The economic outlook is good, and that's not so good for bonds.

Stocks and bonds in 2007 are likely to remain "uncoupled" or "de-coupled," to use two of the descriptors popular these days. Equities should rise in response to continued if not especially robust economic growth and the concomitant expansion of corporate earnings, albeit at a slower rate than in 2006. That same basic environment, however, should allow the Federal Reserve (Fed) to hold rates up at their present levels. Without the support of short-rate cuts, bonds have a less than inspired outlook; not especially negative, to be sure, but not especially promising either, offering little more return than the coupon.
This disparate stock-bond behavior may confuse those investors who earned their stripes during the last 20 to 25 years. From the 1980s to 2000, equities and bonds moved pretty much in tandem, not at all in the disparate way expected in 2007 and observed commonly during the past two or three years. It is natural enough to look for a return to the old pattern. But that pattern has broken, largely because the inflation situation has changed so drastically from the 1980s and 1990s. During the 20-year stretch from the early 1980s to the end of the century, the inflation situation improved on more or less a continual basis. The annual rate of inflation dropped from 13.2% in 1979 to 2.4% in 2000. With less and less need for bond yields to compensate investors for the effect of rising prices on the real value of nominal returns, bond yields could fall almost as consistently as inflation did. Ten-year Treasury yields, for instance, fell by more than 1,100 basis points from 16.0% in 1982 to a low of about 5.0% in late 2000, producing a tremendous, ongoing capital gain for bond investors. Equities rose, on balance, along with bond prices because falling bond yields allowed higher valuations and because a continued economic expansion boosted corporate earnings.
With that inflation adjustment complete, however, and little likelihood that inflation will fall any farther, such common movements for stocks and bonds are much less likely going forward. On the contrary, now the issues of economic growth and Fed policy dominate, and they will tend to push these markets in opposite directions. Because any sign of economic strength lessens the likelihood that the Fed might cut short-term interest rates, the expected growth in the economy in 2007 should prevent much further decline in bond yields. But the same expected growth that will tend to block capital gains on bonds should foster enough earnings growth to lift equity prices. True, the two markets are not quite expected to move in opposite directions, but neither are they forecast to move together.
Of course, if the economy were to falter, as some suggest it will, the markets would behave differently from these expectations. They would remain de-coupled, but their respective prospects would reverse. In the unlikely event that the economy does falter, the Fed would almost certainly cut short-term interest rates, an action that would promote a decline in bond yields and, of course, a rise in bond prices. The relief from lower interest rates might help the stock market, but probably not enough to counteract its poor reaction to the deteriorating earnings that would almost surely accompany such economic weakness. But while such a situation is possible, it is, nonetheless, far from probable.
For one, the main source of weakness in this economy, the housing adjustment, looks contained. To be sure, housing is already in decline and the economy has already suffered a significant drop in construction activity. Still, even in the face of such a substantial downward adjustment, the pace of decline by late 2006 was already beginning to moderate. And with both short- and long-term interest rates now stable, including mortgage rates, that market looks likely to avoid any additional pressure. Housing will continue its downward adjustment, probably through the end of the year. It will tend to slow the pace of economic growth. But the intensity of the housing cutbacks surely will continue to moderate. On that basis, the housing situation seems incapable of precipitating a general economic decline all by itself.
Meanwhile, continued employment growth and annual wage gains averaging 4% to 4.5% should sustain enough growth in household income to promote at least a moderate advance in consumer spending through 2007. Consumer spending may not lead the economy forward, as it has during the past two to three years, but the additional spending allowed by this income growth will nonetheless do much to counteract the adverse effects of the housing adjustment. At the same time, the corporate sector has so much surplus cash that capital spending should grow at nearly double-digit rates, truly an engine of growth.
With this balance of forces generating at least an adequate economic expansion in 2007, if not an especially robust one, it is highly unlikely that the Fed will cut rates, as some forecasters seem to believe, especially those enthusiastic about bonds. Many, who look for a reversal by the Fed, expect policy makers to respond to a mere slowdown in the pace of the real economic expansion. Such reasoning ignores the Fed's only two objectives: inflation and unemployment. It is on these fronts that Congress questions the Fed chairman. His and the Fed's reputation rest almost entirely on success in keeping unemployment low and keeping inflation contained. As long as unemployment remains as low as the 4.5% of the workforce last recorded, Fed policy makers should feel absolutely no pressure to cut rates. Indeed, they will doubtless feel little pressure to cut rates if and until unemployment rises above 5% of the workforce, hardly likely in a growing economy.
On the other side of the ledger, there is inflation. If inflation were to pick up significantly, then both the stock market and the bond market would again move in tandem, as they did in the 1980s and 1990s. Except in such an event, the common movement would go in reverse from the patterns of those last 20 years of the century. Intensified inflationary pressures would drive down bond prices and raise yields, perhaps more than proportionately. The rise in bond yields would probably be enough to depress equity prices, even in a continued economic expansion.
But, as with the risk of a faltering economy, this inflationary prospect, though a risk worthy of consideration, is not especially likely. To be sure, the low unemployment rate and its implication of a tight labor market have raised understandable fears about rising wage gains and a kind of cost-push impetus to inflation. But against that prospect stand three other critical considerations. One, crude oil prices have dropped, falling some 30% during the past six months. Though oil has remained somewhat isolated within the inflation picture, this price drop can only auger well for the general inflation outlook. Second, inexpensive imports, largely from Asia, should keep a lid on pricing leverage in the United States. Even in the face of rising wages, this import pressure should prevent business from fully passing on cost increases. Third, even the prospect of import price hikes from a decline in the foreign exchange value of the dollar is limited. The Chinese have proved that they will prevent much dollar decline against their currency, the yuan, and that fact will limit how far the dollar can fall against other currencies. Besides, China and the rest of Asia are the primary source of most of the inexpensive imports.
Clearly, there are risks on either side of the economic and financial likelihoods. Concern about a softening economy and inflation have adherents in the forecasting community. But there is a huge difference between risks and probabilities. The probabilities, in fact, favor continued economic growth, albeit slowed from 2006, and a still-contained inflation environment. In such a context, the Fed should hold the line on rates that it established in mid-2006, keeping short-term interest rates steady and fostering an environment in which bond yields (and prices) remain in a fairly tight trading range. With that rate and yield backdrop and enough economic growth to support a continued rise in corporate earnings, equities can stay de-coupled from bonds and make additional gains.

Milton Ezrati is a partner and the senior economic strategist at Lord Abbett. He is also an affiliate of the Center on Economic Growth at SUNY, Buffalo, a 30-year Wall Street veteran, a contributor to On Wall Street, and an expert on global and domestic financial issues. From 2000-2001 he was a guest commentator on CNBC's Morning Call, and is currently a host of "Open Exchange" on Bloomberg TV.