Outlook and Market Review - Fourth Quarter 2011

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Based on preliminary estimates from the Bureau of Economic Analysis, the economy grew only 1.7% in 2011 following 3% growth in 2010. For the fourth quarter of 2011, the preliminary economic growth estimate was 2.8% but roughly two-thirds of that growth came from inventory accumulation. Consumer savings rates picked up in the fourth quarter as consumer spending was more in line with income than in prior quarters. While fixed investment slowed, residential investment improved. Both government and exports were drags on the economy in the fourth quarter and this trend is likely to continue. Fiscal stimulus has run its course and the focus is on lowering trillion dollar annual deficits and slowing the inevitable march to a sixteen trillion dollar public debt. The severe weakness of the European economies will take the edge off U.S. export demand and could present a larger drag on what is already a low economic growth.

Weak government spending reduced GDP growth by about 1 percent in the fourth quarter. Spending reductions and belt-tightening at all levels of government will remain a drag on the economy. Without fiscal stimulus, growth must be led by consumers and private investment, which will be difficult until job creation picks up dramatically and housing prices begin a sustained upward trend. The political winds are currently blowing in the direction of income distribution issues, but if the elections bring a focus on household wealth creation, we may see a needed overhaul of the tax and regulatory system. Such a shift would offer upward revisions to longer term GDP growth. The Fed is committed to a low interest rate environment through 2013 and most of 2014 to allow for ample liquidity and credit availability if private sector demand takes hold. Relatively low inflation pressure provides room for continued monetary stimulus in the near term, but the Fed can’t “push on a string.” Stronger business and consumer demand must be forthcoming.

The Federal Reserve Bank estimate of GDP growth for 2012 is 2.5%, which is close to the 2.4% forecast from the Survey of Professional Forecasters. Based on the CPI, the 3% inflation rate in 2011 exceeded the Fed’s 2.5% target, but inflation pressures eased in the last part of 2011 with downward pressures on energy and commodity prices. Most analysts expect unemployment to reverse its current downward path and tick back up in 2012 due to higher labor force participation. Job growth coming out of 2011 has been surprisingly strong with unemployment dipping to 8.3%, strong job growth, and a reduction of jobless claims to a four year low in January. Production and manufacturing data suggest upturns going into 2012. On the downside, there are serious risks in the global economy. The European debt crisis is not likely to be resolved without continued austerity and downward pressures on fiscal spending. If Europe goes over the edge it will bring the U.S. down with it to some degree based on trade, banking exposure and sinking sentiment. Other wild card risks include escalated conflict with Iran over its nuclear program and escalated turmoil in the Middle East from the “Arab Spring.”

Without major geopolitical shocks, the U.S. economy should achieve growth in the 2.4% to 2.6% range with continued low interest rates. If inflation rates remain at the 2% to 2.5% rate and below, we should see 10-year Treasury securities with a 1.8% to 2.1% yield and a near zero rate on short term Treasuries. These “negative real interest rates” should promote investing and spending later in the year as the delevering phase ends for households and job growth builds. Credit risk premiums will expand if the economy underperforms the expected targets or if either Europe or the Middle East turns worse. Unemployment is likely to be about 8.5% at the end of the year unless an unexpected increase occurs in the labor force, which would tilt the unemployment rate higher. This scenario is slightly more optimistic than the consensus of professional forecasters.