fourth-quarter us economic update january 2013

Fourth-Quarter US Economic Update January 16, 2013

Fourth-Quarter US Economic Update January 2013 Summary of Recent Economic Developments

The US economy continued to grow slowly in the fourth quarter, with recent data pointing to real GDP growth of about 1.5%. The outlook is for continued sluggish growth in 2013 and 2014 as headwinds from deleveraging and fiscal policy uncertainty, while diminishing, remain present. With the notable exception of a strong housing recovery, most sectors of the economy grew modestly at best. Job gains slowed, which caused the unemployment rate to stall at 7.8%. Wages accelerated, boosting personal income and likely pushing consumption a little above the Q3 pace. We remain cautious on PCE in early 2013, however, due to higher taxes that took effect on January 1 and ongoing household deleveraging. Business investment probably recovered from its Q3 slide, but it too is growing slowly now. Industrial production inched higher. Trade deteriorated, and government consumption likely dipped. Inflation remains subdued. Households and financial institutions continue to deleverage their balance sheets. Treasury rates rose despite expansion of the Federal Reserve’s quantitative easing program, but credit spreads tightened as credit conditions improved further and investors continued to move into riskier fixed-income assets. Bank lending is rising, and credit markets show increasing signs of normalizing. While not imminent, we expect these trends will clash with highly accommodative monetary policy at some point.

Figure 1: Key Macroeconomic Indicators and Interest Rates

Economic Indicator* 2011:1 2011:2 2011:3 2011:4 2012:1 2012:2 2012:3 2012:4Real GDP, Chg QoQ (%, SA, AR) 0.1 2.5 1.3 4.1 2.0 1.3 3.1 1.0fReal Personal Consump Expnds, Chg QoQ (%, SA, AR) 3.1 1.0 1.7 2.0 2.4 1.5 1.6 1.6aReal Busi Investmt, Eqp & Sftware, Chg QoQ (%, SA, AR) 11.1 7.8 18.3 8.8 5.4 4.8 -2.6 NAReal Residential Investmt, Chg QoQ (%, SA, AR) -1.4 4.1 1.4 12.1 20.5 8.5 13.5 NACorporate Profits, After Tax, Chg YoY (%, SA, AR) 2.1 11.0 7.8 14.5 9.2 4.4 3.2 -2.9fCurrent Account Balance, Annualized (% of GDP, SA) -3.2 -3.2 -2.9 -3.1 -3.5 -3.0 -2.7 NAFederal Budget, 12-mo Def or Surp (% of GDP) -9.5 -8.4 -8.6 -8.2 -8.1 -7.9 -6.9 -6.8Unemployment Rate (%, SA) 8.9 9.1 9.0 8.5 8.2 8.2 7.8 7.8Household Employment, Chg QoQ (000, SA) 348 -238 759 732 1124 428 526 331Nonfarm Payrolls, Chg QoQ (000, SA) 576 389 383 492 677 200 505 453Nonfarm Productivity, Chg QoQ (%, SA, AR) -2.0 1.2 0.6 2.8 -0.5 1.9 2.9 NACapacity Utilization (%, SA) 76.5 76.3 77.2 78.3 78.4 78.8 78.4 78.8GDP Price Index, Chg QoQ (%, SA, AR) 2.0 2.6 3.0 0.4 2.0 1.6 2.7 NAConsumer Price Index, Chg YoY (%, AR) 2.7 3.6 3.9 3.0 2.7 1.7 2.0 1.7CPI ex food & energy, Chg YoY (%, AR) 1.2 1.6 2.0 2.2 2.3 2.2 2.0 1.9Nominal Personal Income, Chg YoY (%, AR) 6.1 5.1 4.6 3.6 3.2 3.1 3.5 4.1aPersonal Savings Rate (%, SA) 4.6 4.7 3.5 3.4 3.7 4.1 3.3 3.6a

Rate or Spread (End of Quarter) 2011:1 2011:2 2011:3 2011:4 2012:1 2012:2 2012:3 2012:4Federal Funds Rate Target (%) 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.253-month LIBOR (%) 0.30 0.25 0.37 0.58 0.47 0.46 0.36 0.3110-Yr Treasury Note Yield (%) 3.47 3.16 1.92 1.88 2.21 1.64 1.63 1.7630-Yr Treasury Bond Yield (%) 4.51 4.38 2.91 2.89 3.34 2.75 2.82 2.95Moody's Baa Long Corp Spread (bp) 154 152 231 227 196 231 190 16810-Yr Interest Rate Swap Spread (bp) 11 12 19 17 8 13 7 6

* Figures are either quarterly or, if more frequent, end of period. f = Forecast1; a = Actual through Nov 2012 Source: Reuters EcoWin

Legend for all Figures: AR = Annual Rate; SA = Seasonally Adjusted; MA = Moving Average; C.O.P. = Change over Period


Economic Outlook

Economic growth in the US probably ended 2012 with a whimper, although the outlook for 2013 brightened a bit with partial avoidance of the “fiscal cliff.” Economists expect fourth-quarter inflation-adjusted Gross Domestic Product (real GDP) to grow by about 1.0%, which would put the average growth rate for 2012 at 1.9%.1 Those same forecasters anticipate 1.9% real GDP growth in 2013 and 2.5% in 2014. Data released since the publication of those forecasts point toward somewhat firmer growth for Q4, probably around 1.5%.

Headwinds that have been restraining US economic growth – most notably deleveraging in the private sector and fiscal policy uncertainty – remain present but are diminishing in intensity. In addition, disruptions from Hurricane Sandy probably slowed growth a bit in Q4, while rebuilding efforts should add to growth this year. We remain comfortable with our outlook for 2.0-2.5% real GDP growth in 2013, although the outcome of the spending portion of fiscal cliff negotiations could bump our forecast down. We would become more optimistic on growth if Washington crafts a “grand bargain” that reforms entitlements, reduces tax expenditures and lowers marginal tax rates. Such an outcome appears highly unlikely given current partisan rancor, however.

Figure 2: Labor Participation Falling Figure 3: Slow Job Growth, Lower Unemployment US Unemployment & Labor Participation Rate (Percent)

Labor Participation Rate United States, Unemployment, Rate, Total, SASource: Reuters EcoWin

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Summary Statistics (3-month moving averages for Employment Changes)US Employment Situation

All employees, Employment, Overall, Nonfarm payroll, total [c.o.p val 1 month, ma 3] Employment, By Sector, Overall, Total (civilian, household survey) [c.o.p val 1 month, ma 3] Unemployment, Rate, Total

Source: Reuters EcoWin

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Real GDP growth of 2.0-2.5% is not bad – it’s actually good for prices of preferred securities – but it is not fast enough to generate new jobs at a rate that would lower the unemployment rate quickly. This is visible in 2012’s labor market performance during a period of about 2% real GDP growth. At first glance, the decline in the unemployment rate from 8.5% in December 2011 to 7.8% in December 2012 looks pretty good. However, labor participation dropped from 64.0% of the working-age population to 63.6% over that period (Figure 2). If the labor participation rate had remained unchanged, the unemployment rate would have dropped by only 0.2% in 2012 rather than 0.7%. If labor participation starts to increase – as it normally does during an expansion – then job growth would need to be even faster to bring down the unemployment rate. Unemployment is going to be sticky, and that has implications for monetary policy.

1 All growth rates are annualized unless otherwise noted. Forecasts in this Update are from The Livingston Survey, Federal Reserve Bank of Philadelphia, December 12, 2012 unless otherwise noted.


Turning to labor market performance in the fourth quarter, we see continued slow growth in jobs along with a lower (unadjusted) unemployment rate (Figure 3). Payroll employment rose by 453,000 in Q4 while jobs measured by the household survey rose by 331,000. Those numbers are fairly close to the 120,000 jobs per month (360,000 per quarter) that need to be created to hold the unemployment rate steady assuming no change in the labor participation rate. More positively, wages accelerated in the closing months of 2012, pushing average hourly earnings up from a low of 1.6% YoY in October to 2.1% in December. Hours worked edged up as well. We expect continued gradual improvement in both employment and wages in 2013.

This combination of job gains, somewhat faster wage growth and higher hours worked should drive further gains in personal income in Q4. Through November, nominal personal income was up 4.1% YoY, and December’s data should look even better (Figure 4). This is a welcome development given higher taxes that went into effect on January 1, 2013. Those taxes include expiration of the 2% social security tax “holiday” that was in effect for 2011 and 2012, higher marginal tax rates and limitations on deductions for upper-income individuals, and new taxes on investment income to fund “ObamaCare.” They will cause a sharp decline in disposable income growth in 1Q2013, although the impact on spending will probably be less.

Figure 4: Income Rising; Spending Subdued Figure 5: Confidence Improving but Fragile Personal Income, Consumption and Savings

Personal Income Account, Overall, Total, Current Prices, USD [c.o.p 12 months] Personal Outlays (PCE), Overall, Total, Current Prices, AR, SA, USD [c.o.p 12 months] Personal Saving, Rate


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United States, Consumer Surveys, Index

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Personal consumption expenditures remained subdued in Q4. Nominal PCE was up 3.5% YoY through November, trailing income gains (Figure 4). Real PCE was up 1.6% in the three-months ending in November, matching the sluggish Q3 pace, but strong December retail sales data suggests Q4 should be a bit better than Q3. The savings rate edged up to 3.6% but is likely to dip for several quarters in response to higher payroll and income taxes. We continue to expect only modest gains in income and consumption in 2013. Consumer confidence remains fragile (Figure 5), personal tax burdens are increasing, and households are deleveraging. All of this is likely to restrain PCE growth, especially early in the year as households adjust to higher taxes.

In contrast to the mostly tepid data on income and consumption, the housing market is – dare we say it? – booming. Home sales, housing starts and building permits are rising rapidly, up 14-27% over the past year. New and existing home sales exceeded 5.4 million units (annualized) in


November, and still-high affordability combined with rising employment should further boost sales (Figure 6). In addition, inventories of unsold homes and homeowner vacancy rates are declining. Although construction of new homes is increasing, it remains well below long-term demand for housing (household formation plus home replacement due to obsolescence or loss such as fire or flood). As a result, existing home supply should continue to be absorbed, which should drive both residential investment and home prices higher. Home prices began rising earlier in 2012 (Figure 7), and we anticipate modest but durable increases in home prices over the next few years. In turn, higher home prices should drive further improvement in mortgage loan performance, which is good news for banks and preferred investors. Higher prices should bolster household wealth and, perhaps, consumption. However, at just 2.7% of GDP, even rapid growth in residential investment would make only modest contributions to overall GDP.

Figure 6: Home Sales Up, Inventory Down Figure 7: Home Prices Rising Slowly New & Existing Home Sales, Inventories and Affordability

New + Existing Home Sales, AR, SA New + Existing Homes for Sale, AR, SA United States, Consumer Surveys, National, Housing Affordability Index, composite, Index


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Figure 8: Shipments and Orders Recovering… Figure 9: …but Capacity Not Constrained (3-mo moving average, annualized)

Real Nondefense Capital Goods ex Aircraft Orders and Shipments

New Orders, Nondefense capital goods excluding aircraft, Constant Prices, SA, USD . [ / Producer Prices, Capital equipment, manufacturing indShipments, Nondefense capital goods excluding aircraft, Constant Prices, SA, USD . [ / Producer Prices, Capital equipment, manufact


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United States, Capacity Utilization, Total index, SA [cop val 12 months] Private Fixed Investment, Nonresidential, Eq & sw, Constant Prices, AR, SA, USD, 2005 prices


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Business investment probably recovered in Q4 after slipping last quarter. Inflation-adjusted shipments of nondefense capital goods excluding aircraft rebounded modestly in the first two months of Q4, and orders also rose, suggesting higher levels of business investment for the quarter as a whole (Figure 8). We do not anticipate strong growth in investment, however, since capacity utilization has remained essentially flat in 2012 around 78.4%. That does not mean investment will be zero, but businesses tend to invest more aggressively when capacity utilization is increasing, which is not the case today (Figure 9).

Industrial production rose by just 1% in Q4 (Figure 10). Hurricane Sandy caused production disruptions that slowed output. Beyond the impact of Sandy, nonfarm inventories added 1.1% to Q3 real GDP growth, and producers responded to that inventory accumulation by trimming production. Slower inventory growth will almost certainly subtract from GDP growth in Q4, although it is difficult to put a sharp pencil on the amount. More positively, surveys from the Institute of Supply Management point to some recovery late in Q4 at manufacturers and strong growth at non-manufacturing companies (Figure 11). In each of these surveys, a reading over 50 signals above-trend growth.

Figure 10: Industrial Production Slowed Figure 11: Service Sector Signaling Strength Industrial Production & ISM Surveys

Production, Manufacturing total ex. motor vehicles and parts, Volume Index, SA [ar ma 3 months] Production, Overall, Total, Volume, 2007=100 [ar ma 3 months] Business Surveys, ISM Manufacturing, PMI total


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The trade deficit widened in October and November, making it likely that trade will be a drag on GDP growth in the fourth quarter. The real trade deficit ballooned to almost $52 billion in November, the worst result since 2008 (Figure 11). Production and port disruptions from Hurricane Sandy may have depressed exports in November, which would explain at least some deficit widening. If December’s deficit retraces half of its November widening, trade would subtract about ½ percent from Q4 GDP. Looking ahead, we expect trade will have little net impact on 2013 GDP growth overall (slightly positive in H1, negative in H2).


Figure 11: Trade Deteriorated in Q4 Figure 12: Inflation Remains Subdued United States, SA, USD

Real Trade Balance and Export & Import Growth

Trade Balance, Total, Goods, census basis, Constant Prices, 2005 prices Exports, Goods and services [c.o.p 12 months] Imports, Goods and services [c.o.p 12 months]


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Price Index, Personal Consumption Expenditure, Overall, Total, SA, 2005=100 [c.o.p 12 months] Price Index, PCE, Overall, PCE less food and energy, SA, Index, 2005=100 [c.o.p 12 months] All urban consumers, U.S. city average, Consumer Prices, All items, 1982-1984=100 [c.o.p 12 months] All urban consumers, U.S. city average, Consumer Prices, All items less food and energy, 1982-1984=100 [c.o.p 12 months]


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Government consumption probably fell again in the fourth quarter after rising by 3.9% in Q3. Government spending subtracted an average of 0.3% from real GDP in the first half of 2012, added 0.75% in Q3, and probably subtracted at least that much in Q4. Looking ahead in 2013, the trajectory of government consumption will depend upon resolution of the spending portion of the fiscal cliff. For now, the spending sequester that was scheduled to take effect on January 1 has been postponed until March 1. That leaves politicians about six weeks to work out a new spending agreement – possibly accompanied by additional tax revenues. If agreement cannot be reached, the sequester will take effect, and the near-term impact on GDP will be sizable. The Congressional Budget Office (CBO) estimates that the unresolved portion of the Budget Control Act of 2011 (i.e., sequester) would subtract about 1.25% from 2013 GDP growth if it is enacted as currently legislated.

Our political crystal ball has always been hazy, and it is particularly so today given the highly partisan nature of current politics in Washington. Although we felt confident that most tax increases embodied in the fiscal cliff would be avoided, we are much less certain about spending cuts. From an economic perspective, we would like to see (i) modest spending “cuts” over the near term to minimize drag on what is already a slow recovery, (ii) entitlement reform to slow the growth of spending on those programs and (iii) tax reform to enhance economic growth. (We put the word “cuts” in quotations because, except under sequester, government spending continues to increase under every budget proposal currently on the table in Washington. “Cuts” refer to slower growth in spending, not lower spending in absolute terms.) At this point, we have no clear idea how remaining fiscal cliff negotiations will turn out. However, it is clear that government spending will reduce GDP growth in 2013; we assume the drag will be somewhat less than 1.25% (CBO estimate under sequester) but greater than zero. We should have a better sense of where government spending is headed by the time of our April Update.

Inflation pressures eased over the course of 2012 as energy prices ended the year about where they began. The consumer price index (CPI) was up 1.7% overall and 1.9% excluding food and energy in 2012 (Figure 12). The PCE deflator was up 1.2% overall and 1.5% excluding food and energy over 12 months ending in November (the latest available data). Inflationary and


deflationary pressures appear balanced over the near term. However, the Federal Reserve’s highly accommodative monetary policy raises longer-term inflationary risks.

Figure 13: Deleveraging Accelerated Slightly, but Major Balance Sheet Trends Intact

United States, Flow of Funds Debt Outstanding, SA, USDDebt to GDP: Total, Financial, Household, Business, Federal

Total Debt Outstanding / Nominal Gross Domestic Product Domestic nonfinancial sectors, nonfederal, households total debt / Nominal Gross Domestic Product Domestic financial sectors total debt / Nominal Gross Domestic Product Domestic nonfinancial sectors, federal government total debt / Nominal Gross Domestic Product Domestic nonfinancial sectors, nonfederal,nonfinancial business total debt / Nominal GDP


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We will conclude this section, as usual, with a look at broad balance sheet trends in the US (Figure 13). Deleveraging in the private sector accelerated slightly in the third quarter (the latest data available), possibly in response to uncertainty over the November elections and looming fiscal cliff. Households and financial firms continue to pare debt rapidly as a proportion of GDP. Most of the decline in debt is in mortgages; credit card debt is about flat, while student and auto lending is increasing. Nonfinancial businesses borrowing edged slightly lower in Q3 but has held roughly steady since late 2010. Given good profitability, low interest rates, strong balance sheets, and ample liquidity, businesses have plenty of room to boost borrowing and investment if and when business confidence improves. Government borrowing continued to rise, albeit at a slower pace than in recent quarters. The current account deficit necessarily shrunk to 2.7% of GDP to accommodate these stronger domestic savings flows. We expect economic growth to remain subdued during this period of deleveraging, which is likely to continue for some time to come.

Market Outlook

Long-term Treasury rates rose in the fourth quarter as US economic growth plodded along and European sovereign debt woes eased (Figure 14). The 30-year benchmark Treasury bond rose by 13 basis points (bp) to end Q4 at 2.95%, and it has risen a further 7 bp to 3.02% as of the date of this report. The Federal Reserve left the federal funds rate unchanged at 0.25%.

The Fed made several important changes to monetary policy in the fourth quarter. First, it expanded its third round of quantitative easing (QE3) to include purchases of US Treasury securities. Recall that the Federal Open Market Committee (FOMC) introduced QE3 at its September 2012 meeting with $40 billion per month of unsterilized purchases of agency mortgage-backed securities. It expanded the securities purchase program at its December meeting to include $45 billion per month of longer-term (4-year and longer) Treasuries. These outright


purchases of Treasuries replaced the Fed’s maturity extension program that concluded at the end of December 2012. The difference between “Operation Twist” and QE3 is that the former did not change reserves and base money (it substituted one maturity Treasury issue for another on the Fed’s balance sheet), while the latter expands them.

Figure 14: Treasury Rates Up, Fed Funds Stable Figure 15: Credit Spreads Tighter United States,Benchmark Interest Rates, USD

Government Benchmarks, Bid, 30 Year, Yield, Close Government Benchmarks, Bid, 10 Year, Yield, Close Policy Rates, Fed Funds Target Rate


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Moody's Baa-Rated Long-Term, Yield Spred to 30-yr Treasury, Close Merrill Lynch, High Yield Master Index, Yield Spread to 10-year Treasury, Yield to Worst


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The second important change is the Fed’s communication of its interest rate policy expectations. Previously, the FOMC provided time-based guidance for the fed funds rate. For example, the September 2012 FOMC statement reads “[the Committee] currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” In December, the FOMC switched to principle-based guidance: “[the Committee] currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.” Under the new regime, it is the unemployment rate (>6.5%), inflation (<2.5%), and inflation expectations (“well anchored” – fuzzy but probably recognizable) that matter. Although the FOMC stressed that given current expectations, the old time-based guidance and new principle-based guidance were broadly consistent (i.e., the Fed still feels rates will stay low through mid-2015 or later), the new formulation gives market participants a better sense of the Fed’s reaction function. That may lead to more variable assessments of when the Fed will begin to raise the fed funds rate, but they will be based on observable data rather than on the market’s interpretation of how the Fed views that data. We think it’s a good change. We will discuss its implications for markets at the end of this section.

Credit spreads tightened in the fourth quarter and have continued to edge tighter in January. Long-term Baa-rated corporate bond spreads narrowed by 22 bp in Q4, more than offsetting the rise in long-term Treasury rates. High yield spreads tightened by 56 bp, easily eclipsing the 13 bp rise in 10-year Treasury rates. Preferred securities also performed well, with various preferred indices posting pre-tax returns ranging from +0.7% to +3.3% in Q4.


Tighter credit spreads were supported by strong and, often, improving credit fundamentals. Corporate profits as a share of GDP remain near record highs (Figure 16).2 Solid earnings and modest capital investment have helped companies strengthen their balance sheets. Interest expense as a percentage of earnings before interest and taxes remains low; long-term debt to total debt is at a record high; and liquidity remains strong (Figure 17). Loan delinquency and charge-off rates are declining across all major loan categories (Figure 18). Finally, household debt burdens continue to decline, especially for homeowners (Figure 19). All of this is good news for credit instruments such as preferred securities.

Figure 16: Corporate Profits Near Record High Figure 17: Balance Sheets Strong Corporate Profits (w IVA & CCAdj) as Share of GDP

Corporate Profits, With IVA and CCAdj, Total before tax, Percent of GDP, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, Total, Curren Corporate Profits, With IVA and CCAdj, Total before tax, Percent of GDP, Post-WWII Average, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, To Corporate Profits, With IVA and CCAdj, Profits after tax total, Percent of GDP, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, Total, Current Price Corporate Profits, With IVA and CCAdj, Profits after tax total,Percent of GDP, Post-WWII Average, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, Tot


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Figure 18: Loan Quality Improving Figure 19: Household Debt Burdens Declining Bank Commercial & Consumer Loan Delinquency & Charge-Off Rates, SA

Delinquency rates, all banks, commercial and industrial loans Charge-Off Rates, all banks, commercial and industrial loans, AR Delinquency rates, all banks, Real estate loans, commercial Charge-Off Rates, all banks, real estate loans, commercial, AR Delinquency rates, all banks, consumer loans, all Charge-Off Rates, all banks, consumer loans, all, AR


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2 Although the corporate profit share of GDP could move higher, history suggests it is more likely to move sideways or decline, especially as the unemployment rate falls (prompting higher wages). If so, corporate earnings would grow no faster than nominal GDP, which might be disappointing to common equity investors.


We anticipate some further tightening of credit spreads in 2013 for the same reasons as last year: slow but steady economic growth in the US, low rates on alternative investments, accommodative monetary policy, and sound credit fundamentals. At current spreads, however, there is less room for tightening than there was when spreads were wider. Investors should calibrate their expectations accordingly.

Although credit fundamentals are currently sound, there are some developing trends that could become worrisome if they run too far. First, the corporate “financing gap,” internally generated cash less capital expenditures, is moving from negative (i.e., internal cash greater than investments) toward positive, and net corporate borrowing in the bond market is increasing (Figure 20). So far, most of this additional borrowing has gone toward balance sheet strengthening: raising long-term debt as a proportion of total debt, and improving liquidity. It has not contributed to greater leverage in aggregate – though there are certainly examples of companies that have increased leverage substantially. Moreover, a positive financing gap is normal. Companies typically do not generate enough cash (net of taxes and dividend distributions) to cover all of their investment requirements. Savings from US households and foreign entities provide funds for those investments. We think the trend in the financing gap is consistent with a gradual return to more normal economic activity.

Figure 20: Financing Gap Normalizing Figure 21: Fed’s Net Balance Sheet Expanding Nonfinancial Corporate Borrowing: Financing Gap & Corporate Bonds

Flow of Funds Instruments, Corporate and Foreign Bonds, Net issues, nonfinancial corporate business Flow of Funds Sectors, Nonfarm Nonfinancial Corporate Business, Memo: Financing gap


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Second, bank credit is growing again. It is up 5.1% YoY, about 1% faster than nominal GDP growth. The Fed’s balance sheet is expanding too. This is no surprise given QE3, but what is different from earlier quantitative easing programs is the behavior of excess reserves. After the immediate rush of liquidity provided by the Fed during the financial crisis, the Fed’s net balance sheet (total assets minus excess reserves, shown in red) was little changed at about $1.3 trilion (Figure 21). That meant that when the Fed injected liquidity into the banking system, it essentially came right back to the Fed as excess reserves. That began changing in 2011, and the Fed’s net balance sheet has expanded gradually to $1.46 trillion today. This means that some of the Fed’s quantitative easing is working its way into the economy. It’s far from dollar-for-dollar (monetary velocity is still falling), and the pace of loan expansion is not alarming. It is, however, another sign of normalization.


The problem is that interest rates are not normal. They have been suppressed by the Federal Reserve’s low short-term rate policy and large-scale asset purchases. The Fed is now purchasing long-term Treasuries equal to roughly two-thirds of long-term Treasury issuance. Mortgage purchases are on top of that! That still leaves investors to buy approximately $250 billion (annualized) in Treasury debt – more than the entire 2007 federal government deficit – but it is clear that when the Fed stops buying, private investors are going to have to absorb a lot more bonds. Higher interest rates likely will be required to attract those investors.

Of course, the difficult part for investors in preferred securities is identifying when tailwinds from sluggish (but not too sluggish) economic growth, shrinking preferred supply and improving credit fundamentals start to be overtaken by headwinds from faster economic growth, rising need for capital, and higher interest rates. Have we reached that point? Are preferred securities’ prices a bubble about to burst?

Our answer today is “no,” but that will not be the case forever. We think current preferred prices are more a reflection of tepid economic and good credit conditions than artificially-low Treasury rates engineered by the Fed. For now, there is still substantial excess economic capacity (in the US and globally) that should keep inflation and interest rates low. Unemployment remains high, although it is trending lower. Capacity utilization rates have stalled out but are well off their lows. Office vacancy rates remain elevated, but housing inventory is falling. US assets are still attractive to foreign investors seeking liquidity and relative safety, but if our government cannot get its fiscal house in order, investment inflows could turn to outflows. Private sector deleveraging is pushing up savings and dampening demand for debt, but eventually that too will subside, as we already have seen in the nonfinancial corporate sector.

More importantly, the Fed’s answer today is emphatically “No!” The Fed’s new monetary policy targets of 6.5% unemployment subject to inflation below 2.5% will certainly not be reached in 2013 and probably not in 2014 – maybe not even in 2015 if political leaders make a mess of things in Washington. And even if the economy shrugs off higher taxes and job growth quickens, it is likely that labor participation will increase and slow any decline in the unemployment rate. The Fed is going to keep the fed funds rate near zero for a long time, and it rarely pays to fight the Fed. What happens to QE3 is a tougher call, and December’s FOMC meeting minutes indicate there is more debate at the Fed about its appropriate end-date than we previously expected. Nonetheless, we think the Fed perceives the risk of being too early in withdrawing monetary accommodation is greater than the risk of being too late. If so, the Fed should act to keep interest rates low throughout 2013.

Unwinding the Fed’s current monetary experiment is likely to be messy and unpredictable. We cannot promise we will get it all right. In fact, we can promise that we will not get it all right. What we will do is follow our credits diligently, seek value, and be faithful students of the preferred market and stewards of your assets. As befits this time of year, we wish you a healthy and prosperous 2013 and thank you for your trust in us.

Flaherty & Crumrine Incorporated January 16, 2013


© 2013, Flaherty & Crumrine Incorporated. All rights reserved. This commentary contains forward-looking statements. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast; the opinions stated here are subject to change at any time and are the opinion of Flaherty & Crumrine Incorporated. Further, this document is for personal use only and is not intended to be investment advice. Any copying, republication or redistribution in whole or in part is expressly prohibited without written prior consent. The information contained herein has been obtained from sources believed to be reliable, but Flaherty & Crumrine Incorporated does not represent or warrant that it is accurate or complete. The views expressed herein are those of Flaherty & Crumrine Incorporated and are subject to change without notice. The securities or financial instruments discussed in this report may not be suitable for all investors. No offer or solicitation to buy or sell securities is being made by Flaherty & Crumrine Incorporated.

fourth-quarter us economic update january 2013

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