Outlook and Market Review - Fourth Quarter 2010

Summary: 

The economy is showing signs of a stronger recovery after approximately a year and a half of recession followed by another year and a half of an unusually weak recovery. The Bureau of Economic Analysis revised estimate of real GDP growth for the first quarter was 2.8% following a 2.6% real growth in the third quarter of 2010. Inventory depletion was a key drag on GDP growth in the fourth quarter of 2010, but this should give an extra boost to first quarter growth. The falling value of the dollar and improved global economies helped stimulate U.S. exports. Further improvement of the export sector of the economy depends on the continued global economic recovery. The economy must grow consistently above 3% to generate enough jobs to bring down unemployment in a meaningful way. While many economists are predicting a self-sustaining recovery in 2011, recent shocks to global political stability and energy prices threaten that recovery.

The unemployment rate remains high at 9% with little promise for dramatic reduction in 2011. The labor force participation rate is at an historic low, making it more difficult to reduce the unemployment rate when discouraged workers finally re-enter the labor market. Core inflation remains low at this point and excess capacity suggests that demand-pull inflation is not on the horizon. Nevertheless, energy prices are rising along with overall commodity prices, setting a stage for cost-push inflation pressures that could materialize, much like the inflation of the 1980s. Concerns over inflation are building but the Fed is not likely to implement an exit strategy from quantitative easing as long as the economy remains sluggish. Quantitative easing has not had the desired effect of bringing the 10-year maturity rates down. This is a critical objective in monetary easing, since mortgage and other long term investment decisions are most directly linked to the 10-year maturity segment. Another round of quantitative easing (QE3) is not out of the question if inflation pressures subside.

Analysts will likely pull back from earlier estimates of a 3.5% growth rate in the second half of 2011, given recent shocks to oil prices and global political stability. A big factor affecting the path of future energy prices will be the ability of Saudi Arabia to offset oil disruptions occurring with other countries in the Middle East. For the near future, the markets will play a tug of war between optimism for an economic recovery and fear over inflation linked to world political instability. The uncertainty of sovereign debt conditions is another wild card.