“This will be the year of China.”

As we begin 2008, custom requires an economic outlook for the New Year. There are three themes that deserve special attention in 2008:

1. This will be the year of China. In addition to the Beijing summer Olympics, much of the world economy hinges on developments in China.
2. Americans will select a new president. It will be the first election since 1928 in which neither candidate is an incumbent president seeking reelection, or vice president seeking to succeed his boss as president.
3. Finally, will 2008 see the fallout from the subprime mortgage market and housing boom of recent years push the Goldilocks economy into recession?

As we consider these three themes for 2008, we will highlight relevant economic indicators in our analysis.

THE YEAR OF CHINA

By the late 1980s, much of the talk was about the approaching end of British rule in 1997 and its meaning. Some thought that 1997 would be not only the sunset of the British Empire, but also the end of nearly half of a millennium in which the West dominated the world.

Consider these developments since Richard Nixon opened China to American economic interests in 1972:

• Over 400 million Chinese have been lifted out of poverty, nearly 75 percent of the world’s total poverty reduction in the last 50 years.
• China has become the world’s largest consumer, exceeding the United States in four of the five basic food, energy, and industrial commodities. It is also the largest emitter of carbon dioxide.
• China’s growth rate is expected to exceed 10 percent in 2008, continuing the pace set during the last decade. Our trade deficit with China for the past 12 months has been $259 billion, about one third of the total net trade deficit of $780 billion for the same period.
• Consistent with these trade flows, China holds 17.8 percent of foreign-held U.S. Treasury obligations as of 3Q07, up from 10 percent in 2003, but down from the 18.9 percent held at the end of 2006. For comparison, Japan holds 25.9 percent, down from 37.1 percent at the end of 2003.
• Approximately 30 percent of China’s exports to the United States are from U.S. companies based in China.
• The link between China as bond investor and the United States as a consumer of Chinese goods can be described as a marriage of convenience sometimes called “Chimerica.”

In a world where roughly 45 percent of U.S. Treasuries are now held by foreign investors versus slightly less than 18 percent in 1990, America and China may not be allies, but their interests align such that this “marriage” must be made to work better than any arranged royal marriage of the past.

The fact that the summer Olympics will be in Beijing is obviously recognition that China has arrived as a full-fledged, world power, arguably soon to become second place to the United States. The economic implications are clear for all to see, and the long-term geopolitical implications will be an all-important challenge for America over the next 10 to 15 years. Will China continue to evolve toward a less authoritarian state that shows friendly tolerance toward its citizens and neighbors, or will its past treatment of Tibet and its enforced population control policies be the benchmark of its governing and political philosophy? We won’t know the direction of China politically for at least another decade, but the trend is now positive.

In 2008, the question of immediate economic importance is this: Will dynamic growth of China, along with India and Brazil, be sufficient to keep the U.S. economy expanding, despite the housing slump and subprime mortgage fallout? If there is a caveat here, it is this: China is still a fragile power not unlike Brazil. Brazil has boomed and then gone bust spectacularly more than once. Alternatively, China’s leaders could decide to slow the rate of growth. This would slow the demand for American exports and, possibly, trigger a serious recession.

THE ELECTION OF 2008: SUSTAINED CONTINUITY OR WILL IT BRING CHANGE?

The issues in 2008 are much the same as in 2004. The American Constitution is centered on a separation of powers which inevitably means change is slow and built on compromise. Most elections sustain continuity in good times (for example, recall 1984, 1988, and 2004) or produce incremental change when the country votes to shift directions (for example, recall 1952, 1968 and 1992). Occasionally, events overtake us and a watershed election occurs (such as 1932, 1964, and 1980). Will the 2008 election serve to sustain continuity, trigger gradual change, or be seen as a watershed event?

Let’s consider several domestic and international issues that will shape this election.

Domestic Issues

Jobs: In recent years, economic growth has been heavily influenced by housing expansion and consumer spending, sparked by easy access to credit. After reaching a low of 4.2 percent in June, unemployment at the end of 2007 was 5 percent — the target traditionally described as “full employment.” Job growth was the slowest in December since 2003 and, excluding new government jobs, payrolls declined.

New home sales have dropped to a 12-year low, down 25 percent in 2007 and expected to decline 9 percent in 2008. The markets are still wondering if all the shoes have dropped in the subprime mortgage saga. On the plus side, nonresidential construction spending is now more than residential construction spending, continuing a steady upward trend since 1Q04. Market events will let voters know if housing is a big local story that gets exaggerated in a global economy, or is it a big sneeze that indicates a serious cold?

Of course, the economic benefit or fallout from globalization also causes anxiety in the mature sectors, such as autos which are negatively impacted by technical change whereby yesterday’s technology becomes obsolete and is replaced by today’s new technology. How will this angst play out on Election Day, 2008?

Both the International Monetary Fund (IMF) and the Federal Reserve are predicting positive real growth in 2008, but around 2 percent versus the 3 percent plus rate of recent years. But will this growth create jobs fast enough to absorb those jobs lost by inevitable economic change?

Health Care: Among the major industrialized countries, only the United States does not have a universal health care system. This does not mean that we spend less than these countries. In fact, on a per capita basis, U.S. government spending for Medicare, Medicaid and the Veterans Affairs Administration is $4,000, well above the average spending of $2,500 per capita spent by other major countries for their universal health care systems. Total health care spending in the United States is now 16 percent of GDP and is expected to be close to 25 percent by 2025.

Employee benefit costs have been rising faster than wages and well above the rate of inflation. This is now reflected in increasing unit labor costs. Also, the portion of workers covered by employer plans is now 59 percent, down from 65 percent six years ago.

In the public sector, the amount of unfunded health benefits that have been promised to retired workers is around $1 trillion, versus $289 billion in the private sector. Unlike Ford or GM, which represent 25 percent of the private sector unfunded liability for retiree health benefits, the pubic sector has only recently been required to disclose the size of this liability. That will have a major impact on the credit costs of state and local governments and their tax burdens in the years ahead.

Suffice it to say, the current health care situation is not sustainable if the recent trend continues. However, there has been no consensus about the issue since the failure in 1993 of the Clinton health plan. Recall that Social Security and Medicare were enacted after watershed elections.

Is an effective compromise possible or will this happen only after an electoral watershed?

Will a comprehensive program still encourage the incredible technical and educational leadership of America’s medical schools, hospitals, and pharmaceutical/medical supply industries?

Will any universal plan really be both cheaper and effective?

Climate Change: By awarding its Peace Prize to Al Gore and the UN’s Intergovernmental Panel on Climate Change (IPCC), the Nobel Committee acknowledged the widespread concern expressed about global warming.

Munich Re, the world’s second biggest reinsurer, indicated that natural disasters will be more frequent and costlier. Its spokesman said that these events cannot be attributed to climate change, but there is a clear pattern emerging: severe storms, heavier rainfall, and more floods.

The good news is that average carbon dioxide (CO2) emissions have declined in the United States since 2000. On the negative side, they increased in Europe, while China and India are rapidly replacing the United States as the leading producers of CO2 emissions. Also, while Beijing will host the Olympics, the city has very real air quality problems which may delay or necessitate the rescheduling of events.

The political question is simple. How effective will any combination of regulation, taxes, and carbon trading or technical innovations be in reducing CO2 emissions? And how much will it cost in terms of lost productivity, slower economic growth, and investment? In the late 1990s the

U.S. Senate rejected the Kyoto Treaty almost unanimously because it cost too much and put the United States at a serious disadvantage versus China, India and Brazil.

Climate change will be an important topic politically for many more years, while the political class develops solutions that are effective without being too costly. Will the solutions be sufficient, timely, and politically palatable? The Democrats are generally committed to more activist, interventionist policies, whereas the GOP prefers less draconian solutions driven by market considerations. However, recall that it was Nixon who established the Environmental Protection Agency and Ford set minimum mileage standards for the auto industry.

Immigration: The issue is really about 12 million illegal immigrants who live here and all the social, political and economic impact that accompanies a group that large. Voter frustration over this issue is perhaps tied to the fact that some states issue a driver’s license to illegal aliens.

Some economists argue that illegal immigrants are economically beneficial because they perform jobs that most Americans refuse to do and, consequently, help to keep labor costs down. Alternatively, because they are illegal, when they do lose a job, they are less likely to claim unemployment benefits to avoid scrutiny. For example, some argue that unemployment rates are actually higher than reported because of the decline in residential housing, as many of the workers are illegal immigrants who do not claim benefits.

After decades of assimilation and declining immigration to the United States, the percentage of immigrants in this country is at levels not seen since the 1920s. Immigration is part of our common heritage. The issue is considered the number one issue by just 10 percent of the electorate, well below the concerns about the economy (44 percent) and terrorism (37 percent). Nevertheless, it is the type of emotive issue that could decide close races in 2008 and will shape the future direction of the country, because Hispanic Americans are the fastest growing minority group in the United States.

International Issues

Terrorism: At the end of 2007, the ugly face of Jihadism reared its head in Pakistan with the murder of Benazir Bhutto. While the surge in Iraq under General Petraeus has been successful based on levels of violence and a reduction of both American and Iraqi casualties, events in Pakistan remind us how fragile if not dangerous the Middle East is. Unlike Iraq, Pakistan does have nuclear weapons. It is landlocked and very mountainous, which favors Osama Bin Laden and his al-Qaeda supporters. Pakistan is vital to the stability of the world economy and necessary to the efficient functioning of the global economy.

In prior elections, national security issues have generally benefited the GOP. The lack of an effective military strategy in Iraq has tarnished voter confidence in the GOP’s handling of foreign affairs. The surge in Iraq, if it continues favorably, may help restore faith in the GOP, especially if McCain is their nominee. Burton Malkiel, the author of A Random Walk Down Wall Street, has observed that events, not asset prices, are random. He makes the point that prices are not capricious; rather, they respond quickly to news that is capricious. This is what makes capital markets efficient. In recent years, the risk premiums for debt and equity have been small by historical standards. The lesson for 2008 is simple: unexpected events may well shape the economy for many years. In 2000 no one mentioned al-Qaeda or said anything that might have seriously suggested the horrific events of 9/11.

The wild card for 2008 is this: what unexpected foreign events might occur that will force us to enter uncharted waters, like we saw with Pearl Harbor, the invasion of Korea, the death of John Kennedy, and the Iran hostage crisis?

The Dollar: Both China and Japan have reduced their holdings of. Treasuries over the past year (Japan since 2005). A reduced demand for dollar-denominated bonds signals a weakening demand for dollars. It is commonplace to hear stories about Europeans taking a long weekend in New York to shop and essentially saving more than the cost of the trip because of the weak dollar. Another illustration of the dollar’s fall, a tube ticket in London is $8 versus just $2 for the subway in New York.

Dollar weakness suggests several questions:

• Is the dollar now undervalued? It has shown a net decline against the euro since 2001.
• Will foreign investors require higher returns as an incentive to own dollar-denominated debt securities, such as corporate and U.S. Treasury bonds? This could mean that the yield curve steepens as the Fed cuts the fed funds target rate to 3 percent to encourage growth and the 10-year bond remains at current levels (4 percent) or higher in order to continue to attract foreign investors.
• Will a weaker dollar encourage more foreign direct investment in the United States? Airbus is now considering building in this country in order to more effectively compete with Boeing. When the dollar was weaker in the 1990s, we saw large capital goods export to Europe. After 2000, the decline of capex spending in Europe saw a wider trade gap between the European Union and the United States. In 2007, the trend reversed and the net trade deficit with Europe narrowed by $17 billion.
• Will a weaker dollar prove a double-edged sword: good for exports but bad for inflation? In 1966, when the Britain devalued the pound from $2.80 to $2.40, then Prime Minister Harold Wilson said that this did not change the pound in everyone’s pocket. Of course, the subsequent inflation that followed left Wilson discredited and open to a narrow defeat in the 1970 election. A weaker dollar could also reverse if foreign investors perceive U.S. stocks to be undervalued and/or the opportunities for direct investment look more attractive. However, that process takes several years. Nevertheless, 2008 might see the bottom of the current cycle of dollar weakness with a gradual appreciation in subsequent years.

There are many other domestic and international issues that will be discussed by the candidates in 2008. We can make these observations regarding the upcoming election:

• No one can predict the winner and it is clear that no front-runners have emerged.
• Current conventional wisdom says that the Democrats will retain control of Congress and have a better than even chance of winning the White House. If the GOP can unite around an effective candidate, we could see the continuation of divided government, which has been the norm in all but eight years since 1980.
• A Democratic sweep of Congress and the White House would mean activist government, significant changes to the Bush tax cuts, and more protectionist trade and economic policies. Depending on the leaders of Congress and the President, a divided victory could result in a divisive stalemate on many issues, or bring about pragmatic deals in pursuit of incremental change.

On balance, the markets like incremental, predictable change and, therefore, would find divided government led by pragmatic dealmakers the safest outcome, albeit not necessarily likely as of today.

THE GOLDILOCKS ECONOMY: ANOTHER PLUS YEAR OR A RECESSION?

The answer to this question depends on your outlook about the effects of the housing slowdown and the fallout from the subprime mortgage mess. This is a problem that impacts Wall Street: Will it reach your street as well?

From March 1997 to February 2007, home prices in the 20 major metro markets increased at an annual rate of 10.9 percent. Between 1990 and 2007, the percentage of home ownership increased from 64 percent to 70 percent. That would explain why housing prices increased with equity-like returns than their normal pattern of tracking inflation

However, in the past year, new home sales have tumbled and inventories of homes for sale have increased from 7.1 months to 8.5 months. The S&P/Case-Shiller Index showed that housing prices declined 6.1 percent in the past year. Professor Shiller recently said that the momentum of price decline will continue at a faster rate in 2008. He has also predicted that housing prices have not bottomed yet and will remain depressed for several years.

All the issues associated with the current housing bubble and its perceived impact on the banking system is reflected in the increased TED spread, the difference between 3-month Treasury bills and 3-month LIBOR. For the first half of 2007, the spread ranged between 50 and 100 basis points, but in the second half the range has been wider and more volatile. The range has been between 100 and 200 basis points, exceeding 200 basis points in mid December. At year end the spread was 146 basis points and 129 basis points as of January 23rd.

Linear projections would indicate a recession in 2008, but people are still spending.

New car sales are continuing at an annual volume of 16.2 million, a decline from 16.6 million in January, but higher than 15.3 million in July, the end of the current model year for most carmakers. In November, existing home sales increased marginally, despite falling sales of new homes.

Initial results for spending in November/December are just short of the 2.5 percent year/year gain that had been projected, which is just modestly below 2.9 percent in the comparable period in 2006.

Despite declining consumer confidence in 2007, consumer spending continued to increase in real terms and helped to maintain growth. In December, after declining to a two-year low of 87.8 percent in November, the Consumer Confidence Index increased to 88.7 percent. The consensus expectation was for a decline to 86.5 percent.

While consumers are still spending, business spending has been slowing. The Purchasing Managers Index (PMI) has been below 50 for most of 2007. The December Index was 46.9 versus an average of 45.9 and a low of 39.9. Capacity Utilization was 81.5 percent, up slightly from the previous month and the low of 81.1 percent seen last January. The ISM Manufacturing Index for December was on the downside at 47.7, a sharp decline from 50.8 in November. The ISM has been declining for the last six months. However, the Business Barometer Index was

56.6 percent in December. This Index has been more robust in 2007, at more than 50 percent, than the PMI, which was below 50 percent. While spending has slowed, the Prices Paid Index expanded for the 71^st consecutive month.

Whether we have a recession in 2008 might depend on the strength of U.S. exports. Despite all the focus on housing in recent years, exports and business fixed investment have led both government and personal consumption expenditures since 2003. Furthermore, IT spending is expected to expand in the next few years. Finally, in a recent CNBC poll of money mangers, only 2 percent predicted a recession.

Exports have become a major engine for U.S. growth. Our trade deficit has been declining since 2005 despite higher energy costs. Also, keep in mind, the United States depends less on imported energy (35 percent of energy consumption) than Europe (56 percent), or Japan (80 percent). This fact bodes well for 2008, despite the obvious uncertainties in the Middle East and how that could impact the supply of oil.

The U.S. economy, because of lower trade barriers and fast economic growth in Asia, is very different than it was 25 years ago. Despite his obvious flaws as president, Nixon opened China and the rest is history. Hong Kong has been transformed over the last 35 years. As China and India take their rightful place as economic giants, the United States will provide the technology and innovation to support the expansion of basic goods, services, and infrastructure for these giants. In 2008, the weaker dollar will also be an important factor in continued economic growth.

We continue to hear more bad news from the combined housing and mortgage debacle. When it comes to real estate, experts often remind us of the old adage that real estate is about location, location, and location. Nevertheless, markets such as Florida, California, Arizona and Nevada will feel a good bit of the pain, but it will not be enough to reverse the U.S. economic engine in 2008. Growth may be slow and we may even see a negative quarter for growth, but recall that a recession is defined as a decline in the gross domestic product (GDP) for two or more consecutive quarters. The facts do not suggest that this should happen but the fear we have seen recently could make this a self fulfilling prophesy.

But there are two factors that cannot be ignored. There is an upcoming election and there is always the unexpected that can occur.

The upcoming election could be another watershed that marks a significant change in the current direction of the country that began in 1980. That year the voters opted for growth over fairness. Despite continued economic expansion, there is considerable concern about growing economic inequality. This we may call the equity issue versus the growth issue for the 2008 race. Both Governor Huckabee and Senator Edwards have made that a major theme in their respective campaigns. Nonetheless, we need investment to grow and innovate if we are to maintain our technical and innovative leadership that has been our hallmark for over 100 years. We may be lucky to find a middle ground that can provide for both equity and growth

WHAT DOES THIS MEAN FOR YOUR BANK?

The reality is that none of us is clairvoyant enough to see the unexpected. Thus, as chance may have it, any commentary is limited because “we see as through a glass darkly.” In the world of economic forecasting, we are just like Monday morning quarterbacks—it all becomes much clearer after the fact. The best we can do is to keep a clear mind and be flexible enough to respond to both the opportunities and risks.

• Speaker Tip O’Neill used to say that all politics were local. The same is true of economics. Depending on the local economy this may be an opportunity to build new relationships with customers seeking either residential mortgages or commercial loans. In his letter in a recent issue of Banking New York, the CEO of Cattaraugus County Bank observed, “Despite talk of a credit crunch, the truth is community banks are open for business.” You should be open for this new business and be ready to seek it.
• Many of the local companies in your community may be enjoying significant trade with China, India, Brazil, or another fast growing economy. Likewise a weaker dollar may mean that some of your local companies are well positioned to increase their export activities especially of capital goods needed to satisfy their growth. Now may be an excellent chance to become one of their lenders or provide the specialist skills needed to complete these transactions, such as trade finance or foreign exchange.
• The volatility of rates will probably not decrease. Be sure your ALM team employs an up to date model that is robust and exceeds regulatory requirements. Events in 2008 will probably justify the time and effort.
• While the yield curve has declined, the spreads have widened. This reflects both the credit concerns and increased volatility we noted previously. That means it may be hard to restructure your investment portfolio without taking some losses but it does mean there will be buying opportunities for new funds or assets that, may be undervalued. This will be especially true if you are also growing relatively low cost deposits.
• The municipal bond sector will need special diligence this year. Many bank qualified issues are insured. As we noted previously, some of these insurers have been downgraded or will be downgraded by the rating agencies. Do your homework. Research the insurer and understand the revenue capabilities of the municipal issuer.
• For those banks which have equity portfolios, stocks with lower betas and good yields will offer excellent potential especially if they have strong earnings and a record of regular dividend increases.

Joseph G. Blake, CFA, Financial Advisor
John S. Walker, CFA, Kutztown University/Ambassador Financial Group