As a result of Hurricane Katrina, Highland Global, LLC examined the economic situation and the economic outlook for the coming quarters.  Highland Global believes that it is appropriate to reassess our economic projections that were originally included as part of our State of the Economy 2^nd Quarter 2005 released in early August.  We believe that Hurricane Katrina is likely to have a significant adverse impact upon economic activity in the months ahead.  In our previous State of the Economy commentary, we stated the following:

It is likely that the current elevated level of energy prices will result in some softness in economic activity in the second half of 2005 and into 2006.  Continued demand growth from China and concerns over inadequate refining capacity are likely to result in continued elevated oil prices for the immediate future.  Furthermore, speculative activity in the oil markets may be contributing an additional premium to the current elevated price of oil.  Any exogenous shocks in the oil markets resulting in short-term price spikes could have a significant adverse impact upon global economic growth and U.S. economic activity.  Based on other information, it appears that many businesses have begun to accept higher energy prices and have begun to pass on a portion of the added costs associated with higher energy prices to consumers.  Therefore, the risks to economic activity stemming from higher energy prices appear to be weighted towards conditions that may perpetuate further economic softness in the coming quarters.

          As a result of Hurricane Katrina in the Gulf of Mexico, the United States’ oil production has slowed considerably.  Nine refineries have been shut down, with three of these flooded, while an additional four refineries have reduced output due to the storm.  These closed refineries, listed in the table below, account for roughly 12% of U.S. refining capacity.

          As a result, oil prices remained above $70 per barrel and gasoline prices jumped significantly to over $3 per gallon in many areas of the U.S.  The supply disruptions at the above refineries may create gasoline supply shortages reminiscent of those which occurred as a result of the 1973-74 Arab oil embargo.  President Bush and many state government officials have already begun urging consumers to conserve their fuel use, by driving only when needed.  The supply disruption stemming from closure of several refineries along the Gulf Coast as well as from the shutdown of oil production on many rigs in the Gulf of Mexico is likely to have a significant adverse impact upon the economy.

          Following the Arab oil embargo in 1973-74, oil prices (WTI crude) jumped from $4.31 per barrel in late 1973 to $10.11 in early 1974.  The consumer price index, which increased by 8.94% in 1973, increased at a much more rapid rate of 12.1% in 1974 as a result of the attending rise in oil prices.  Real GDP, which had grown by 5.8% in 1973, contracted by 0.5% in 1974 and by 0.2% in 1975.  Oil prices continued to surge higher throughout the decade, spiking again as a result of the Iranian revolution in 1979 and Iraq’s invasion of Iran in 1980 (sometimes referred to as the second Arab oil embargo).  As such, economic growth retrenched during 1980 by 0.2%.

          It seems that there is a clear and direct relationship between energy supply disruptions and economic growth and inflation.  Following the Arab oil embargo of the early 1970s and the second energy crisis in 1979-80, the economy experienced periods of high inflation and declines in real GDP.  We believe that this current energy supply disruption in an environment of already tight refining capacity, will likely presage a period of sub-par economic growth in the coming quarters.

In addition, in recent days the Treasury yield curve has started to invert, with long-term rates threatening to move lower than short-term rates, which financial history shows precedes a pending recession.  As of August 31, 2005, the 10-year Treasury yielded 4.02% with the 2-year yielding 3.84%.

Though we do not believe that the preponderance of evidence points to a recession, we feel that economic growth will be severely negatively impacted by the oil supply disruptions in the U.S. and that the probability of the economy slipping into recession is low.  However, we believe there is a moderate possibility that the U.S. economy may exhibit a period of stagflation—low growth and high inflation.

Economic Outlook 2005

Based on the current assessment of a number of economic factors, some of which have changed significantly over the last few days, the previously solid foundation for continued economic growth may be threatened by the adverse systemic impact of a spike in energy prices stemming from supply disruptions due to Hurricane Katrina.  The energy supply disruption and the accompanying high gasoline prices may have an adverse impact upon consumer confidence and consumer spending—the latter of which has been an underlying cause of the economic growth over the last two years.  A retrenchment in consumer spending is likely to precipitate slower economic growth and may prompt a decline in the robust housing market.  A collapse of the real estate market would also precipitate further weak economic activity.  These factors, combined, could have a severe toll on economic activity in the coming quarters.  These factors suggest that the risks to the economy are weighted heavily towards weaker economic activity in the coming quarters.

Our revised expectations for the economy include:

• Real GDP growth of 2 ½% – 3% for 2005.

• The Federal Reserve may be forced to suspend its removal of monetary policy accommodation.  Should economic conditions deteriorate, the Federal Reserve may have a dilemma regarding monetary policy.  Weaker economic growth would suggest a cut in interest rates.  However, rising inflation would suggest a rise in interest rates.  We believe that the Federal Reserve would rather contain inflation, even if that were to mean a lower growth in real GDP.  Therefore, we feel that the target federal funds rate will still be roughly 4% for 2005 and may increase in 2006 to 4 ½% – 5%.

• Inflation is likely to increase in 2005 with the core CPI increasing by roughly 2% – 2 ¼%.  The core CPI is likely to increase by 2% – 2 ½% in 2006.

• Continued geopolitical concerns, along with concerns over demand and supply imbalances and tight refining capacity, may result in continued elevated oil prices.  OPEC may increase production during the second half of the year in order to address any potential supply shortages in the fourth quarter.  Saudi Arabia has agreed to increase production to cover supply shortages stemming from the disruptions in the Gulf.  However, it is unlikely that these increases will have a material impact on lowering the price of oil due to refining capacity shortages.  Given recent developments, oil prices (WTI) are likely to average $60-$65 per barrel for the coming months following a potential price spike to in excess of $80 per barrel.  Oil prices are likely to remain at elevated levels throughout the first half of 2006 as well and may rise to as high as $80 per barrel.

There are a number of risks to the economy in 2005 and 2006, which could have significant adverse impacts upon economic performance during the year.

• Continued geopolitical risks and tensions regarding instability and security in the Middle East may create uncertainty that could suppress demand in the global economy and help fuel a premium in oil prices.  Escalating tensions over North Korea and Iran’s nuclear programs could also have an adverse impact upon economic activity and oil prices.

• Continued elevated oil prices may have an adverse impact upon global economic growth and economic activity in the U.S. and lead to unwelcome inflationary pressures throughout the broader economy.  This could ultimately prompt some retrenchment in consumer spending, which would contribute to further soft economic performance.

• Further increases in interest rates by the FOMC may temper any gains in the equity markets and may temper the robust activity in the real estate markets.  The adverse systemic impact stemming from a bursting of the bubble in some real estate markets could dampen economic growth significantly.

• An unwelcome rise in core inflation could dampen consumer confidence and business executives’ confidence, prompting a slowdown in economic activity, which could be further aggravated by a potentially more aggressive tightening of monetary policy by the Federal Reserve in response.

Conclusion

          With oil and gasoline prices remaining at elevated levels due to supply disruptions in the Gulf of Mexico and refinery closures due to Hurricane Katrina, economic growth is likely to be compromised.  Based on the state of the economy in the second quarter and recent developments in the aftermath of the hurricane, conditions are likely to foster softness in the economy for the remainder of 2005 and into 2006.