The market responded positively to the Federal Reserve’s decision not to raise short-term interest rates at their August 8th meeting. The Dow Jones Industrials (+1.7%), Standard & Poor’s 500 (+2.4%) and Nasdaq Composite (+4.4%) all finished the month with solid gains. Technology led sector performance posting a gain of 8.3%. Energy was the worst performing sector with a loss of 4%.

The question is no longer whether economic growth will slow, but whether we will have a soft landing, with real GDP growth slowing to 2-3%, or a recession. Housing and consumer spending will continue to be drags on growth. The housing market is clearly headed for a hard landing, just as bank regulators begin to implement much stricter lending standards. Home inventories are up 50% in the past year, and existing home prices are likely to see an annual decline after an August report showed median home prices rose just 1% year-over-year. The weakness in housing is likely to have a much greater impact on consumer spending, as a result of the unprecedented amount of mortgage equity withdrawal that will inevitably dry up in the months ahead. The personal savings rate has been negative for the past 16 months, which means consumers continue to borrow to finance their spending. Consumer confidence hitting a nine-month low and weak sales reports from companies like McDonalds and Starbucks are early indications that consumer spending is weakening.

The direction of long-term interest rates is critical to the soft landing scenario. The yield on the 10-year treasury has fallen from 5.25% in June to 4.78%, reflecting slower economic growth and moderating inflation expectations. Assuming the Federal Reserve has concluded its tightening campaign, lower long-term interest rates will help support the housing market and ease the debt burden on consumers. It may even ignite a new round of mortgage refinancing. Some might suggest rates are too close to historical lows to decline further, but U.S. yields are currently the highest among the G7 nations. We think rates may approach 4-4.5% as economic growth slows.

Declining long-term interest rates reflect positively on the outlook for inflation. Labor costs are a critical component of the core inflation number that the Fed watches closely to determine monetary policy. While wage gains have accelerated recently, the employment cost index (which accounts for benefits) is up only 3% in the past year and remains in a declining trend. Corporations are intent on limiting wage increases and cutting benefits in order to maintain profit margins, as higher energy costs impact the bottom line. Employment gains have also been in a declining trend over the past 12 months, with fewer than 125,000 new jobs added to the economy in each of the past four months.

The lid on labor costs has been one reason corporate earnings have remained strong. S&P 500 earnings were up 16% in the second quarter. While earnings growth rates will likely slow in the second half of the year, declining interest rates and lower inflation will allow stock price multiples to expand.

We don’t think a recession is in the cards, because past recessions have seen the economy slow, with inflation continuing to rise, and the Fed continuing to raise interest rates. The Fed is not contending with rising labor costs. Corporate profits remain strong and balance sheets are flush with cash. Bond yields are declining, but the yield curve is only mildly inverted. Strong economic growth in China and India is helping to offset slower domestic growth. As a result of our economy becoming more service-oriented, and therefore less sensitive to the business cycle, the recent slowdowns and recessions have become milder, which bodes well for the current mid-cycle slowdown.

Our view is that the economy will continue to slow, the Federal Reserve will stop raising interest rates, and the market will climb a wall of worry as core inflation fears wane, long-term interest rates decline, and stock prices play catch-up with the rise in earnings over the past three years.

Our primary concern is the price of oil. We think the recent decline in oil prices below $70/barrel is temporary. With oil approaching $80/barrel in July and August, there was no decline in global demand growth and capacity issues are still a major concern. Analysts’ consensus estimates are for oil prices to decline to $63/barrel in 2007 and $57 for 2008. We think a more likely scenario is that oil prices will approach $100/barrel over the next one to two years. For this reason, we continue to maintain an overweight in the energy sector.

We remain fully invested in our model equity asset allocation with an emphasis on large-cap stocks. We continue to believe that as the economy slows, large-cap stocks will outperform small- and mid-cap stocks. We also believe that developed markets will outperform developing markets as the global economy slows. In our large-cap equity portfolio, we recently increased our weighting in the financial sector and reduced our weighting in the materials sector, to better position ourselves for slower economic growth.

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