 through mid-2006 reflecting this valuation problem.

Inflection Point from Inflation We think the biggest 2007 economic risk is from inflation, particularly in the U.S. The U.S. has already had a substantial inflation problem due to dollar weakness earlier in the decade. It suffered 4.7% overall CPI inflation in the 12 months through September 2005. Core CPI inflation reached 2.9% in August 2006.

The year-over-year core PCE deflator, the Feds preferred measure, rose to 2.4% in August 2006. It has receded in recent months, but we note difficulties in the core inflation outlook that may cause it to move to a new high. The 0.12% month-over-month increase in December 2005 and the below-normal beginning-of-year rises in January 2006 (0.15%) and February 2006 (0.17%) create the possibility of a big runup in the year-over-year core PCE deflator in coming months. In addition, auto and truck prices contributed substantially to the low core PCE deflator readings in September through November, but further price cuts are unlikely; and we think rent increases, a heavily weighted component, will remain strong in 2007. Also, the core PCE deflator was subject to big upward revisions in July 2005 and July 2006, meaning monthly inflation since March 2006 (the last fully revised data) may have been understated. The bottom line is that core inflation is running well above the Feds target, and it looks to us as if it will rise in coming months, not fall, as required to keep the Fed on hold.

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Core PCE Deflator and Benchmark Revisions

2.6% 2.4% 2.2% y/y % change 2.0% 1.8% 1.6% 1.4% 1.2% pre 2005 benchmark revision thru 2005 Q1 Sep-01 Jun-02 Mar-03 Dec-03 Sep-04 Jun-05 pre 2006 benchmark revision thru 2006 Q1 Mar-06 post benchmark revision thru 2006 Q3

1.0% Mar-00 Dec-00

Source: Haver; Bear, Stearns & Co. Inc. estimates.

Market Implications We expect rate hikes by all the major central banks as they grapple with the excess liquidity from low interest rates earlier in the decade.

As a starting point for our forecast, we expect two 25-basis-point hikes each in Japan, Europe, and the U.S. by the third quarter of 2007, with more possible depending on inflation. We think the next U.K. rate move is more likely to be up than down. China tightened some on January 5, raising its reserve requirement. We expect more hikes there. We expect bond yields to rise an equal amount, leaving yield curves relatively flat in Europe and mildly inverted in the U.S.

We think large currency and commodity movements are closely related to monetary policy. Dollar weakness and commodity price gains earlier in the decade were directly related to low U.S. interest rates and the Feds commitment to limited (measured) rate hikes. The dollars 2006 weakness against the euro and pound reflected the dovish Fed pause versus the hawkish hikes in England and Europe. Key U.S. and U.K. Interest Rates
7% 6% 5% 4% 3% 2% 1% 0% Jan-99 U.S. fed funds rate Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 UK base rate

Source: Haver; Bear, Stearns & Co. Inc.

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Given our expectation of solid U.S. growth with somewhat higher inflation (a reversal from the mid-2006 moderation), we expect the dollar to strengthen. It may settle at $1.25 per euro, $1.85 per pound, and 120 yen per dollar at year-end 2007. We expect stronger-than-consensus global growth in the first half of 2007. This will tend to strengthen commodities on the margin, undercutting the global slowdown-related weakness. Separately, we think commodities would weaken substantially if central banks imposed monetary restraint (as measured by a substantial decline in gold prices). We disagree with the bearish economic interpretation of the recent commodity price decline. We note that commodity prices generally fell in the 1990s despite relatively strong U.S. and global growth. We think average commodity prices respond to changes in the value of the dollar. Their rise was overly exuberant in 2006 on the view that the Fed would be dovish. We think recent declines are an unwinding of that overexuberance, not a change in the global growth outlook. Regarding equities, we thought rising core inflation and related rate hike expectations would stop equity gains in the second half of 2006. Instead, core inflation moderated, in part due to sharp auto and truck price declines, providing a green light for equities. We dont see that continuing in 2007. In the next few months, we think global equities should move higher in response to economic and profit growth, but we then expect a speed bump (like the bull-market corrections in May 2006 and March 1994) when it becomes clear that the Fed will be hiking, not cutting. We note solid long-term prospects for U.S. and global equities on the basis of valuation, innovation and globalization (see Solid Long-Term Equity Returns on April 11, 2005).

Price/Earnings Ratios for U.S. Equities and Bonds

35 30 25 P/E 20 15 10 5 0 Mar-85 Baa Corporate Bonds Equities

Mar-88

Mar-91

Mar-94

Mar-97

Mar-00

Mar-03

Mar-06

Source: Haver; Bear, Stearns & Co. Inc.

Important Disclosures

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The costs and expenses of Equity Research, including the compensation of the economist(s) that prepared this report, are paid out of the Firm's total revenues, a portion of which is generated through investment banking activities. This report has been prepared in accordance with the Firm's conflict management policies. Bear Stearns is unconditionally committed to the integrity, objectivity, and independence of its research. Bear Stearns economists and personnel report to the Director of Research and are not subject to the direct or indirect supervision or control of any other Firm department (or members of such department). This publication and any recommendation contained herein speak only as of the date hereof and are subject to change without notice. Bear Stearns and its affiliated companies and employees shall have no obligation to update or amend any information or opinion contained herein, and the frequency of subsequent publications, if any, remain in the discretion of the author and the Firm.

Bear, Stearns & Co. Inc. Equity Research Rating System: Ratings for Stocks (vs. analyst coverage universe): Outperform (O) - Stock is projected to outperform analyst's industry coverage universe over the next 12 months. Peer Perform (P) - Stock is projected to perform approximately in line with analyst's industry coverage universe over the next 12 months. Underperform (U) - Stock is projected to underperform analyst's industry coverage universe over the next 12 months. Ratings for Sectors (vs. regional broader market index): Market Overweight (MO) - Expect the industry to perform better than the primary market index for the region (S&P 500 in the US) over the next 12 months. Market Weight (MW) - Expect the industry to perform approximately in line with the primary market index for the region (S&P 500 in the US) over the next 12 months. Market Underweight (MU) - Expect the industry to underperform the primary market index for the region (S&P 500 in the US) over the next 12 months.

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