NAPM - Orange County

Policy Choices Are Key to the

Recovery’s Strength

Scott F. Grannis
March 18, 2010

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 NAPM - Orange County
The thinking one year ago:

• The economy was entering a deep depression and deflation

• Massive bankruptcies and collapsing asset prices would cripple
the economy for years
• Obama’s policy proposals amounted to a “declaration of war on
investors, entrepreneurs, small businesses, large corporations,
and private-equity and venture-capital funds.” -Larry Kudlow,
2/27/09
• Obama’s agenda called for an unprecedented peacetime
expansion of government spending, regulation, and tax burdens.

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 NAPM - Orange County
The thinking today:

• The economy is stuck in a “new normal” mode with growth of

only 2-3%
• Significant economic slack and weak growth will keep inflation
very low
• The Fed will not raise rates until late this year or next year
• The major risks are weaker growth and deflation
• Asset markets are at risk if fiscal and monetary stimulus are
withdrawn

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 NAPM - Orange County
Friedman’s “Plucking Model” of growth says U.S. could
grow over 6% per year for the next 4 years
16
U.S. Real GDP
10
3.1% p.a. growth trend
from 1966 on

Source: Bureau of Economic Analysis, Calafia Beach Pundit scottgrannis.blogspot.com

1950 1960 1970 1980 1990 2000 2010

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 NAPM - Orange County
Stocks have a lot of upside potential as well

2000 2000
S&P 500 Index
1000 1000

6.8% p.a.
100 trend 100

8% p.a.
trend

Source: Bloomberg scottgrannis.blogspot.com

10 10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

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 NAPM - Orange County
Key tenets of Supply-Side theory

• Economic growth is driven by supply, not demand

• Supply is a function of work, investment, and risk-taking, and is
very sensitive to incentives
• Low & flat tax rates, a stable & strong dollar, low inflation and
free markets maximize the incentives to work and invest
• Inflation is monetary, and can be seen in sensitive asset prices
(e.g., gold, dollar, yield curve)
• Government spends money less efficiently than the private sector

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 NAPM - Orange County
The challenges we face today

• Monetary policy has a strong inflationary bias

• Government has a strong expansionary bias
• Tax burdens threaten to increase
• Protectionist sentiment threatens
• All combine to inhibit investment, dampen confidence, constrain
productivity, depress the dollar, depress equity prices, and slow
growth

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 NAPM - Orange County
Monetary policy is extremely accommodative

10% Real Yields vs Yield Curve Slope

8%

6%
Real Fed Funds
4%

2%

0%
1-10 Slope
-2%

Source: Federal Reserve, BEA (PCE core deflator) scottgrannis.blogspot.com

-4%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

8
 NAPM - Orange County
Bank reserves are a potential inflation time bomb

1400
Adjusted Bank Reserves
1000

Quantitative Easing

Y2K 9/11

100

Source: St. Louis Federal Reserve scottgrannis.blogspot.com

60
1997 1999 2001 2003 2005 2007 2009

9
 NAPM - Orange County
Gold is sending a strong inflationary signal

2000
Real Gold Price

1000

700

500

400

300
Source: Bloomberg, BLS http://scottgrannis.blogspot.com

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

10
 NAPM - Orange County
The dollar is very weak

135
Real Broad Dollar Index
125

115

105
average
95

85

Source: Federal Reserve Board scottgrannis.blogspot.com

75
1973 1977 1981 1985 1989 1993 1997 2001 2005 2009

11
 NAPM - Orange County
Commodity prices are rising

500
CRB/Reuters Spot Commodity Index

400

300

Source: Commodity Research Bureau scottgrannis.blogspot.com

200
1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
burlap, butter, cocoa beans, copper scrap, corn, cotton, hides, hogs, lard, lead scrap, print
cloth, rosin, rubber, soybean oil, steel scrap, steers, sugar, tallow, tin, wheat, wool tops, zinc

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 NAPM - Orange County
Oil is expensive, but not a killer

150
Real Crude Oil Prices
100

70

40

20

10

Source: Bloomberg, Bureau of Labor Statistics scottgrannis.blogspot.com

6
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

13
 NAPM - Orange County
Inflation is alive and well

200
Producer Price Index
3.5%
inflation
'04-
100 1.7% inflation
'83-'03

9% inflation
0-1% '74-'82
inflation
'60-'65 4% inflation
'66-'73 Source: BLS
30
1960 1970 1980 1990 2000 2010
scottgrannis.blogspot.com

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 NAPM - Orange County
But bonds are priced to slow growth (2-3%)

6.0%
Strong 10-yr Treasury Yields
5.5%
Growth
5.0%
Average
4.5% Growth
4.0%
Slow Growth
3.5%
3.0%
Recession
2.5%
2.0% Depression
1.5% & Deflation
Source: Bloomberg scottgrannis.blogspot.com
1.0%
2005 2006 2007 2008 2009 2010

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 NAPM - Orange County
Federal government spending has surged

30%
Federal Government Finances
25%
Spending
20%

15%
Revenues

10%

5%

Source: Bureau of Economic Analysis, U.S. Treasury; rolling 12-month periods; Feb '10 est.
0%
1969 1974 1979 1984 1989 1994 1999 2004 2009
scottgrannis.blogspot.com

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 NAPM - Orange County
Total government spending is at a post-War high

60
U.S. Government Spending, % of GDP
50

40

30

20

10

Source: www.usgovernmentspending.com scottgrannis.blogspot.com

0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

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 NAPM - Orange County
A deficit >10% of GDP is a real problem

3% Surplus/Deficit % of GDP
surplus
0%
deficit
-3%

-6%

-9%
$1.5 trillion
Source: Bureau of Economic Analysis, U.S. Treasury
-12%
1968 1973 1978 1983 1988 1993 1998 2003 2008
scottgrannis.blogspot.com

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 NAPM - Orange County
Higher tax rates would likely slow growth and fail to
generate sufficient revenues

2 The Laffer Curve

100%

Tax Rates, 3
% of Income C

1
0%
Tax Revenues

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 NAPM - Orange County
Consider the evidence

100%
Tax Rates vs. Tax Revenues 90%
20%
80%
70%
15%
60%
Tax Revenues Top Tax Rate 50%
10% 40%
30%
5% 20%
10%
Source: Internal Revenue Service, U.S. Treasury, OMB scottgrannis.blogspot.com
0% 0%
1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

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 NAPM - Orange County
Profits have doubled since ‘98, but equities are flat

1400 28
Corporate Profits vs GDP
1000 20

Profits
500 10

Nominal GDP

Source: Bureau of Economic Analysis, NIPA; Q4/09 est. scottgrannis.blogspot.com

200 4
1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

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 NAPM - Orange County
Corporate PE ratios are below average

35
NIPA P/E Ratio
30

25

20
average
15

10

Source: Bloomberg, NIPA; based on most recent quarterly NIPA profits and S&P 500 prices
0
1960 1970 1980 1990 2000 2010
http://scottgrannis.blogspot.com

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 NAPM - Orange County
Credit spreads are still quite high

2000
Corporate Spreads
1800
1600
1400
1200
1000 High Yield
800
600
400
Investment Grade
200
0
1997 1999 2001 2003 2005 2007 2009
Source: Merrill Lynch Corporate Master Index scottgrannis.blogspot.com

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 NAPM - Orange County
Swap spreads lead, and are back to normal

140
5-year Swap Spreads
120

100

80

60

40

20

Source: Bloomberg scottgrannis.blogspot.com

0
1993 1995 1997 1999 2001 2003 2005 2007 2009

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 NAPM - Orange County

Business investment is rebounding, but flat for 13 years

80
Capital Goods Orders
70

60

50

40

U.S. Department of Commerce, Census Bureau scottgrannis.blogspot.com

Source:
30
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

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 NAPM - Orange County
Manufacturing is rebounding

10%
67
ISM Index (NAPM) vs. GDP
8%
62
ISM
6%
57
4%
52
2%
47
0%
42 Real GDP
-2%

37 -4%
Source: Institute for Supply Management, Bureau of Economic Analysis
32 -6%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
scottgrannis.blogspot.com

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 NAPM - Orange County

Global manufacturing is rebounding, but still very depressed

130
Global Industrial Production
120

110
Eurozone U.S.
100

90
Japan
80

Source: Eurostat, Min. of Economy, Federal Reserve scottgrannis.blogspot.com

70
1997 1999 2001 2003 2005 2007 2009

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 NAPM - Orange County

Housing prices appear to have bottomed, after falling 35%

240
Inflation-Adjusted Home Prices
220

200

180

160

140

120

Source: Case Shiller, BEA; last data point Dec. '09 scottgrannis.blogspot.com
100
2000 2002 2004 2006 2008 2010

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 NAPM - Orange County
Residential construction appears to have bottomed

2.5 Housing Starts

2.0

1.5

1.0

0.5

Source: Commerce Department scottgrannis.blogspot.com

0.0
1968 1973 1978 1983 1988 1993 1998 2003 2008

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 NAPM - Orange County
Mortgage rates are very low

10%
30-yr Fixed Mortgage Rates
9%

8%
Jumbo
7%

6%

5%
Conforming

Source: BanxQuote scottgrannis.blogspot.com

4%
1998 2000 2002 2004 2006 2008 2010

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 NAPM - Orange County
Conclusions

• The “new normal” scenario is too pessimistic

• A Friedman “plucking” scenario is too optimistic
• 3-4% real growth with a rising inflation trend seems reasonable given current
policies
• Stronger growth is possible if we cut spending, don’t raise taxes, and tighten
monetary policy
• The November elections are likely to bring significant and positive changes
for fiscal policy
• Bullish: equities, corporate & emerging mkt debt, commodities
• Bearish: T-bonds, MBS, foreign currencies

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