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August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and

August 2010

August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and global
August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and global
August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and global
August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and global
August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and global

Economic and Market

2010-Issue 5

August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and global
August 2010 Economic and Market 2010-Issue 5 “Bringing “Bringing you you national national and and global

“Bringing“Bringing youyou nationalnational andand globalglobal economiceconomic trendstrends forfor moremore thanthan 2525 years”years”

In This Issue:

Recovery’s One-Year Anniversary!!?

Is The “New-Normal” 25 Years Old???

Will Economic Soft Patch End Soon??

It Is Still All About Jobs!!?

Restoring Household Capabilities!?!

Armageddon

Hypochondria!!!

Real Yields

Are Not

Deflationary!??

Bonds Scream

Buy

Stocks!!?

The global economy slowed in the second quarter, awakening concerns about the speed and sustainability of the recovery. We believe the economy has experienced a very normal recovery cycle slowdown which should prove temporary. Stimulative forces have unfolded in the last few months which should produce a revival in economic growth by the fourth quarter.

The slowdown in second quarter real GDP growth to 2.4 percent is reinforcing a widespread impression this recovery is “different” and being forced slower under the weight of unique structural headwinds including widespread debt deleverging and substantially lowered risk propensities. The recovery is now one year old and while not strong by older postwar standards, is actually doing better than most perceive. In our view, this recovery is suffering less from newfound structural headwinds than it is from a permanently lowered rate of labor force growth which has been stunting recoveries for the last 25 years. If this is the “new-normal” economy, so far it is doing better than the “old-normal economy of the last 25 years,” and when adjusted for a permanently lowered rate of labor force growth evident since the mid-1980s, is growing at a rate very comparable to older postwar norms.

Recovery Is One Year Old?!?

Assuming the end of the recession is June 2009, the recovery has just completed its first year. There is a widespread impression this is the weakest recovery in the postwar era. While the speed and character of this recovery is disappointing compared to many postwar recoveries, it is not the worst ever. Actually, in its first year, the contemporary recovery has outpaced the last two recoveries in terms of real GDP growth, job creation, and profits!

During the first year of the current recovery, real GDP has risen by 3.2 percent compared to a 2.6 percent first-year gain in real GDP during the 1991 recovery and only a 1.9 percent rise in real GDP in the first year of the 2001 recovery. Many may also be surprised the contemporary recovery has produced better job results (even if they are still disappointingly weak) than was achieved in either the 1991 or 2001 recoveries. In 1991, persistent private job gains did not emerge until one year after the recession ended and it took 21 months before constant private job creation was produced after the 2001 recession. In the current recovery, however, persistent private job creation began last year-end, only six months after the recession ended! Moreover, private job losses continued for at least a full year after the 1991 and 2001 recessions, whereas this recovery has already produced 510,000 private sector jobs in the last six months. Finally, the profit recovery cycle in the contemporary period is among the best of the entire postwar era.

We are not suggesting the current recovery is great. Clearly, this recovery has significant room for improvement, particularly in job creation and household income growth. However, the consensus perception that this recovery is the “worst ever” and consequently extremely vulnerable to a potential double-dip recession is overblown. We had been expecting about 4 percent real GDP growth during this expansion and while its first year is somewhat less, it is not disastrously deficient. Finally, even if this recovery is weak compared to older postwar norms, it is still stronger than any other recovery in the last 25 years.

Are Expectations For A Robust 1982-Style Recovery Realistic???

Since the last recession was one of the deepest on record, many believe the recovery should be much stronger. Historically, the worst recessions have been followed by the strongest recoveries and many consider the 1975 and 1982 recoveries (which followed deep recessions) as appropriate benchmarks in which to judge the contemporary recovery. On this basis, the current recovery fails miserably. First-year real GDP growth rates during the 1975 and 1982 recoveries were 6.2 percent and 7.7 percent respectively—nearly double the contemporary recovery!

Economic & Market Perspective

A consensus believes the substantial underperformance of

the current recovery to these historic benchmarks reflects the “new-normal” character of the economy. An economy which

is “different this time,” one which faces newfound “structural

headwinds” (including household debt deleverging and a generalized reduction in private sector risk propensities) and consequently an economy destined to deliver sub-par growth for several years.

However, based on these older postwar recovery norms, not

only is the current recovery sub-par, but so were both of the last two recoveries. That is, whatever is causing the “new-normal” economy has been doing it for the last 25 years. The “new- normal” is actually kind of old—at least a quarter century old. So can the fact the current recovery is weaker than those of

1975 or 1982 be explained by newfound structural headwinds

as a result of the 2008 crisis? Maybe in part, but not fully.

Whatever forces are stunting the contemporary recovery, they seem to have been at work for many years.

The current recovery and those of the last 25 years have grown slower compared to U.S. recoveries 30 to 40 years ago. In our view, this is mostly due to a watershed reduction in the growth of the U.S. labor force since the mid-1980s. The rate

of underlying resource growth (i.e., land, labor, and capital)

has always been one of the most important determinents of economic growth. This has been true throughout history and across countries. Indeed, in recent years, emerging world economic growth has outpaced developed country economic growth mostly because emerging economies have a much faster labor force growth rate.

Since WWII until the mid-1980s, the U.S. labor force grew strongly fueled by baby-boomer demographics and the steady entrance of women into the workforce. But since the middle- 1980s, U.S. labor force growth has slowed dramatically. Between 1960 and 1984, the U.S. labor force grew at the annualized pace of 2.2 percent, whereas since 1984 it has only risen at a 1.1 percent annualized rate. During the 1970s, the U.S. labor force rose at an annualized growth rate of 2.7

percent. In the last 10 years, by contrast, the annualized growth

in the labor force has only been 0.7 percent.

Interestingly, if the U.S. had the same “resource growth” that

it did in the 1970s, the current recovery would probably be

growing at least 2 percent faster (i.e., 2.7 percent less 0.7 percent). Adding 2 percent to the current first year recovery growth rate in real GDP yields 5.2 percent growth (i.e., 3.2 percent actual first-year growth plus a 2 percent labor force growth adjustment) which would not be considered a sub-par recovery. Indeed, with this labor force adjustment, the current

recovery first-year growth rate is better than either the 1970 or

1980 recoveries and much more comparable to the robust 1975

and 1982 recoveries.

Is the current recovery truly a “new” new-normal? Or, has

“new-normal slower labor force growth” been in force already

for more than 25 years? The last three recoveries have been

slower, but not necessarily due only to debt or other challenging structural problems as many suggest. Rather, they have been weaker recoveries simply because the U.S. no longer possesses rapid resource growth as it did in earlier decades. Since the mid-1980s, the annual growth in real GDP has seldom been above 4 percent. For example, between 1960 and 1985, annual real GDP growth was above 4 percent more than half of the time. Since 1985, however, it has only exceeded a 4 percent annual growth rate 28 percent of the time.

The new-normal economy, which so many believe the U.S. is headed toward, may be a better description of where we have been for the last 25 years! In this light, achieving a 3.2 percent real GDP growth rate in the first year of this recovery with virtually no labor force growth may be a much more successful result than widely appreciated. Indeed, it is better than 60 percent of the time since 1985.

Even if the contemporary period is a “new-normal” recovery, it is thus far proving stronger than the “old-normal”—that is, compared to the last two recoveries or the average performance since 1985! Our belief is this recovery appears quite “normal.” It is not as strong as recoveries of the 1960s and 1970s (nor should we expect it to be since back then the U.S. was enjoying the impact of demographically charged labor force steroids) but nor is it as weak as recoveries of the last 25 years. It is a recovery which thus far is ahead of the “normal” (at least the normal for the last 25-year era of slower U.S. resource growth), primarily because it is coming from a deeper recession. Therefore, is the contemporary recovery really a chronic disappointment that is vulnerable to a double-dip recession? Or, is the current recovery (soft patch notwithstanding) actually much stronger than most perceive?

Will Economic Soft Patch End Soon???

The softer tone of economic reports since late spring is probably the result of a very normal mid-recovery slowdown. Typically early in a recovery, contractionary forces begin to emerge which temporarily slows growth in the economy. This is exactly what happened earlier this year.

From late last year until early spring, the 10-year Treasury bond yield rose from about 3.2 percent to about 4 percent, the national average 30-year mortgage rate jumped to about 5.5 percent, crude oil prices rose from about $70 to about $90, the trade-weighted U.S. dollar index surged by more than 15 percent, the European sovereign debt crisis cause several bond yield spreads to widen, and finally, Chinese officials spent most of the last year tightening their domestic policies. The result? A “policy hiccup” (higher interest rates, oil prices, the dollar, and bond spreads) combined to temporarily slow the pace of the economic recovery.

The good news is most of this policy hiccup has already been reversed suggesting economic growth will likely strengthen again before the year is over. The 10-year Treasury yield is now below 3 percent, the national average mortgage rate is about 4.5 percent, oil prices had fallen toward $70 just a few weeks

ago, the U.S. dollar index has retraced about one-half its advance from its lows of last year, the European crisis is fading away (and junk bond, swap and money market spreads are tightening again), and finally, China has seemingly completed its tightening campaign. Just as the policy hiccup led to a slower recovery this spring, the reversal of these policy forces should help economic performance during the last half of this year.

It Is Still All About Jobs!?!

Most still question whether this recovery is sustainable and the recent soft patch has exacerbated these fears. This issue will not be settled until there is a period of healthy and persistent job gains. We still think most indicators suggest job creation will strengthen as the year progresses. The biggest reason for our optimism is the ongoing stellar business profit cycle. Profits create jobs and profits continue to be the bright light in this recovery. Additionally, a survey of business expectations for employment over the next six months has recently risen to one of its highest levels in 15 years, the Conference Board’s Employment Trends Index continues a steady advance in recent months, both the ISM manufacturing and services sector employment survey components now suggest expanding employment, Challenger layoff announcements have been back to normal recovery levels since late last year, productivity growth simply can not rise much further (in the last year the rate of productivity growth is at a 30 year high), the Monster.com online job postings index has risen steadily since early this year and temporary jobs (typically a leading indicator for permanent positions) has been surging since late last year.

August 2010

economic revival? They are often a leading indicator of real economic growth and since the end of June, stock markets about the globe have posted healthy rallies. Since China stopped tightening, emerging economy stock markets have been leading the way after underperforming for much of the last year. Within the U.S., the stock market rally has been led by those sectors most sensitive to the economic cycle including materials, industrials, transports and small capitalization stocks. Commodity markets have also come to life in recent weeks as while gold and the U.S. dollar lose their safe-haven premiums built up during the European crisis. Finally, although Treasury bond yields show no sign yet of any impending recovery, other parts of the bond market are improving. Investment grade and junk bond spreads, mortgage-backed bond spreads, municipal bond spreads, money market spreads and swap spreads have all been tightening again in the last month.

Economic growth may remain tepid in the first part of the third quarter, but we expect reports to soon improve and for real GDP growth in the fourth quarter to again reach 3 to 4 percent.

Financial Markets??!?

The S&P 500 currently sells at about 13 times one-year forward mean estimated earnings per share while the 10-year Treasury bond yield currently sells at about 33 times its annual coupon payment. Normally, the stock market sells at a price-earnings premium to the bond market. Seldom has the stock market appeared so cheap while simultaneously the bond market appears

so expensive. The current relative pricing of the stock and bond markets make sense if a depression is coming (or perhaps even

If

job creation does quicken in the next several months, double-

if

one isn’t coming but rather a widespread “depression panic”

dip fears should finally fade and confidence should improve

capabilities have been restored in the business community (solid

is

imminent). Should job creation improve in the months ahead

among both businesses and households. A major potential

and confidence in an ongoing recovery (even if slow) broadens,

driver of future economic growth in this recovery could be

a

stock market at 13 times earnings and a 10-year Treasury bond

from a widespread improvement in economic confidence. Many

profit gains for the last six quarters, healthy balance sheets, lean operations, massive excess cash flows) and consequently,

yield of 3 percent will look pretty silly in a world characterized by solid outperforming earnings growth, record-low interest rates and a less than 1 percent core consumer price inflation rate.

a broadening acceptance that the recovery is sustainable could

produce a period of considerable business spending and hiring.

Although the household sector continues to face formidable challenges, it also has seen meaningful improvement in many economic capabilities. Both the household debt burden (financial obligations as a percent of disposable personal income) and the household energy burden have declined to levels only about average since 1980. Household liquidity remains remarkably elevated, household net worth has been rising in the last year, persistent private job creation (even if slow) has been ongoing since year-end, home prices have risen mildly in the last year, the personal savings rate has surged and presides near a 20- year high and pent-up demands have grown significantly in the last several years. While consumers still face many headwinds, most may be underestimating how much household economic fundamentals have improved during the last couple years. Since some capabilities have been restored, should job creation and confidence begin to accelerate, the household sector could finally become a much larger force for growth in this recovery. Are the financial markets already suggesting an impending

Stock market volatility is tiring, especially when it has gone on for so many years. So is the array of confusing economic reports—some good and some bad which seemingly never offer resolve. Finally, the number, variety and persistence of new potential Armageddons is also fatiguing. Like others before, this recovery won’t unfold in a straight line and won’t be without doubts along the way.

But hang in there! Right now, while the soft patch is concerning,

it appears to be a normal slowdown within an ongoing recovery.

Underneath the daily litany of news is a slow but constant improvement in economic and financial market indicators. The economy is growing again (maybe not as fast and consistently as we all want), profits are rising again, jobs are being created again, incomes are growing again, consumers are spending again, and stock, bond, commodity and even housing prices are recovering.

bond, commodity and even housing prices are recovering. James W. Paulsen, Ph.D. Chief Investment Strategist, Wells

James W. Paulsen, Ph.D. Chief Investment Strategist, Wells Capital Management

Economic & Market Perspective

2Q Soft Patch???

The U.S. economy hit a “soft patch” in the second quarter slowing real GDP growth to 2.4 percent. As this chart illustrates, personal consumption has been weak during the first year of this recovery relative to historic norms. However, other parts have fared better. In the last year, real spending by domestic residents (i.e., real gross domestic purchases which is real gross domestic product less exports and plus imports) has risen at the healthy pace of almost 4 percent! This growth rate

in domestic purchases was not achieved until at least two years into the recovery during either of the last two expansions. Every recovery is unique. In the first year of the 2001 recovery, consumption was stronger and business spending was weaker. Today, consumer spending is weaker but business spending is stronger. No doubt, for this recovery to sustain and mature, job creation will have to improve. We think it will??!

Consumer Spending vs. Total Domestic Spending

Annual Growth in Real Personal Consumption Expenditures (Solid) Annual Growth in Real Gross Domestic Purchases (Dotted)

Annual Growth in Real Gross Domestic Purchases (Dotted) Emerging Story Re-Emerges!? Emerging Market economic and

Emerging Story

Re-Emerges!?

Emerging Market economic and stock market trends have been heavily influenced by the Chinese policy official tightening campaign during much of the last year. As this chart illustrates, both the relative stock price performance of emerging market stocks and industrial commodity price trends stalled once Chinese tightening began. In recent weeks,

however, as Chinese policy tightening seems to be ending, both emerging stock markets and commodity prices have shown renewed signs of vigor. While Chinese actions may have caused a temporary pause, the “Emerging Market Story” once again seems to be re-emerging!

Emerging Markets and U.S. Industrial Activity

*Morgan Stanley’s Emerging Market Stocks Total Return Index relative to S&P 500 Total Return Index.
*Morgan Stanley’s Emerging Market
Stocks Total Return Index relative to S&P
500 Total Return Index.
Shown on a natural log scale.
**CRB Raw Industrial Commodity Price
Index. Shown on a natural log scale.
Relative Total Market
Return Stocks*
Performance
(Solid) of Emerging
CRB Raw Industrial Commodity Price Index** (Dotted)

August 2010

One-Year Recovery Anniversary?!?

Contrary to popular belief, this recovery is not the weakest recovery on record. It is not even the weakest recovery of the recent era. The top chart shows first year recovery growth rates in real GDP for every recovery since 1970. The contemporary recovery is weaker than any during the 1970s and early 1980s, but is stronger than each of the last two recoveries during the last 25 years. Moreover, as illustrated by the lower two charts, the job market has actually been “better” during the current recovery than it was in either the 1991 or 2001 recoveries. In 1991 it took a year, and in 2001 it took 21 months before persistent private job creation was achieved. In the current recovery, persistent private job gains began within six months of the end of the recession.

Additionally, in both the 1991 and 2001 recoveries, private job losses persisted for at least one year after the recession ended. By contrast, this recovery has created 510,000 private jobs during the last six months! Finally, the profits cycle in the contemporary recovery is among the best of any postwar recovery. Compared to the entire postwar era, this recovery is sub-par. However, the level of disappointment in this recovery seems overdone. It is not the “worst-ever” recovery, its character is not supportive of depression scenarios nor even excessive double-dip fears and it is the “best recovery” in 25 years at least in terms of real GDP growth, job creation, and profits.

Real GDP Growth Rates in First Year of Recoveries

1970s–1980s vs. 1990s–2000s Monthly NonFarm Private Payroll Changes Private Payroll Changes—1991, 2001, and 2009
1970s–1980s vs. 1990s–2000s
Monthly NonFarm Private Payroll Changes
Private Payroll Changes—1991, 2001, and 2009 Recoveries
Private Payroll Changes in First Six Months After Recession (Open Bar)
Private Payroll Changes in Second Six Months After Recession (Solid Bar)

Economic & Market Perspective

Why Recovery is Weaker Than the 1970-82 Recoveries???

Considering how deep the 2008 recession was, many suggest the current recovery should compare with recoveries that followed other deep recessions like 1975 and 1982. The current first year recovery growth rate of 3.2 percent is paltry compared to the 6.2 percent gain in real GDP during the first year of the 1975 recovery or the 7.7 percent explosive growth in the first year of the 1982 recovery. Many believe this reflects the special structural headwinds that characterize the current recovery, including that households are deleveraging, raising savings, and avoiding normal risk behaviors. However, we believe the weaker growth comparison is primarily due to a factor not widely recognized and something which has been stunting recoveries for the last 25 years—weaker labor force growth. The pace of resource growth (land, labor and capital) has always been a major (if not “the” major) factor determining the rate of economic growth across countries and throughout history. For example, emerging world economies have been and will continue to grow faster than developed economies mostly because they are enjoying faster labor force growth rates. The top chart illustrates the U.S. labor force. As the trend lines suggest, the rate of growth in the U.S. labor force has slowed significantly since the mid-1980s. Between

1962 and 1984 the U.S. labor force grew 2.1 percent annually whereas since it has only risen at an annualized rate of 1.1 percent. The lower chart shows since this “downshift” in the U.S. labor force growth rate, real GDP growth has seldom been above 4 percent and recovery growth rates have proved far less robust than they were prior to 1985. In the decade of the 1970s, the labor force grew 2.7 percent annually. By contrast, in the last 10 years, the U.S. labor force has only grown at a 0.7 percent annualized rate. Therefore, economic recoveries between 1970 to 1984 enjoyed a “persistent 2 percent labor force growth booster.” If the current recovery’s first year growth rate is adjusted for this labor force growth differential compared to the 1970s, it does not look weak. Adding 2 percent (2.7 percent labor force growth in the 1970s less the 0.7 percent growth in the last 10 years) to the current recovery first year real GDP growth rate produces a 5.3 percent rate—better than the 1970 and 1980 recoveries and much closer to the outcomes during the 1975 and 1982 recoveries. This is not a “new-normal” recovery. Rather, slower economic growth has been prevalent for the last quarter century due to a much slower “new-normal” rate of labor force growth.

U.S. Civilian Labor Force

Shown on a natural log scale. In millions.

Annual Real GDP Growth
Annual Real GDP Growth

August 2010

Job Market to Wag the “Economic/Market” Dog!!?

Ultimately, the economic and stock market outcomes for the rest of this year will be determined by the job market. If job creation remains tepid, double-dip fears will again escalate aborting any hope of a further stock market rally. Alternatively, should job creation improve, acceptance of a sustained recovery will emerge and the current level of bond yields and the current valuation of the stock market will appear far too low. This chart overlays the S&P 500 stock price index with the level of initial weekly unemployment

insurance claims (shown on an inverted scale and as a 4-week rolling moving average). Since 2000, weekly unemployment claims and the stock market have trended remarkably closely. Should claims remain stalled at around 450K, the stock market will likely meander as it has much of this year. Conversely, a renewed improvement in unemployment claims (similar to what occurred from early 2009 to early 2010) would likely push the stock market to new recovery highs before the year is over??!

Stock Market vs. Unemployment Claims S&P 500 Composite Stock Price Index (Solid) Log scale. 4-Week
Stock Market vs. Unemployment Claims
S&P 500 Composite Stock Price Index (Solid)
Log scale.
4-Week
Moving Claims
Average (Dotted)
of Initial Log
Unemployment
Insurance
Scale.

Several Indicators Suggest Job Market is Improving?

Job reports have recently been discouraging, but several indicators suggest a more robust recovery in the job market is forthcoming. These two charts and those on the next page offer some reasons for optimism on the job front. First, profit per job has soared by 35 to 40 percent in the last year—its greatest annual growth rate in at least 60 years! Profits are

what create (and lead) jobs and this story continues to remain fantastic. Second, the Conference Board’s Employment Trends Index comprised of 8 labor market indicators has risen by more than 10 percent from its low 13 months ago signaling improved labor market results in the months ahead.

Private Job Growth vs. Profit Per Private Job Growth Conference Board Employment Trends Index Annual
Private Job Growth vs.
Profit Per Private Job Growth
Conference Board
Employment Trends Index
Annual Growth in Private NonFarm Payrolls (Solid)
Annual Growth in Total Corporate Profits Per
Private NonFarm Job Ratio (Dotted)

Economic & Market Perspective

More Indicators Pointing UP for Jobs!?!

Third, business employment expectations are close to the highest levels of the last 25 years! Fourth, employment surveys from the ISM manufacturing and services sector both show a return to expanding job markets. Fifth, monthly layoff announcements have returned to normal recovery levels suggesting the recessionary purge has ended. Sixth, productivity has exploded by more than 6 percent in the last year to one of its fastest annual growth rates in decades which

has probably contributed to slower job creation. However, as the chart illustrates, productivity is not likely to expand much further and in past recoveries has often weakened at this point in the recovery cycle. If productivity slows, companies may be forced to boost job creation. Seventh, online job postings have been rising rapidly since year-end. Finally, temporary job positions, often a leading indicator for permanent job creation, has been surging since late last year.

Federal Reserve Business Outlook Survey Six Month Employment Expectations

ISM Purchasing Managers’ Employment Surveys*

*Above 50 percent implies “expanding” payrolls. Manufacturing Sector (Solid) Non-Manufacturing (Services) Sector (Dotted)

Challenger U.S. Job Cut Announcements Annual U.S. Productivity Growth Monster Employment Index* U.S. Temporary Help
Challenger U.S. Job Cut Announcements
Annual U.S. Productivity Growth
Monster Employment Index*
U.S. Temporary Help Services Jobs
Thousands of Jobs
*Index of Online Job Opportunities

August 2010

Soft Patch Reversal??

We think the economic soft patch in the second quarter was primarily the result of significant tightening forces that began to emerge late last year. The 10-year Treasury bond yield rose from about 3.2 percent in November to about 4 percent in April, the national average 30-year mortgage rate rose close to 5.5 percent earlier this year, oil prices rose from about $70 last year to about $90 in May, and the U.S. trade-weighted dollar index surged by more than 15 percent between last December and its recent peak. Moreover, the European sovereign debt crisis caused several U.S. bond spreads to widen and finally, since last year, Chinese government officials have been tightening various policies to moderate their economic recovery. Combined, these broad-

based contractionary forces slowed the pace of the economic recovery. The good news? Most of these same forces have subsequently been reversed. The 10-year Treasury yield has recently declined by more than 1 percent to about 3 percent, the 30-year mortgage rate is now about 4.5 percent, oil prices recently were trading in the mid-$70s, the U.S. dollar has retraced about one-half its advance since its low last November, the European crisis has improved significantly and Chinese officials appear to be ending their tightening campaign. Just as the tightening forces during the first several months of this year led to a summer slowdown, the reversal in these forces should soon bring better economic reports?!?

10-Year Treasury Bond Yield

Crude Oil Futures Price Trade-Weighted U.S. Dollar Index
Crude Oil Futures Price
Trade-Weighted U.S. Dollar Index

Economic & Market Perspective

Restoring Household Capabilities!!??

Although U.S. households continue to face many economic challenges, progress is being made in restoring consumer capabilities! Both the U.S. household debt and energy burdens (i.e., debt and energy expenses as a percent of disposable personal income) have returned to about “average” by historical comparisons back to 1980. While still problematic, the debt burden is no longer “record-setting” nor even uncommonly high. Balance sheet ratios also have improved. Household liquidity has risen substantially and household net worth has been rising again in the last year. Although job growth is not yet strong, it

has been rising again this year. Similarly, home prices seem to have stabilized during the last year. Moreover, pent-up demands for big ticket items (durable goods and houses) have certainly risen. Finally, the personal saving rate has recovered and has been hovering about a 15 to 20 year high in recent months. If job creation quickens in the months ahead as we anticipate, the consumer may show surprising strength boosted by renewed capabilities in an economy with extremely low interest rates and (at least currently) stable inflation!?

U.S. Household DEBT Burden* U.S. Household ENERGY Obligations Ratio* *U.S. Household Financial Obligations Ratio
U.S. Household DEBT Burden*
U.S. Household ENERGY Obligations Ratio*
*U.S. Household Financial Obligations Ratio (principal and interest
payments, lease payments, and property tax payments as a
Percent of Disposable Personal Income.)
Source: Federal Reserve Board
*Personal Consumption Expenditures on Energy Goods and
Services. (Table 2.3.5 NIPA accounts) as a Percent of
Disposable Personal Income.
Household Liquidity*
U.S. Household Net Worth*
*Household Liquid balances as a Percent of
Disposable Personal Income.
*Shown on a natural log scale. In Trillions $.
U.S. Household Employment*
*In Millions.
Case-Shiller 20-Composite
Home Price Index
U.S. Personal Savings Rate*
U.S. Household Real Durable Goods
(Big Ticket Items) Spending*
*U.S. Households Saving as a Percent of
Disposable Personal Income.
*Shown on a natural log scale.

| 10 |

August 2010

Are Financial Markets Smelling an Economic Revival???!

Are the financial markets already reflecting a coming reacceleration in the economic recovery? They tend to lead economic performance and their recovery in recent weeks is encouraging. Stock markets about the globe have rallied substantially since early July. Leadership within the stock market has been dominated by economically sensitive sectors including industrials, materials, and transports. Emerging market stocks have also regained leadership with the Chinese Shanghai stock price index recently rising to its highest level since early May and the Korean Kospi stock price index recently establishing a new high for the recovery cycle. Commodity prices have also recovered, bolstered both by a weaker U.S. dollar and by improving economic reports about

the globe. Treasury yields have yet to show any sign of an impending strengthening in the economic recovery. The 10- year Treasury yield remains close to 3 percent. However, other parts of the bond market have been reflecting an improving economic tone. Mortgage-backed bond yield spreads, junk bond yield spreads, treasury swap spreads and LIBOR yield spreads have all tightened again in the last few weeks. Finally, “safe-haven” investments (which investors flock to in times of economic uncertainty) including the U.S. dollar and gold have lost their luster. The improved tone of the financial markets during the last month may be the first sign the economic soft patch is nearing an end?!?

S&P 500 Composite Stock Price Index

CRB Commodity Price Index

Relative Stock Price Performance Materials Stocks* Relative Stock Price Performance Industrial Stocks* *S&P 500
Relative Stock Price Performance
Materials Stocks*
Relative Stock Price Performance
Industrial Stocks*
*S&P 500 Materials Stock Price Index
relative to S&P 500 Index.
*S&P 500 Industrial Stock Price Index relative
to S&P 500 Index.
Relative Stock Price Performance
Emerging Market Stocks*
2-Year Treasury Swap Spreads
*MSCI Emerging Market Stock Price Index relative to
S&P 500 Index.
Price of GOLD
Trade-Weighted U.S. Dollar Index

|

11 |

Economic & Market Perspective

| 12 |

Armageddon Hypochondria!??!

Fear has remained elevated since the crisis ended. This is the legacy of the Great Crisis of 2008—a widespread post traumatic stress disorder or “Armageddon hypochondria.” As would any hypochondriac, the financial markets tend to extrapolate any disappointing report (symptom) instantly to “economic death” (double-dip or depression). And the economic patient has of course exhibited many symptoms— none of which have yet ended the recovery. These charts provide a statistical look at the ongoing “crisis mentality.” The top chart is an index that monitors conditions in the financial markets. Movements below zero represent periods of financial market stress or rising potential for “crisis.” The middle chart examines the rolling one-year regression coefficient between the daily percent change in the U.S. stock market and the daily change in the crisis index. Until 1997, the regression coefficient hovered about zero, suggesting movements in the crisis index had no impact on the stock market. However, the stock market became much more sensitive to the crisis index in 1997-98 during the Asian and Russian crises. Since, the regression coefficient hovered about 5 implying that the stock

market declined by about 5 percent for every 1 point decline in the crisis index. Moreover, the dot-com meltdown in 2000 led to a doubling in the stock market sensitivity to changes in the crisis index (i.e., the regression coefficient spiked to about 10 at its peak). The impact of the crisis index on the stock market decayed steadily throughout the last recovery (the regression coefficient declined to about 2 in 2007), re-spiked again to about 10 during the 2008 crisis and has remained elevated since. The lower chart is the R-squared of the one-year rolling regressions. This chart illustrates the proportion of the total volatility in the stock market explained by changes in the crisis index. In the early 1990s, movements in the crisis index had virtually no impact on the stock market. In the last year however, the crisis index has explained about 70 percent of the daily movements in the stock market! This chart explains why “market fundamentals” don’t seem to matter as much any more. Often in the last couple years, the stock market has been driven more by the next panic than by fundamentals. This probably won’t last forever, but for now, investors should be prepared for a stock market which remains “crisis phobic”!??

Bloomberg United States Financial Conditions Index*

*The Bloomberg Financial Conditions Index combines yield spreads and indices from the Money Markets, Equity
*The Bloomberg Financial Conditions Index combines yield spreads and
indices from the Money Markets, Equity Markets, and Bond Markets into
a normalized Index. The values of this index are z-scores, which repre-
sent the number of standard deviations that current financial conditions
lie above or below the average of the 1992-June 2008 period. Rising
(Falling) values suggest improving (worsening) financial conditions.
Percent of Stock Market Volatility Explained
by the Changes in the Bloomberg
U.S. Financial Conditions Index***
***R-Squared estimated from a rolling 1-year regression of the daily percent changes in the
S&P 500 Index on the daily changes in the Bloomberg U.S. Financial Conditions Index. The R-
Squared is a measure of the percentage amount of the volatility in the dependent variable (i.e.,
stock market) explained by change in the independent variable (i.e., financial conditions index).

U.S. Stock Market Sensitivity to CRISIS**

**Rolling 1-year (i.e., trailing 262 daily observations) estimated regression coefficients of daily percent changes in the S&P 500 Index from daily changes in the level of the Bloom- berg U.S. Financial Conditions Index. The vertical scale records the estimated percentage impact on the S&P 500 from a one point change in the Financial Conditions Index. For example, a value of eight implies that in the previous year, the stock market tended to rise (fall) 8 percent for every one point increase (decrease) in the Financial Conditions Index.

August 2010

Bond Market Deflation Scare REDUX???

The collapse in Treasury bond yields since April has exacerbated deflationary fears. The bond market could be positioning for and forecasting that a more serious deflationary outcome lies ahead. Or, it could simply be wrong. Surprisingly, the behavior of the bond market closely parallels the beginning of the last recovery. Then, as now, after a brief recovery yield hiccup, the 10-year Treasury yield collapsed to almost 3 percent during the summer of 2003 amidst intensifying deflationary fears. Thereafter, however, the economic recovery strengthened, deflation fears subsided, and bond yields reversed and surged higher. Ultimately, the intensity and duration of the contemporary

deflation scare will likely be determined less by how low the core consumer price inflation rate declines than by the perception of “real” economic growth. As long as a soft patch persists, deflation fears will linger. Should economic momentum weaken even further, deflation fright will intensify and bond yields could continue to decline. Most likely, in our view, is an outcome similar to the 2003 recovery. The current soft patch in the economic recovery will likely improve during the balance of this year quelling imminent deflation fears and making current bond yields appear inappropriately low!??

Annual CORE Consumer Price Inflation Rate 10-Year U.S. Treasury Bond Yield October 1, 2002 to
Annual CORE Consumer Price Inflation Rate
10-Year U.S. Treasury Bond Yield
October 1, 2002 to January 1, 2004
10-Year U.S. Treasury Bond Yield
October 1, 2009 to January 1, 2011

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Economic & Market Perspective

Real Yields NOT Deflationary!??

Deflationary risk would be higher if “real yields” were higher. Today, although bond yields are quite low, they are not “mispriced” relative to underlying inflation conditions. As this chart shows, the current real yield is only slightly below its long-run average. The surge in real yields during the 1930s is one of the major forces which promoted deflationary pressures. Similarly, high real yields during the 1980s helped end the inflation spiral of the 1970s by promoting continued

disinflationary conditions. While deflation risk is certainly elevated today, current “real yields” do not suggest the bond market is overly concerned about deflation (if they were, bond investors would demand a higher “real yield”) nor are the relatively benign contemporary real yields promoting deflationary forces. Currently, this chart seems more supportive of a period of “price stability” (like the 1960s?) than suggesting imminent deflationary risks??!

Real (Inflation-Adjusted) Long-Term Treasury Bond Yield*

*Long-term Treasury Yield until April 1954, 10-Year Treasury Yield thereafter. Bond Yield less annual rate
*Long-term Treasury Yield until April 1954, 10-Year Treasury Yield thereafter.
Bond Yield less annual rate of consumer price inflation.

Is Disinflation Ending???

Is disinflation starting to ebb? Probably not

core rate of consumer price inflation has been accelerating again since early this year and commodity prices have also recently begun to recover. Maybe these trends will soon reverse. However, it would not take many more core CPI

but, we note the

reports coming in “above expectations” (particularly if these coincided with reports of reviving real economic growth) before current deflationary concerns gave way to inflationary worries?!!

Core Consumer Price Index

Annualized Monthly Inflation

Rates

CRB Commodity Price Index

to inflationary worries?!! Core Consumer Price Index Annualized Monthly Inflation Rates CRB Commodity Price Index |

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August 2010

Trade/Government No Longer Deflationary?!!?

Trade surpluses (deficits) and government deficits (surpluses) act as a “stimulative” (contractionary) force on the economic cycle. The top chart adds these two stimulative forces together as a percent of nominal GDP. One of the reasons there has been intensifying “deflationary” evidence in recent years is because between the late-1990s and 2009, these two sectors (trade and government) chronically produced a “net leakage” of economic growth and acted as a contractionary force on the cycle. For example, in 2000, the combined government surplus (fiscal tightening) and trade deficit (international trade tightening) amounted to a record-setting leakage of about 7 percent of GDP! The stimulative forces of trade and government during the 1970s probably contributed to the inflationary bias in the economy. Moreover, the continued

accomodative nature of these sectors throughout much of the 1980s and early 1990s probably helped ensure a disinflationary (rather than deflationary) outcome. However, the amazingly “restrictive” force presented by trade and government since the late-1990s is one reason the last recession was as bad as it was and why deflation is as much a risk today as it appear to be. The good news, for those worried about potential deflation? In the last year, the government and trade sectors have combined to provide the economy with an “injection” of stimulus equal to 6 to 8 percent of GDP. These sectors have become an inflationary force. The recent position of trade and government could create future inflationary issues. However, similar to the 1980s, they may also simply stave off ongoing deflationary pressures???

Net Exports and Net Fiscal Spending as a Percent of GDP*

*U.S. Net Exports plus Net Government Spending as a Percent of Nominal GDP

Current Annual Consumer Price Inflation Rates for 75 Countries
Current Annual Consumer
Price Inflation Rates for 75 Countries

1. Venezuela 2. India 3. Pakistan 4. Egypt 5. Argentina 6. Iran 7. Vietnam 8. Turkey 9. Ukraine 10. Kazakhstan 11. Costa Rica 12. Uruguay 13. Russia 14. Iceland 15. Saudi Arabia 16. Hungary 17. Greece

18.

Indonesia 19. Tunisia 20. Sri Lanka 21. Brazil 22. Kenya 23. South Africa 24. Romania 25. Philippines 26. Guatemala 27. Mexico 28. Estonia 29. Thailand 30. Ecuador 31. U.K. 32. Singapore

33.

Panama 34. China 35. Oman 36. Israel 37. Australia 38. Kuwait 39. S. Korea 40. Belgium 41. Hong Kong 42. Poland 43. Colombia 44. Cyprus 45. U.S. 46. New Zealand 47. Austria 48. Luxembourg

49.

Norway 50. Slovenia 51. Denmark 52. Malaysia 53. Peru 54. France 55. Spain 56. Canada 57. Bulgaria 58. Bolivia 59. Italy 60. Czech Rep. 61. Portugal 62. Taiwan 63. Chile 64. Finland 65. Lithuania

66.

Slovak Rep. 67. Germany 68. Sweden 69. Croatia 70. Netherlands 71. Switzerland 72. Morocco 73. Japan 74. Ireland 75. Latvia

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Economic & Market Perspective

Bonds Scream

“Buy Stocks”!!?!

The stock market currently trades at about 13 times future estimated earnings while the 10-year Treasury bond currently trades at about 33 times its annual coupon payment! As illustrated in the chart, stocks have normally traded at a richer valuation compared to the bond market. The contemporary

stock/bond valuation divergence makes sense if a deflationary abyss is coming, but may look fairly ridiculous if the economic recovery proves to be sustainable. Stock prices and bond yields may “both” rise significantly should a consensus emerge which embraces an ongoing economic recovery!?!

Price-Earnings Ratios U.S. Stock Market vs. U.S. Bond Market

S&P 500 Price to Mean Estimated 1-Year Forward Earnings Estimate (Solid) 100 divided by U.S. 10-Year Treasury Bond Yield (Dotted) Shown on a natural log scale.

Treasury Bond Yield (Dotted) Shown on a natural log scale. Hmmmm ? While jobs are scarce

Hmmmm

?

While jobs are scarce today, this survey suggests they are no harder to find than they were in most past recessions since 1970. If this is the case, why is the duration of unemployment “off the charts” today? If jobs are no harder to come by today than they were in 1975, 1982, and 1992, why isn’t the average duration of unemployment 15 to 20 weeks as it used to be rather than at 35 weeks today? Is this because the unemployed

simply don’t have the skills required by employers? And, if so, why wouldn’t that fact show up in a much higher “jobs are hard to get” number? Alternatively, could these two charts be explained by government continuing to extend unemployment benefits? If you continue to pay people to stay unemployed,

wouldn’t this be the expected result? Just something for policy

officials to ponder over

?

Conference Board’s Average Duration That Unemployed have been Out of Work

Average Duration That Unemployed have been Out of Work Conference Board’s “Jobs Hard To Get” Survey

Conference Board’s “Jobs Hard To Get” Survey