Outlook and Market Review - Fourth Quarter 2008

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According to advanced estimates, the economy shrank at a 3.8% annualized rate in the fourth quarter, following a .5% decline in the third quarter. On a year-over-year basis, the economy contracted .2%. Housing, investment, and consumption continue to slide even as the money supply and bank liquidity expands rapidly. The fourth quarter decline was widespread with only government spending and a narrower trade deficit contributing to positive GDP growth. Labor markets follow overall economic activity with a lag. The fourth quarter jump in the unemployment rate to 7.6% from 7.2% was consistent with a maturing economic slump. Additions to inventories boosted fourth quarter growth in 2008, but will have a negative influence on first quarter 2009 growth as firms scale back inventory and production. With the fourth quarter inventories-to-sales ratios moving higher in most industries and with demand plummeting, businesses will reduce production in the first quarter of 2009.

The combination of high levels of debt, declining wealth from housing, lower equity values, lower income, job losses, and weakening confidence makes the current economic environment unlike a normal business cycle downturn. Monetary policy initiatives to pump liquidity into the banking system generated rapid growth in the money supply that has been largely canceled out by a declining demand for money (velocity). Even with short term interest rates approaching zero, credit conditions remain stringent. Banks are hesitant to expand loans and the private sector is hesitant to take on more debt. The Government’s role as the “spender of last resort” will not really begin until later in 2009. Even so, there is some concern about the ability of government spending to make meaningful inroads in permanent job creation and stimulate consumer spending in the current environment. The stimulus must be very high to move past consumer desires to save and pay down debt rather than boost consumption.

Real GDP growth for 2009 will likely hover around zero without a normal breakout recover. Unemployment will rise above 8% by year end. Short term interest rates will remain very low by historic standards with Fed Funds remaining about 0%. Longer term rates are likely to fall as the Fed switches to buying long term Treasury securities (driving prices up and yields down) rather than focusing on only short term government securities. Declining aggregate demand and falling capacity utilization should continue to beat down inflation to the point that deflation becomes an issue in the short run. The U.S. is not alone in this debacle, as the global recession becomes more entrenched. Leading economic indicators for the OECD global country groupings are all falling in unison.