us economic outlook bowed but not broken

7/29/2019 Us Economic Outlook Bowed but Not Broken

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04 May 2012 Page 1 of 27

04 May 2012

North America U.S.Economics

[email protected]

effrey S. Rosen, Ph.D.Chief [email protected]

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U.S. Economic Outlook: Bowed but Not Broken

Weaker inventory growth and a slight pullback in durable goods consumption are expected to cause adeceleration in GDP growth in the second quarter. Real final sales, however, will be boosted by anatural pickup in investment spending as the negative effects of the accelerated depreciation tax creditwane.

Recent developments, including a deceleration in payroll growth and a slight pullback in homeconstruction, combined with long-run uncertainties from Europe and the U.S. fiscal cliff that willappear in January 2013 have raised alarms and have caused many economists to return to theirpessimistic views.

The structural problems that hindered growth over the past few years, however, started to abate inthe first quarter and have not been disrupted by the softening economic numbers. Therefore, wecontinue to think overall growth rates can exceed expectations.

Consumption will hinge on how confident consumers are in the stability of the economic recovery.Normally, we view sentiment readings as a nonfactor in consumption growth and rely solely onincome gains. In this case, however, the expectations indices are the only source of data that explainshow consumers feel about future economic conditions and how they may respond if income growthsoftens for another quarter.

Businesses are still in a prime position to focus on investment spending. With a glut of savingsearning low returns, investment returns do not need to be that high to prompt a shift from savings toinvesting.

Quarterly conference call on the economy: Tuesday, May 15, at 2:00 p.m. ET. Register here.Disclaimer:

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Copyright 2012 Briefing.com, Inc. All rights reserved. The Investorside Research Association certifies its members have no investment banking conflicts.
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North AmericaU.S. Economics

04 May 2012 www.BriefingResearch.com Page 2 of 27

Table of Contents

Forecast Assumptions ................................................................................................................................................................................................ 3

Economic Overview ................................................................................................................................................................................................... 5

Personal Consumption Expenditures .......................................................................................................................................................... 8

Nonresidential InvestmentEquipment and Software .......................................................................................................................... 11

Nonresidential InvestmentStructures .................................................................................................................................................... 12

Residential In vestment ................................................................................................................................................................................ 14

Inventory Investment .............. ............... .............. ............... ............... ............... ............... ............... ............... ............... ............... ............... . 16

Net Exports ................................................................................................................................................................................................... 17

Government Spending .............. ............... ............... ............... ............... ............... .............. ............... ................ .............. ............... .............. 19

Business Activity Indicators..................................................................................................................................................................................... 21

Employment Situation ................................................................................................................................................................................. 21

Inflation .......................................................................................................................................................................................................... 23

Monetary Policy ............................................................................................................................................................................................ 25


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Forecast Assumptions

Sequestration: The failure of the so-called Super Committee to reach an agreement on cutting debt

triggered an automatic $1.2 tln reduction in government spending from 2013 to 2021, split betweendefense and nondefense sectors. Estimates from the Congressional Budget Office on governmentoutlays due to the sequestration for 2013 are used in our model.

Bush Tax Cuts: The Bush-era tax cuts are set to expire at the end of 2012. The economy is fragile andfailure to do anything could send the U.S. back to recession. With the assumption that tax cuts areextended, it will not make a difference economically if legislative action that extends tax cuts is delayed toearly 2013 so long as people believe that the retroactive action will occur.

Stable Short-term Interest Rates: The Federal Reserve announced that economic conditions are likely

to warrant an exceptionally low level for the fed funds rate through at least late 2014.Operation Twist: The Fed is driving a Treasury curve flattening by selling short-term securities andbuying long-term bonds. Rates on the 10-year Note have fallen below 2.00%. With no movement inshort-term rates expected for another two years, the 10-year Treasury rate should remain low through2013.

Slight Uptick in Commodity Prices: Crude prices will continue to inch higher as the U.S. recoverycontinues to expand. Demand from Asia will offset weakness in Europe. Other commodities, includingprecious metals, industrial metals, and foodstuffs will keep pace.

Equity Market: Fundamental factorscontinued earnings growth, low inflation, and low interest ratesprovide a reasonable basis to conclude the equity market has good potential to achieve a double-digitpercentage gain in 2012 barring an unforeseen shock.

Weaker Home Prices: While the rate of foreclosures should decelerate as the economy picks up in2012, the number of real estate owned (REO) properties will continue to expand and will add inventoryto an already overstocked housing market. Home prices, therefore, are likely to suffer downwardpressure through 2012.


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FORECASTQ4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13 2010 2011 2012 2013

Real GDP and Components (Quarter-over-Quarter Annualized, Unless Noted) (Year-over-Year)

GDP 3.0 2.2 1.4 2.2 2.5 2.2 2.1 2.0 3.0 1.7 2.1 2.2

Personal Consumption 2.1 2.9 1.9 2.4 2.4 2.5 2.4 2.6 2.0 2.2 2.2 2.4

Fixed Investment 6.3 1.4 12.2 9.0 7.2 7.7 5.9 6.3 2.6 6.8 7.5 7.5Inventory Investment* 52 70 29 25 30 22 23 20 59 35 38 20

Net Exports* -412 -411 -407 -412 -413 -416 -421 -425 -422 -414 -409 -421

Exports 2.7 5.4 1.8 2.6 3.5 3.0 3.0 3.0 11.3 6.7 3.5 2.9

Imports 3.7 4.3 0.4 3.0 3.2 3.0 3.2 3.3 12.6 4.9 2.6 3.0

Government Spending -4.2 -3.0 -1.2 -1.7 -1.0 -1.0 -1.7 -1.7 0.7 -2.1 -2.1 -1.4

Business Activity (Quarterly Average, Unless Noted) (Yearly Average)

Housing Starts (000s) 670 687 675 690 690 700 700 700 585 610 686 703

Vehicle Sales (mln units) 13.4 14.5 14.4 14.4 14.3 14.7 14.9 15.1 11.6 12.7 14.4 15.0

Industrial Production** 1.2 1.3 0.7 1.5 0.6 0.6 -0.2 0.0 5.4 4.1 4.5 1.6

Capacity Utilization 77.8 78.7 78.7 79.0 79.1 79.1 79.2 79.3 73.7 76.8 78.9 79.2

Unemployment Rate 8.7 8.2 8.1 8.1 8.1 7.9 8.0 7.8 9.6 8.9 8.2 7.8Prices (Year-over-Year, Unless Noted) (Year-over-Year)

GDP Deflator 2.1 1.9 1.8 1.6 2.0 2.1 2.2 2.2 1.2 2.1 1.8 2.2

CPI Headline 3.3 2.8 2.5 2.2 2.8 2.7 2.8 2.8 1.6 3.1 2.6 2.7

CPI Core 2.2 2.2 2.0 2.1 2.2 2.3 2.5 2.3 1.0 1.7 2.1 2.4

PCECore 1.8 1.9 1.9 1.7 1.8 1.8 1.7 1.9 1.4 1.4 1.9 1.8

PPI Headline 5.5 3.4 3.0 3.4 3.0 2.9 2.7 3.5 4.2 6.0 3.2 3.5

Crude Oil ($/bl)*** 94.2 102.9 102.7 100.0 102.0 105.0 109.0 113.0 79.5 95.1 101.9 110.8

Trade-Weighted FX 1.7 1.2 2.2 3.6 4.6 3.1 7.4 3.5 -4.9 -4.3 2.9 4.0

Interest Rates (Quarterly Average) (Yearly Average)

Fed Funds Rate 0.08 0.10 0.19 0.18 0.12 0.12 0.12 0.12 0.18 0.10 0.15 0.12

3-Month Treasury 0.01 0.07 0.16 0.15 0.15 0.20 0.22 0.24 0.14 0.05 0.13 0.22

10-Year Treasury 2.04 2.03 2.10 2.20 2.20 2.20 2.30 2.30 3.22 2.78 2.13 2.28

Real Income (Quarter-over-Quarter Annualized, Unless Noted) (Year-over-Year)

Disposable Income 1.7 0.4 1.5 0.9 2.8 1.0 0.7 0.9 1.8 1.3 1.1 1.4

Consumer Credit 3.3 4.2 0.5 1.2 0.6 0.6 0.6 0.6 -5.4 -1.1 2.0 0.7

Household Net Worth** 1.8 3.5 -0.3 -0.2 0.9 2.5 2.8 1.9 5.4 1.3 2.0 6.3

* Billions of chained (2005) dollars** Percent change quarterly (yearly) rate*** Quarterly (yearly) average


5/27



Economic Overview

Recent developments, including a deceleration in payroll growth and a slightpullback in home construction, combined with long-run uncertainties fromEurope and the U.S. fiscal cliff that will appear in January 2013 have raised

alarms and have caused many economists to return to their pessimistic

views.

The structural problems that hindered growth over the past few years,however, started to abate in the first quarter and have not been disrupted by

the softening economic numbers. Therefore, we continue to think overall

growth rates can exceed expectations.

Monetary policy remains extremely accommodative. Businesses could takeadvantage of the potentially stronger consumption rates with increased

capital spending.

In our last U.S. Economic Outlook, Growth Prospects, Full Speed Ahead, wepointed out that the structural problems that have faced the economy since thestart of the recessionincluding higher unemployment, elevated debt, and weakhousing demand were beginning to abate. This led us to believe that U.S.growth prospects in 2012 could easily exceed the modest expectations of 2.0%

growth that many economists projected at the beginning of the year.For the first two months of 2012, the economy looked to be following thattrack.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

GDP Growth

(q/q % annualized)

history forecast

Source: BEA, Briefing Research

-2%

-1%

0%

1%

2%

3%

Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13

Contribution to GDP Growth

(percentage points)GDP PCE EquipmentStructures Inventories ResidentialImports Exports Government

Source: Briefing Research


6/27



Businesses added more than 200,000 jobs each month.

Motor vehicle sales surpassed 15.0 mln SAAR for the first time since the

Cash for Clunkers tax rebate inflated sales levels.

Both housing starts and sales showed renewed strength.

Growth was not only poised to exceed expectations but was on pace to exceedpotential for a second consecutive quarter for the first time since the first andsecond quarters of 2010.

The data suddenly weakened in March, however, and renewed fears that growthcould mirror the lackluster performance seen in the spring and summer of 2011.

Payrolls barely topped normal labor force growth and aggregate wages

softened.Housing starts and sales reversed directions, striking fear that the gains in

January and February were the result of temperate weather conditions

and not newfound demand.

Manufacturing production contracted for the first time since November

2011.

On top of the sudden slowdown in the hard data, the long-term economicoutlook became a bit murkier.

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

2009 2010 2011 2012

Aggregate Wages

(m/m)

Source: BLS

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Manufacturing Production

(m/m)

Source: Federal Reserve


7/27



Ten European countries (and counting) are currently in a recession.

Many of these countries are advocating for more austerity, which will

likely deepen their respective recessions. This will cut into potential U.S.

exports and feed concerns about earnings prospects that could weigh onthe equity market.

The U.S. is set to experience a severe fiscal contractionon par with a

3% - 5% decline in GDPif Congress does not extend the Bush-era tax

cuts, payroll tax cuts, and/or eliminate the automatic sequestration.

Without a compromise in Congress, the U.S. faces a strong chance of

falling back into a recession in 2013.

With all of these potential problems, it is no wonder that economic pessimism

has returned.We do not think the economic situation has changed enough to warrant suchpessimism.

Everything we highlighted in our prior outlook, which discussed the potentialfor stronger-than-expected growth, remains intact.

The only real change since that report was published is that the possiblenegative outcomes have become more pronounced than before. Still, we feelthe upside potential for the U.S. economy remains greater than the downside

risk.

0 1 2 3 4 5 6

Netherlands

Spain

United Kingdom

Denmark

Ireland

Italy

Czech Republic

Greece

Slovenia

Portugal

Consecutive Quarters of Negative Real GDP

Growth

Source: OECD


8/27



Personal Consumption Expenditures

Consumption growth is expected to be a leader in economic growththroughout the forecast.

Growth in the first quarter hinged on consumers dipping into savings tosupport consumption. Another quarter of weak income growth, however,

could cause consumers to pull back on spending.

For the second consecutive quarter, consumption growth hinged on pent updemand for durable goods. Spending in this sector grew by 15.3% in Q1 2012after increasing 16.1% in Q4 2011.

The difference between the two quarters is where consumers received the funds

that fueled the spending growth. In Q4 2011, real income levels increased2.1%, which was nearly equal to total real consumption growth that quarter. Inthe first quarter, real income growth slowed to 1.2%. That was not enough tosupport a 2.9% increase in consumption.

In order for overall consumption spending to rise 2.9%, consumers dipped intotheir savings and pushed the personal savings rate from 4.5% in the fourthquarter to 3.9% in the first quarter. That was the first time the savings ratedipped below 4.0% since Q4 2007.

Dipping into savings is normally viewed as a good response to the recovery.Consumers try to smooth their consumption levels over time. The usage ofsavings signals that consumers believe income growth will pick up in the nearfuture and allow them to replenish their savings with stronger future incomegains.

The household financial debt obligations ratio, which is the percentage ofdisposable income required to meet minimum monthly debt payments, reached

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Personal Consumption Expenditures Growth

(q/q % annualized)

history forecast


-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Real Disposable Income

(q/q % annualized)

History Forecast



9/27



its lowest level since 1984. Consumers have more money in their pocket, and,more importantly, have the ability and the means to take on more debt.

That was an added incentive for consumers to smooth their consumption levels

in the face of weak income growth. It was also one of the reasons why wesuspected that personal consumption growth could exceed expectations.

Looking at the second quarter, however, consumption growth will most likelyslow.

While all durable sectors showed strong growth, motor vehicles and partsspending, which had languished during the recession and most of the recovery,provided the bulk of the gain with a 28.7% increase. Motor vehicle demandshould remain elevated in the second quarter, but levels most likely will dip.

The rest of consumption will be reliant upon how confident consumers are inthe stability of the economic recovery.

As long as the perception remains that future income growth will be enough tosubsidize current consumption, consumption growth should continue to expandin the face of another quarter of soft income gains.

The converse, however, is also true. If future income growth is expected totrend lower, consumers will hold back on spending and keep savings elevated.

Normally, we view sentiment readings as a nonfactor in consumption growth

and rely solely on income gains. In this case, however, the expectations indicesare the only source of data that explains how consumers feel about futureeconomic conditions and how they may respond if income growth softens foranother quarter.

Unfortunately, the indices point in different directions.

The initial claims level reversed directions and turned higher in April, which is apotential sign that the recovery may be softening. The participants in the

15.0%

15.5%

16.0%

16.5%

17.0%

17.5%

18.0%

18.5%

19.0%

19.5%

1980 1985 1990 1995 2000 2005 2010

Financial Obligations Ratio

Source: FactSet

0%

1%

2%

3%

4%

5%

6%

7%

2006 2007 2008 2009 2010 2011 2012

Personal Savings Rate

Source: BEA


10/27



University of Michigan Consumer Sentiment Survey discounted the long-termimpact of the rise in claims and showed stronger positive future expectations.On the other hand, the Conference Boards Consumer Confidence Surveyshowed a notable pullback in long-term expectations.

If the Consumer Sentiment Survey is the more accurate gauge of consumerattitudes about the recovery, then another quarter of weak income levels willlikely not have a bearing on consumption. If the Consumer Confidence Surveyis the correct gauge, consumption levels most likely will underperformexpectations.

Risks to Personal Consumption Forecast

A disorderly default in Europe could cause banks in the U.S. to tightencredit standards and choke off a potential increase in consumer demand.

Businesses may launch another round of layoffs if demand does not meetinitial 2012 expectations. Consumers would again worry about job security

and revert to higher savings rates.

The government sector makes up nearly 17% of total nonfarm payrolls.There may be significant payroll losses that could have detrimental effects

on our longer-term consumption expectations if numerous government

programs are slashed in the next round of deficit reduction negotiations.

0

20

40

60

80

100

120

2009 2010 2011 2012

Consumer Expectations

Sentiment Confidence

Source: FactSet


11/27



Nonresidential Investment Equipment and Software

Most sales forecasts assume a constrained consumer with limited demandgrowth. There is little reason, from a companys point of view, to speed upthe transition from replacement of obsolete equipment to expansion until

the economic recovery gains more traction.

Business balance sheets are showing near record cash surpluses. Given thelow returns on business savingsespecially considering the Fed does not

expect to increase the fed funds rate until at least late 2014it would not

take a sizable shift in demand to justify large capital projects.

Nonresidential investment in equipment and software in the first quarter was

disappointing, increasing by the smallest amount (1.7%) since Q2 2009. Thelackluster gain, however, was most likely the result of timing issues rather thanthe start of a new low-growth trend.

Congress passed an accelerated depreciation tax credit in 2011 that expired lastDecember. That action likely caused businesses to pull forward investmentpurchases that normally would have been made in Q1 2012 into Q4 2011.Investment spending most likely will return to normal in the second quarter andgrowth in the neighborhood of 15% is likely.

There is room for upward potential in that forecast too.

Even as profit growth has slowed, business balance sheets continue to show aglut of savings. Since interest rates are at all-time lows, the return on savings isextremely low. Alternatively, the costs for investment are also low.

The return on investment does not have to be very high to justify a shift toinvestment spending from savings.

When businesses decide to make the shift is unknown.

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Equipment and Software Growth

(q/q % annualized)

history forecast


-$400

-$200

0

$200

$400

$600

$800

2000 2002 2004 2006 2008 2010

Domestic Business Balance Sheet

Gross Savings minus Gross Investment

(blns)

Source: FactSet


12/27



Businesses still face considerable uncertainty about future demand that makes itdifficult for companies to start an investment cycle.

In the U.S. fiscal headwinds from a sharp drop in government spending and the

potential for severe tax increases could have a detrimental effect on disposableincome levels and cut deep into demand growth.

At the same time, new regulations stemming from Dodd-Frank, the AffordableCare Act, and the EPA make it difficult for firms to know the true cost of doingbusiness.

Separately, export-centric firms that do businesses with Europe have to dealwith multiple recessions there and the possibility of more demand loss fromfurther austerity.

Until the tax and regulatory situation in the U.S. is made clearer and Europemakes progress in fighting recessions, businesses may be content to hold casheven though the returns are extremely low.

Risks to the Forecast for Investment in Equipment and Software

Stronger (weaker) than expected consumption will have an outsized positive(negative) effect on investment.

Nonresidential Investment Structures

Nonresidential construction has suffered from an excess supply ofcommercial, office, and other structures.

Instead of following oil prices higher, mining construction has turned downthe last two quarters. Mining may be following weaker natural gas prices.

Our outlook for investment in nonresidential structures has not changed overthe previous few quarters.

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Nonresidential Structures Growth

(q/q % annualized)

history forecast


0 10 20 30

Interest Rates

Cost of Labor

Other

Quality of Labor

Insurance Costs

Competition from Large

Inflation

Government Regulations

Taxes

Poor Sales

Single Most Important Problem Facing Small

Businesses

Source: NIFB Small Business Economic Trends


13/27



Growth in the sector is split between mining construction and normalnonresidential buildings.

Mining development has been the predominant growth factor as high energy

prices have led to an expansion in oil and gas exploration. The correlationbetween oil prices and structures spending was extremely close-knit.

That correlation, however, broke down over the last two quarters as higher oilprices failed to bring about an increase in mining investment. Instead, mininginvestment growth is becoming more reliant upon natural gas prices.Unfortunately for investment, natural gas prices are at historic lows. Eventhough the cost for undertaking an investment project is at historic lows, thereturns specifically to the mining sector may still not be enough to justify newconstruction growth.

The supply of normal nonresidential structures remains abundant. There islittle reason for builders to boost construction significantly in these areas overthe next few years.

As a result, construction spending growth will be predicated on higher energyprices.

Risks to the Nonresidential Investment in Structures Forecast

Given the strong correlations between mining construction and natural gasprices recently, volatility (up or down) in natural gas prices could cause big

shifts in construction growth.

Relief in the commercial real estate securitization markets would increase theamount of potential buyers in the marketplace and have a gradual, positive

effect on prices.

0

50

100

150

200

250

300

2005 2007 2009 2011

Mining Construction and Energy Prices

(indexed; 2005 = 100)

Mining Oil Natural Gas

Source: BEA, FactSet


14/27



Residential Investment

Inventories of new homes have stabilized and demand expectations haveimproved. For the first time since the peak in residential construction in2005, there is a clear trend developing that suggests builders will be better

off producing more homes in the coming year.

Residential investment has the potential to be the most important sector foreconomic growth in 2012.

In the immediate term, it is unclear if the drop in starts in March was the resultof a payback period following temperate weather conditions in January andFebruary.

Warmer-than-normal temperatures may have caused builders to move upproduction to take advantage of the weather conditions. That could meananother month or two of weak housing starts and lackluster residentialinvestment growth before starts return to a normal production schedule.

The construction spending levels failed to confirm this theory.

Residential construction spending actually declined substantially in Februarybefore rebounding in March. This suggests that builders are being cautious onwhich luxuries to include in new homes and are keeping costs in check with

expected demand. Thus, starts can rise, but overall spending growth mayremain muted.

In the long term, our forecast for residential investment has not changed sincelast quarter.

A combination of modestly stronger sales coupled with a continued pullback inhome construction has brought inventory levels, especially in the single-familysector, down to a manageable level.

-5%

0%

5%

10%

15%

20%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Residential Investment Expenditures

(q/q % annualized)

History Forecast


0

100

200

300

400

500

600

700

800

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Housing Starts

('000s)

History Forecast

Source: FactSet, Briefing Research


15/27



At the same time, weak home prices coupled with low interest rates havebrought home affordability levels to their all-time high. Home sales should starttrending higher.

That means, for the first time in a long time, new home inventories may be toolow for demand expectations.

That should result in a spurt of homebuilding growth that lasts years, notmonths.

The question is how risk averse are builders going to be?

After suffering some of the largest losses from any economic sector, buildersmay not be willing to move ahead in a significant manner until they areabsolutely sure that demand is stable. Construction growth may remain deflated

relative to expected inventory/sales levels.There is also still a large supply of shadow inventorywith many held by banksas REOs in the marketplace. As banks liquidate their holdings, pricingpressures will remain to the downside.

Builders will have to compete against this low-priced distressed housing. Thatcould cause smaller profit margins.

80

90

100

110

120

130

140

150

160

170

2000 2002 2004 2006 2008 2010 2012

Home Affordability Index

(indexed; 1990 = 100, SA)

Source: FactSet

0

1

2

3

4

5

6

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Total Home Sales

(mlns of homes)

History Forecast

Source: FactSet, Briefing Research


16/27



Risks to Residential Investment Forecast

Homebuyers may shrink from the marketplace as there is no incentive totrade up for a new home if prices continue to trend lower.

New home inventories are at historic lows. There is a large shadowinventory of distressed properties that have not yet been repossessed or put

up for sale. With distressed properties still selling at a notable discount to

both existing and new homes, the gains in overall sales may not translate

into stronger new home sales unless prices decline. This could lead to

weaker production levels if homebuilders cannot meet those lower price

points.

Inventory Investment

Inventory levels will remain volatile, but the net contribution to 2012 and2013 GDP is expected to be only +0.02 and +0.15 percentage points,

respectively.

Historically, the contribution to GDP from inventory changes has averagedabout zero each quarter, but the variance is quite large. Therefore, on a quarter-to-quarter basis, the contribution to GDP is quite volatile as strong positive

contributions one quarter are followed with equally strong negativecontributions the next.

After a strong increase in inventories in Q4 2011, inventories failed to contractin Q1 2012. That means the 1.94 percentage point contribution to fourthquarter GDP has not yet been offset.

We suspect that inventories will contract in the second quarter and weigh downGDP growth.

-10

0

10

20

30

40

50

60

70

80

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Change in Inventories

(blns of chained (2005) dollars)

history forecast


0.50

0.51

0.52

0.53

0.54

0.55

0.560.57

0.58

0.59

0.60

2001 2003 2005 2007 2009 2011

Final Sales to Total Inventory Stock Ratio

history forecast



17/27



While we are confident that inventories will not have a large impact on 2012 or2013 GDP overall, it is possible that the quarterly inventory movements causewide variation in our quarterly forecasts.

Risks to Inventory Forecast Inventory growth is based upon steady growth in expected demand levels.

If businesses believe demand is going to be weaker, inventory growth may

deteriorate.

Net Exports

A stronger dollar, as a result of relatively stronger U.S. growth compared tothe rest of the developed world, will keep upward pressure on importdemand and weigh down GDP. Slowing growth in Europe will constrain

U.S. export growth.

The trade balance is expected to widen slightly over the coming quarters.The trade deficit flattened in the first quarter and growth may remain muted inthe near term.

On the export side, European countries are expected to struggle in 2012. Thatshould result in weaker demand for U.S. exports. European demand, however,

only makes up 22% of total U.S. exports. Even if Europe suffers a severecontraction, it will not have much of an effect on overall U.S. exports.

On the import side, elevated commodity prices, chiefly oil, will put upwardpressure on import growth. At the same time, however, a shift to lowerinventory levels will reduce pressure on imports of consumer goods.

In the long term, the big concern is how the dollar will react to the Europeandebt crisis.

1700

1800

1900

2000

2100

2200

2300

2400

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Net Exports

(mlns of chained (2005) dollars)

Exports Import


76

78

80

82

84

86

88

90

92

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Real Trade-Weighted Broad Foreign

Exchange Index

history forecast

Source: Fed, Briefing Research


18/27



In real terms, the Feds broad trade-weighted dollar index has deterioratedslightly from December 2011 and has increased only 4.3% since reaching an all-time low in July 2011. The index remains 4.4% below its level from December2007 at the start of the recession.

The dollar has room to appreciate over the next few months, especiallyconsidering the U.S. economy is expected to outperform most developedcountries, even when using a pessimistic U.S. viewpoint as the source of thecomparison.

Since the export trends lag movements in the dollar by approximately sixmonths, a return to pre-recessionary levels most likely will not impact exportdemand until 2013 when the downturn in Europe will have hopefully reversedcourse. The improvement in demand should offset the losses caused by the

stronger dollar.At the same time, a stronger dollar combined with an improving economywill increase demand for imports.

As a result, the U.S. trade deficit will likely widen toward the end of the year.

70

75

80

85

90

95

2005 2006 2007 2008 2009 2010 2011 2012

U.S. Dollar Index

Source: FactSet


19/27



Risks to the Net Export Forecast

There have been grumblings in export-driven countries that the devaluationof the dollar will harm their interests, and they are becoming increasingly

worried about asset inflation being driven by foreign capital. Foreigncountries may implement stronger capital controls in an effort to stem the

appreciation of local currencies.

Austerity measures in Europe combined with weakening growthexpectations in many Asian countries could cause a larger-than-expected

deceleration in world growth and lead to lower-than-expected demand for

U.S. goods.

Government Spending

The CBO said federal government spending is expected to contract in 2012and 2013 as spending cuts begin to take hold.

State and local government budgets have stabilized, leaving room for someupside growth.

Total government spending is expected to fall 1.9% in 2012 and 1.5% in2013.

The CBO recently released its revised long-term forecast. It showeddiscretionary outlays falling 2.8% and 6.7% in 2012 and 2013, respectively.

The drop in spending is the result of agreed-upon cuts from the 2011 debtceiling negotiations and the automatic sequestration from the failure of theCongressional Super Committee to compromise on a long-term deficitreduction plan.

-6%

-5%

-4%

-3%

-2%

-1%

0%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Government Spending Growth

(q/q % annualized)

history forecast



20/27



Estimates show that the effects of the austerity measures combined with theexpiration of the Bush-era tax cuts and the payroll taxes could contribute to a3% - 5% contraction in GDP. That type of contraction would drive the U.S.back into a recession.

Congress will have to come up with a compromise that limits the effects of thesequestration and the tax cut expiration by either reworking the amount ofausterity and/or extending the tax cuts.

State and local governments remain over indebted but increased revenues fromproperty and sales taxes have stabilized government budgets. State and localgovernment spending should rise gently in the coming quarters.

Risks to the Government Forecast

Unless Congress is able to compromise on smaller austerity measures, theCBO estimates that automatic sequestration will lower federal spending by

6.7% in 2013. That would reduce GDP below our expectations.

A stronger-than-expected economic recovery could result in higher taxrevenues and lead to stronger state and local government spending.


21/27



Business Activity Indicators

Employment Situation

The initial claims level reversed directions and began trending higher inApril.

Uncertainty at both the fiscal level and with immediate consumer demandwill weigh heavily on business expansion in the near term.

A pickup in consumption could have an oversized effect on hiring.The employment sector looked like it was on firm footing for most of Q4 2011and Q1 2012. Payroll gains in excess of 200,000 were the norm and layoffswere beginning to peter out.

The sector suddenly switched gears in March and April. Nonfarm payrollsbarely exceeded normal labor force growth and the initial claims level began torise.

There are some analysts who pinned the weakness in the labor sector as atemporary correction from seasonal adjustments paring down the weather-related hires from earlier. While that is a logical conclusion, the data does notgive it much support.

Sectors with large labor forces that work primarily outside, such as construction,saw modest gains that were not enough to support the overall improvement inemployment. Furthermore, the downturn in the March payroll numbers did notcome from those sectors.

Both the acceleration and deceleration in payroll growth over the past fewmonths was widespread and distributed among multiple sectors. This suggests

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Unemployment Rate

history forecast

Source: BLS, Briefing Research

340

360

380

400

420

440

460

480

500

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Initial Claims

('000s, 4-wk MA)

Source: FactSet


22/27



the recent downturn may not be a temporary seasonal effect but is insteadcaused by business uncertainty about the future.

Like last quarter, many corporations discussed the potential for weak

sales/demand growth in their earnings calls. A deceleration in hiring would be anormal response to potentially slowing sales.

Beyond consumer demand, businesses are also concerned about future fiscalpolicy. As we mentioned previously, the Bush-era tax cuts and the payroll taxcuts are set to expire at the end of the year. If Congress fails to pass anextension, personal disposable income will fall significantly and have a sizablenegative impact on consumer demand. Thus, sales growth may weaken further.

At the same time, a substantial cutback in fiscal spending as a result of theautomatic sequester will cause government payrolls to shrink and lower

aggregate income. Like the tax policies, this will result in a downward shock toconsumer demand.

Businesses may be waiting for some of the fiscal uncertainty to pass beforehiring demand starts to pickup.

Risks to the Employment Forecast

As we showed in the nonresidential investment forecast, businesses are flushwith cash. The opportunity cost for hiring an extra worker has declined.

Budgetary cuts are expected to shave approximately 25,000 governmentworkers per month from total payrolls through 2012. Further budget cuts

could result in an accelerated layoff program where government payrolls

decline by 35,000 - 40,000 per month.


23/27



Inflation

Recent commodity spikes have driven headline inflation rates above Fedtarget levels.

Firms have been reluctant to pass on these higher costs into general pricesand risk alienating customers, yet more companies have indicated that they

expect to pass higher commodity costs on to the consumer in the near

future.

Slack in the labor market should keep inflation growth well containedthroughout the forecast.

Our model suggests core PCE will average 1.8% in 2012 and 2.0% in 2013,within the Feds target of 1.5% - 2.0% yearly growth.

Our inflation outlook has not changed materially over the past few quarters.

The surge in commodity prices over the past several months has had limitedeffect on consumer inflation rates. The pass-through to core consumer priceshas been even smaller.

The key to inflation growth is income growth. If incomes increase, firms havethe ability to pass on higher prices with minimal demand loss.

In a low-growth environment, income growth does not increase fast enough tospur inflation. Thus, firms are pressured to hold prices low or risk thepossibility that consumers switch to competing products. Passing throughprices to the consumer too soon may be detrimental to a firms revenuepotential.

Weak economies beget weak inflation rates.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

PCE Prices Growth Rates

(y/y)

Headline Core

Source: BLS, Briefing Research

50

75

100

125

150

175

200

225

2005 2006 2007 2008 2009 2010 2011

Commodity Spot Prices and Inflation

(indexed; 2005 = 100)

Raw Industrials Foodstuffs

Energy CPI - Headline

Source: CRB, BLS


24/27



Even if the economy rebounds beyond our expectations in 2012, the amount ofslack in both the capital and labor markets will constrain inflation growth.

It would take the economy growing well above 3.0% for several consecutivequarters before inflation growth is sustained above the Feds target.

Risks to the Inflation Forecast

Given the spike in oil prices in 2008, when the world was in a recessionaryenvironment, there is no guarantee that oil price growth will remain stable

during the forecast. While a spike would not affect core prices or our

monetary policy forecasts, it could raise headline growth more than we

expect.

Rising commodity prices coupled with a strengthening labor sector couldgive producers the incentive to pass on higher prices earlier in the business

recovery than the output gap would normally suggest.

Financial firms have ample excess reserves. If banks decide that theeconomy is stabilizing, we could see a rise in lending. This would add

inflationary pressures to the economic system.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

GDP Deflator

(y/y)

History Forecast



25/27



Monetary Policy

The FOMC reiterated that economic conditions are likely to warrant anexceptionally low level for the federal funds rate at least through late 2014.

High unemployment and low inflation should deter the Fed from raisingrates. As a result, our estimates show normal monetary policy mechanisms

will not be reactivated until mid-2015 at the earliest.

As the economy recovers, we could see the Fed removing some of theexcess liquidity by eliminating some of the quantitative easing measures

enacted during the financial crisis. This may include the selling of assets

purchased during the last year.

The FOMC reiterated at its last meeting that it believes economic conditions arelikely to warrant an exceptionally low level for the federal funds rate at leastthrough late 2014.

According to our estimates of the Taylor Rulea forecast of the fed funds rategiven inflation rates and unemploymentthe fed funds rate should be negativefor the next few years. The Taylor Rule had never projected a negative fedfunds rate prior to the Great Recession. This estimate fits with the Fedscurrent projections that the fed funds rate will remain low until at least late2014.

The more immediate concern is the path long-term rates will take afterOperation Twist ends in June.

As we pointed out in our April 26 report, Unconventional Wisdom: How LongCan the Twist-a-thon Last?, the Fed does not have enough maturing short-term securities to extend Operation Twist beyond the first half of 2013.

-6%

-5%

-4%

-3%

-2%

-1%

0%

Q4-13Q2-13Q4-12Q2-12Q4-11Q2-11

Fed Funds Rate Prediction

(Taylor Rule)

Source: Briefing Research

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

2008 2009 2010 2011 2012

Federal Reserve Balance Sheet

(blns)

Source: Federal Reserve


26/27



If Treasury rates start rising following the end of Operation Twist, the Fedmay start looking into selling its MBS or agency holdings to keep long-termTreasury rates down.

Otherwise, the only option for the Fed would be a nonsterilized action (i.e.,QE3). As long as the recovery continues to follow on an upward path, the Fedwill most likely not go in this direction.

Risks to the Monetary Policy Forecast

An unexpected, sustained increase in inflation or inflation expectationscould lead the Fed to increase the fed funds rate before 2014.


27/27



Briefing Research Salesason Green

Director, Institutional [email protected]

U.S. Offices

Chicago Headquarters401 North Michigan, Suite 2910Chicago, IL 60611800-752-3013

California Office577 Airport Boulevard Suite 150Burlingame, CA 94010

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