Economic activity appears to be at about a 4% annual rate in the year’s final quarter, with strength in production outstripping demand. Industrial production rose at a 7% annual rate in the October-November period, with indications for another rise in December. Further, housing starts continue to defy the laws of gravity. But other indicators are showing some strain.

Curiously, durables manufacturers orders showed a broad-based decline in November. New home sales fell for a third consecutive month in November, and existing home sales fell for a second month. Jobless claims have been somewhat higher than expected, and Chicago area manufacturing grew more slowly than expected in December. Finally, holiday related sales, while good, were not as strong as hoped or expected.

What is going on? Perhaps the headwinds we have spoken of are beginning to bite. To reiterate, the consumer appears out of joint. The saving rate is too low; debt ratios are too high; the year’s tax cut was spent by autumn while mortgage refinancing activity has slowed to a trickle. Added to these are that the homeownership rate is a record while employment growth is still slow. Housing is less affordable than earlier while there is no pent-up demand. Finally, discretionary incomes are being eaten alive by higher food and energy costs.

To be sure, capital spending for labor saving equipment will likely continue strong owing to robust profit growth, favorable tax breaks, and continuing efforts by business to offset rising commodity prices and wage and benefit costs with strong productivity. Moreover, at least so far, business seems willing to add modestly to inventory despite an absence of pricing power.

In the midst of all this equity markets have rallied merrily; the dollar has fallen relentlessly; and fixed income prices have remained steady amidst a passive Federal Reserve. These may well change early in the New Year for there is a broad consensus that growth will be strong in 2004 with the strength being front end loaded. The consensus is also for interest rates to rise and the dollar to continue falling while equity markets forge ahead.

The consensus may be surprised, however, if employment growth remains weak. Specifically we think the risk is that November’s meager 57K rise in nonfarm payrolls could be followed by another weak report for December. In this event expectations would abruptly change. For example, prospects for a change in credit policy by the Federal Reserve would be pushed even further into the future. Fixed income markets would rally such that if the Treasury Ten Year were to fall through 4.10%, mortgage related buying could shove rates down sharply. And the dollar could blow off to the downside, making a good low in the first quarter. Finally, the equity market and commodity prices might correct on prospects for slower demand growth and profits.

We would regard such a correction in stocks and commodities as a buying opportunity because an early rally in fixed income markets would have interesting repercussions for future growth. Specifically, a downward adjustment in mortgage rates would boost refinancing activity, providing the economy with needed cash flow at about the same time that big tax refunds would be flowing to consumers. This would then boost growth prospects for the spring and summer, helping stabilize or improving the dollar’s value, which would be positive for both stocks and bonds. We would expect the dollar to also benefit from slowing growth in China in 2004 and the negative implications that might have on trade flows in Asia and Europe.

If we are right, the Federal Reserve would have ample reason to lay low all through 2004. And with inflation remaining non-existent fixed income markets should be stable at lower yields, helping stabilize construction activity. If by year end 2004 the federal funds rate is still 1%, the Treasury ten year should not be above 4%.

Unexpectedly slow growth early in 2004 and faster growth in the spring and summer would be followed by a relapse late in the year and in 2005 as fiscal stimulus fades and favorable business tax breaks expire. But that is not the focus right now.

The upcoming labor market report is the focus, and we think it will be weak because of continuing sluggish manufacturing payrolls, slowing construction and retail jobs, and layoffs in the mortgage area. Moreover, with the consensus being so one-sided toward strength, we see the risk to the entire year being toward a failed recovery. Of course, external shocks could operate positively or negatively, and there are plenty of potential candidates such as the U.S. election, Iraq, Pakistan, a terrorist event, imbalances in China, Usama’s capture, etc. These are unforecastable, however, and therefore cannot be factored in.

Focusing on the internal dynamics of the economy, how might the recovery abort? Our best candidate is from a quick end to inventory accumulation, which would cause employment to remain weak with negative implications for income growth. And with housing supply and demand coming into alignment, a stubbornly weak job market could trip up the real estate market, triggering price weakness and negative equity for a lot of recent homeowners and refinancers. Were this to occur, consumers would retrench, the economy would stall, and concerns about deflation would justifiably resurface, causing interest rates to tumble. In such an environment both trade and tax policies might be reevaluated, and not in a favorable manner.

This is a risk in our view; not a forecast. Our most likely roadmap is for a slower first quarter, followed by strength in the middle two quarters and finally a weaker year end. Monetary policy would remain steady all year and into 2005, and the dollar would make a low early in 2004.

We will be watching and monitoring all the twists and turns in our roadmap. Throughout, though, we hope the New Year is a healthy, prosperous, and peaceful one for all.