One of the primary engines for recent U.S. economic growth has been the housing sector. Housing has fueled consumer spending through cash-out refinancing, home-equity loans and job growth in real estate related sectors.

Some of the housing growth can be attributed to demographic-driven demand. However, the real fuel heating the sector is the resiliently low mortgage rate. Low rates make monthly payments more affordable and inflate home prices. Consumers have been accessing their newfound wealth through cash-out refinancing and home-equity loans. Consumers are spending that money on goods from overseas and energy imports.

Consumer spending on foreign goods and energy imports has kept the U.S. economy on track. Fearing economic overheating, the Federal Reserve has begun taking away the lighter fluid long ago. The Fed short-term rate increases have been to no avail. Demand for U.S. bonds from overseas kept bond prices high and their yield low. While the Fed was putting the lighter fluid away, our trading partners poured it right back onto the fire.

Why such demand? Overseas suppliers exporting goods to the U.S. looked for a safe place to invest their profits. U.S. rates are still relatively higher and therefore more attractive than other safe alternatives such as European or Japanese bonds. As a result, overseas profits were recycled right back into the U.S. economy.

The relative attractiveness of U.S. Treasuries may begin to fade as other major central banks - such as the European Central Bank (ECB) and the Bank of Japan (BOJ) - are beginning to tighten their monetary policy in order to keep the lighter fluid away from the flames. Lower relative demand for U.S. bonds would result in higher rates. Higher rates result in higher monthly payments for homes and less money for the U.S. consumer to spend.

It has long been argued that as U.S. consumer spending slows down, corporations flush with cash will be ready to pick up the slack. Indeed, U.S. corporate profits are at record levels.

So far, corporations have used the cash to repay debt and buy back stock shares. But they, in general, did not reinvest for future growth. Capital expenditures have lagged behind. Corporate balance sheets remain to be very healthy.

As the lion's share of corporate profits came from overseas operations, we believe the bulk of capital investments are likely to be made in the same place from which the profits came: overseas.

Alternatively, companies with loads of cash and no prospects make for very attractive acquisition targets. It is no coincidence we are witnessing a resurgence of 1980s-style leveraged buyouts.

We do not believe domestic corporate investing will be sufficient to replace consumer spending as a driver of economic growth. However, a new wave of mergers and acquisitions may provide the needed catalyst for a multiple expansion in the equity markets; so we remain optimistic.

As an investor, what does this mean for my portfolio? Traditionally, when economic momentum slows, the more defensive sectors of the economy tend to benefit. We therefore began to favor larger companies over small consumer staples, and healthcare and financials over cyclical high-growth areas.

Conclusion