Energy prices, financial markets to challenge economy in '08

While Citi Investment Research expects growth to remain positive, the fourth quarter of 2007 and first quarter of 2008 figures could approach zero, as the economy deals with higher energy prices and a new round of financial market restraint. Revisions pushed third quarter Gross Domestic Products higher - to 4.9 percent - to some extent borrowing from fourth quarter growth, which could slip to between 1Ú2 percent to 1 percent.

We see real GDP rising approximately 1.5 percent, 2.5 percent, 2.75 percent and 3 percent respectively, during the four quarters of 2008. This brings average annual economic growth to 2.2 percent this year, 2.3 percent next year and 2.9 percent in 2009.

Achieving these growth numbers will likely require a more aggressive Fed response than we had previously forecast.

Keeping in mind that the "neutral" Fed funds target rate tends to fall along with slowing aggregate demand and lower core inflation; renewed financial market restraint - the degree of which we previously had not anticipated - will have to be countered by a progressively lower level for the nominal funds rate.

This should provide the Federal Reserve with the scope to engineer a more aggressive lower short-term rate structure into the second quarter of next year than we had previously forecast.

Our outlook now calls for a 3.5 percent funds rate target to be reached by mid-year 2008, but the target could be cut more than that. Short-term rates should hold this level into 2009.

The equity market staged a powerful rally ahead of the Fed meeting on Oct. 31, however, investor optimism quickly disappeared in the weeks following the 25 basis point cut, as threats to economic growth and corporate profitability returned to the forefront.The S&P 500 fell more than 9 percent of the next 17 trading sessions.

To us, the market's chief issue at present is the lack of concrete information about the breadth and magnitude of credit and derivative losses at major banks.

In recent months, markets have reacted powerfully to small pieces of incremental data, both positive and negative. We expect this ebb and flow to continue as many of the questions facing the market have relatively "long tails" and will take time to resolve.

Going forward, Citigroup Chief U.S. Strategist Tobias Levkovich maintains overweight recommendations in semiconductor, software, retailing and media, along with diversified financial stocks.

He is currently underweighting the food, beverage and tobacco, household products, capital goods, utilities, materials and real estate sectors. He favors growth over value due to a range of factors, including the potential for corporate operating margin compression, attractive valuation and sector performance trends.

However, there are concerns about the direction of corporate profit margins and a potential increase in protectionist rhetoric that could pressure equity markets in the second-half of 2008 into 2009.

Mid-year 2008 targets for the S&P 500 and Dow Jones Industrial Average are 1,725 and 15,500, respectively, dropping to 1,675 and 15,100 by the end of 2008.

For more information, e-mail william.a.creekbaum@smithbarney.com or call 689-8700.

Smith Barney does not provide tax and/or legal advice. Please consult your tax and/or legal advisors for such advice.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.