In the "old days," economists and policymakers believed the U.S. economy could sustain a long-term growth rate of 2.5 percent per year. After revisions to the national income and product accounts in 1999 (when the Commerce Department began to incorporate software expenditures as investment) history was re-written and new beliefs came to the forefront. Now the conventional wisdom holds that real (inflation-adjusted) GDP can grow between 3 and 3.5 percent a year without generating inflationary pressures.

The government won't have complete data for 2000 GDP until March 2001. With three quarters of the year in, economists are expecting to see real GDP growth in excess of 5 percent. This would mean that from 1995 to 2000 real GDP expanded at an annual average of 4.6 percent - more than one percentage point faster than the accepted, sustainable long-term limit. This is exactly what has placed Fed officials in a high state of alert for the past two years. NABE economists are predicting that real GDP will slow to a 3.4 percent rate in 2001. This appears downright anemic after the past few years, but is in fact healthy. Interestingly enough, even though some analysts are starting to predict an economic downturn, NABE economists have actually revised their 2001 forecasts higher since the beginning of the year.

Though not as robust as the past few years, this rate of growth will still generate positive corporate profits on the whole. Given the sharp drop in equity markets in 2000, the upward trend in profits could mean that equity values may actually increase in 2001 as investors grow accustomed to the smaller magnitude of profits. Incidentally, the NABE forecast panel does not make stock market predictions.

It all begins with the consumer
Consumer spending accounts for two-thirds of economic growth in the United States. Consequently, GDP growth depends a great deal on the consumer sector. Spending in 2000 is estimated to come in at the same pace as the previous year, with the bulk of the gain taking place in the first half of the year. Economists are now predicting that consumer spending is geared to moderate to a more sustainable pace in 2001.

Motor vehicle sales grew steadily through the late 1990s and surged to an unprecedented height in 2000 even as sales began to fall off toward the end of the year. Automakers have already trimmed production schedules and laid off workers. The NABE forecast panel is predicting a moderate 5.2 percent drop in 2001 to 16.5 million units from 2000's expected record of 17.4 million units. But it wouldn't be surprising to see an even larger drop-off in sales considering how high they have been over the past several years. The consumer wealth effect, which has boosted demand, went into reverse through most of 2000, and consumers may not have come to terms with this yet. Faced with all-time low savings rates and all-time high debt, consumers may finally realize that buying a new car every year is not financially prudent.

Housing market moderates
After reaching their highest level in 13 years in 1999, housing starts decreased in 2000. Despite the decline, this was a decent year for the housing market. Sales of new homes will decrease less than 1 percent during the year even though starts declined nearly 5 percent. However, sales of existing homes fell 4 percent in 2000. Look for a broader decline in 2001 with housing starts predicted to drop 6.3 percent. Declines in the housing market will seep through to spending on furniture and appliances. This will hamper total retail sales in 2001, particularly for consumer durable goods.

Investment demand is anticipated to moderate
Business fixed investment (which includes spending on producers' durable equipment & software and nonresidential structures) expanded 10.3 percent per year between 1995 and 1999. After moderating somewhat in 1999, growth accelerated sharply in 2000 despite the fact (or because of the fact) that the Y2K bug scare was over. The composition of capital spending shifted away from equipment and toward structures in 2000. Economists are predicting a moderation in investment spending in 2001 to show a respectable 8.6 percent gain. To some extent, the slower spending on fixed investment will stem from slower growth in after-tax corporate profits. The NABE panel predicts that profits will increase 5.0 percent in 2001 - about two-thirds the pace reported for 2000.This is certainly better than the 1998 showing when profits actually declined. Profit growth was healthier from 1995 to 1997.

Foreign sector red ink deepens
Net exports are nearly always a drag on GDP since the United States tends to import more than it exports. In terms of GDP growth, it matters whether they are a bigger or smaller drag. In recent years, the biggest deterioration in real net exports came in 1998 and 1999. The net export deficit for 2000 widened less sharply since export growth accelerated dramatically. Exports and imports are predicted to increase by roughly the same percentage in 2001. Since imports are larger than exports in total magnitude, the same percentage change still means that imports will increase more than exports next year. In any case, if this forecast is realized, it means a smaller drag on GDP growth coming from the foreign sector in 2001 relative to the two previous years.

Jobless rate and inflation uptick?
The civilian unemployment rate averaged 4.0 percent in 2000 - the lowest level in 31 years. It was the fifth straight year in which the jobless rate fell below the once magic level of 5.5 percent, that is, the level of unemployment previously associated with "full employment." In the old days - prior to the "new economy" paradigm -- economists and policymakers believed that inflationary pressures would come into full force when the unemployment rate reached 5.5 percent. While wages undoubtedly accelerated in 1995 and 1996 when the jobless rate decreased, wage increases were matched by productivity gains. When productivity rises, wage gains are not inflationary and are generally not passed on to consumers in the form of higher prices for goods and services. Productivity is expected to increase 2.8 percent in 2001, slower than the 4.3 percent hike to be recorded in 2000. If wage gains don't moderate in tandem with productivity, inflationary pressures may develop. But economists are now predicting that the jobless rate could tick up a notch to 4.2 percent in 2001 as slower economic activity reduces the demand for labor. This might help quell wage demands.

Inflation was at its lowest rate in 1998 measured by both the consumer price index and the GDP price deflator. A surge in oil prices boosted both measures in 1999 and 2000. The GDP price index measures changes in the composition of output as well as changes in price. It isn't a fixed basket of goods like the CPI. As a result, it reflects the attempt by consumers and businesses to shift to lower priced goods, and in turn measures a lower inflation rate than the more widely quoted consumer price index. It also means that inflationary pressures take longer to develop with the GDP deflator than the CPI. Economists are predicting downward momentum in the CPI but a slight uptick in the GDP deflator for 2001.

Interest rates: up, down or sideways?
Interest rates rose in the past two years but aren't predicted to change significantly in 2001. The Fed raised its federal funds rate target three times in 2000 -- twice by 25 basis points and the last time by 50 basis points. This pushed the federal funds rate to 6.50 percent by mid-year where it stayed through year-end. Economists are now predicting that the Fed will lower its target rate in 2001 as slower economic growth coupled with sharply depreciated stock prices cause recession concerns. At the same time, the NABE forecast panel expects the average level of short and long term interest rates to be roughly unchanged next year.

THE BOTTOM LINE
Economic growth, inflation and interest rates are variables that will no doubt impact the investments in your portfolio. If this panel's forecast pan out, it will mean slower economic activity and slower profit growth for 2001. Slower profit growth could dampen equity prices. However, negative earnings warnings brutalized the major stock indices in the final quarter of 2000 - particularly the NASDAQ composite index. This may allow some wiggle room in the upside going forward, especially should positive earnings surprises pop up.

Falling interest rates are generally bullish for the equity market. First, the underlying value of a company's income stream is increased at lower interest rates, as interest income becomes a weaker substitute for profits. Further, lower interest costs reduce the expenses paid by companies - boosting profits. Despite the NABE forecast for flat rates, current market expectations of a Fed easing early in 2001 (confirmed by Fed chairman Alan Greenspan himself in a recent speech) should set the stage for at least marginally lower rates next year.

What are the risks going forward? The Economic Advisory Committee for the Bond Market Association believes there is only a 25 percent chance of a recession in the next 12 months. However, they do up the odds for the next 24 months to 30 to 50 percent.

The baby and the bath water ...
This doesn't mean that opportunities for profitable investments will be nil in 2000. Indeed, the shifting composition of economic output will lead to market rotation of industries, which are in or out of favor. The economic outlook can set the framework for finding new investment opportunities. However, it is important to remember that well-managed companies often march to the tune of their own drummer - particularly if they are gaining market share in a profitable manner. So don't unload profitable companies even if they are part of an industry undergoing cyclical change.