Economic Outlook:Navigating the Recovery

Chris Low

Chief Economist

March 2010

22

The Big Themes

• Waves of crisis subsiding, but still an issue (Greece).• Washington’s challenges to investors.• Timing the most important economic signals. • Staying a step ahead of the Fed.

33

2010 Political Calendar (The Plan)

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Healthcare No bill in Jan.

WH wants

Budget FY 2011

Taxes Debate

Financial Reform

House Senate

1st time HB tax credit End

Campaign Limited agenda

Election 11/02

44

2010 Political Calendar (The Reality)

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Healthcare White House stretched health reform debate into the spring.

Budget Delayed until healthcare debate ends.Taxes

Financial Reform

Senate? Reconciliation?

1st time HB tax credit End

Campaign Limited agenda

Election 11/02

55

2010 Fed Calendar (highlights)

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

FOMC mtg 1/27 3/16 4/28 6/23 8/10 9/21 11/03 12/14

End most liq progs

2/28

End mtge purchases

3/31

End “extended period”

6/23

FF rate to 0.25%

8/10

Rate hikes ?

Earliest likely date.

66

GDP is growing again

Recession

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

2000 2002 2004 2006 2008 2010

GDP

Forecast

77

Thanks to stimulus

10%

13%

15%

18%

20%

23%

25%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Federal outlays as a% of GDP

88

But stimulus is But stimulus is not forever, andnot forever, and sustainablesustainablerecoveryrecoverydepends on thedepends on theprivate sectorprivate sector

99

Deep recessions have V-shaped jobs recoveries(as long as GDP recovers, of course…)

94

96

98

100

102

104

106

108

110

112

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

1981-82

1990-91

2001

2008-09

93

94

95

96

97

98

99

100

101

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

1981-82

1990-91

2001

2008-09

GDP = 100 at cycle peak Jobs = 100 at cycle peak

1010

Still Waiting for Employment Turn…

-1,000k

-800k

-600k

-400k

-200k

0k

200k

400k

2007 2008 2009 2010

1111

…but the emp. diffusion index is stronger than 2-years after the 2001 recession…

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

1.35

11.35

21.35

31.35

41.35

51.35

61.35

71.35

RecessionDiffusion index

1212

…manufacturing payrolls are growing…

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-300.00

-250.00

-200.00

-150.00

-100.00

-50.00

0.00

50.00

RecessionDiffusion index

1313

…and the Workweek is rising

32.5

32.7

32.9

33.1

33.3

33.5

33.7

33.9

34.1

34.3

34.5

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Average Workweek

1414

Key Sectors

Consumers

1515

Step 1: Savings rate Rose to 4.3%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%RecessionSaving rate (4 qtr avg)

1616

Step 2: borrowing transitions to saving

2000 2003 2006 2009

-$500bn

-$250bn

$0bn

$250bn

$500bn

$750bn

$1,000bn

$1,250bn

$1,500bnRecessionChange, household debt, SAAR

1717

Step 3: spending falls below trend, but is growing again

2000 2002 2004 2006 2008 2010

$7,000bn

$7,500bn

$8,000bn

$8,500bn

$9,000bn

$9,500bnRecession

Real consumption

Housing-boom era above-trend growthhas given way to below-trend growth now.

1818

Key Sectors

Business

1919

Step 1: Inventories were overbuilt,then worked off

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

1.35

1.40

1.45

1.50

1.55

1.60

1.65

Recession

Retail I/S ratio

2020

Step 2: Orders tanked, then recovered

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

20.0

30.0

40.0

50.0

60.0

70.0

80.0RecessionISM mfg ordersNon-mfg orders

2121

Step 3: Inventory cycle shifts into up phase

Recession-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

2000 2002 2004 2006 2008 2010

Inventory contrib. to GDPForecast

2222

Key Sectors

Housing

2323

Step 1: Sales bottom in Feb 2009

4.0m

4.5m

5.0m

5.5m

6.0m

6.5m

7.0m

7.5m

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Existing home sales

2424

Step 2: Inventories peak in July 2009

1.5m

2.0m

2.5m

3.0m

3.5m

4.0m

4.5m

5.0m

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Existing home inventories

2525

Step 3: Prices should bottom this spring

$100k

$120k

$140k

$160k

$180k

$200k

$220k

$240k

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Median existing home price

12-mo average

2626

Housing Pitfalls• End of Fed mortgage purchases. • End of 1st time homebuyer tax credit version 2.0.• Looming foreclosures.

Reasons for Housing Optimism

• 1st time homebuyer tax credit version 3.0 will follow if sales falter in an election year.

• GSEs renting homes to foreclosed families, which will keep foreclosed homes off the market.

Housing doesn’t matter like it did in the boom, because no one subsidizes spending with home equity debt anymore.

Reason not to worry

2727

Keys to inflation

2828

Market expectations for CPI inflation

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

2010 2011 2012 2013 2014 2015 2016 2017 2018

Big jump next year.

2929

Cyclical components are deeply deflationary

3%

5%

7%

9%

11%

13%

15%

17%

19%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%RecessionsCPIAugmented Unemployment Rate

3030

The dollar will drive inflation when unemployment is low again

90

95

100

105

110

115

120

2006 2007 2008 2009 2010

250

300

350

400

450

500

550

600

Broad trade weighted dollar, left

CRB raw indust. index, right

3131

The $ view is not all badThe bear case for the dollar:

• The 2nd lowest short-term interest rates in the industrialized world.

• The deficit is huge and Congress is threatening the autonomy of the Fed.

•The Treasury’s strong dollar policy is all talk.

The bull case for the dollar:

• Europe and the UK face a tougher banking cleanup than we do.

• The dollar appears to be correctly valued from a balance-of-trade perspective, even with China.

• Debt-to-GDP % US = 84.9% (IMF), right in the middle of the G-7 pack.

The Balance:

Dollar is already strengthening as it becomes clear US will raise rates before Europe, the UK or the BoJ.

3232

-$2tn$0tn$2tn$4tn$6tn$8tn

$10tn$12tn$14tn$16tn$18tn

Peak housing Now Healthy again

Home equityMortgage Debt

Assumes there are mortgages on 70% of the housing stock.

Risks: It could take years for household delevering to end

3333

Risks: State Budgets are Busted

Pew center for the states: http://downloads.pewcenteronthestates.org/BeyondCalifornia.pdf

3434

Change in State & Local Payrolls (2-mo avg)

-80k

-60k

-40k

-20k

0k

20k

40k

60k

80k

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

3535

Risks: Washington

• New taxes will be part of FY 2011 budget• Cap and trade (or EPA carbon restrictions) • Healthcare reform will cost more than benefit in first years• Finance reform (increased regulation = less credit)

3636

Fed can wait for clear falling unemployment rate before tightening

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%RecessionUnemployment rateFed funds target19 months

13 months

3737

10-yr TIPS yields in 100bp range for 2 years10-yr UST should stay below 4.5% as long as inflation is low

3838

Inflation outlook

In the short and medium term, inflation will trend downward due to lack of pricing power and pursuit/protection of market share. Longer-term (beyond the next three years) the dollar will move into the driver’s seat. By then, we expect the Fed will be tightening and therefore the dollar will have stabilized.

Growth outlook

After a quarter or two of robust, stimulus-fueled growth, GDP will settle onto a slowly rising path. The result is likely to be reminiscent of the early 1990s:

• below trend GDP growth• lingering fear of a double dip• slower than usual drop in unemployment rate• little private-sector debt growth

3939

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