Nobody knows for sure what will happen in the coming year, but the demand for predictions is so high that I will throw mine into the ring. Let's start with the economy. There will be no recession in '08. The economy will start the year slowly, with the gross domestic product growing less than 1% in the first quarter (after a similar increase in the last quarter of 2007). By the middle of the year, the economy should begin picking up steam; it should grow 2% to 3% in the second half.
By June, the subprime-mortgage disaster will ease. Although delinquencies will have risen, the foreclosure crisis will ebb as most lenders make deals with beleaguered mortgage holders. As the housing crisis eases, the flow of credit will return to more normal levels and lending will revive. However, home prices will keep falling or remain stagnant at best. Prices of real estate just got too high during the last boom, and down cycles for housing last much longer than they do for the stock market.
The slow economy will keep inflation under wraps, but energy prices are likely to stay high. Overall inflation will run 2% to 3% in 2008, and core inflation (that is, excluding certain volatile items, such as food and energy) will remain a bit more than 2%, the Federal Reserve's limit for "acceptable" price increases.
Interest rates and the dollar. Rate movements will closely follow the pattern of economic growth. The Fed is likely to lower short-term rates several more times in early 2008 and bring its key federal funds rate down to about 3.5% by midyear. But the pickup in economic activity by the second half of the year will cause the Fed to raise rates again. Notwithstanding what the Fed does, I don't believe we will see yields on ten-year Treasury notes below 3.5%, and these rates are likely to rise to well beyond 4% in the second half of 2008.
I also think that the dollar will reach its low sometime during the first quarter of 2008 and then start rising. The dollar is far below its "purchasing power parity" level (a measure of the greenback's buying power), which is a good guide to long-term exchange rates. A stronger economy and rising interest rates will also be good for the dollar.
Prospects for stocks. Shares should have a good year, returning 8% to 10%. Stocks will rise as economic growth picks up in the year's second half and head winds from the credit crisis ease. Earnings will take a hit in the first quarter of 2008, but profits will begin to recover by the second quarter. Stocks are reasonably valued, even when priced against poor earnings. Once earnings increase, stock returns will be considerably better.
Financial stocks, by far the worst-performing sector in 2007, could well be the best in 2008. Foreign stocks, which I have long recommended, will continue to do well. But if the dollar rises, foreign stocks won't benefit from currency gains and might lag U.S. stocks. As the U.S. economy slows, Chinese stocks will continue to cool -- plus, they're likely to suffer a hangover after the Beijing Olympics. Still, investors should maintain a diversified portfolio, with about 40% of their stocks allocated to foreign markets.
Political outlook. Of course, there's the presidential election in November. I predict that Hillary Clinton will take the Democratic nomination and Rudy Giuliani the Republican nod. How about Bill Richardson as Clinton's choice of running mate and John McCain as Giuliani's?
The race will be a dogfight. I say the Democrats will win the White House and retain control of the House and Senate. That will cause the market to flutter a bit, as investors fret about the heightened prospects for higher taxes. But strengthening U.S. and global economies will keep the market on track for still another winning year.
Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.