Outlook and Market Review - Fourth Quarter 2012

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The U.S. economy is still far behind a typical recovery. In the revised estimate, the economy grew by a miniscule 0.1% in the fourth quarter of 2012. Consumers contributed 1.5% growth to GDP, but were drowned out by reduced government spending and a continued slide of the international trade account. Neither of these drags on growth is likely to improve much in 2013. GDP growth for all of 2012 was only 2.2%, following a 1.8% growth rate in 2011. Since the start of 2010, growth has averaged 2.2 percent, which is especially dismal given the historic depth of the starting point. As we approach the fourth anniversary of economic recovery this summer, we have a $1 trillion gap between what the economy is producing and potential GDP. That gap represents lost jobs and lost wealth that is abnormal during a recovery. A few years of GDP growth of at least 3 percent to 5 percent will be needed just to get back on a normal track. Unfortunately, even optimistic students of the economy are not predicting GDP growth that high in the near future. Job growth is improving and the housing sector is rebounding, but there are significant drags that remain from the massive federal debt overhang (discussed in prior Outlooks). The payroll tax cut expired on Jan. 1 and some combination of higher taxes and spending reduction is inevitable. Automatic spending cuts are in place unless Congress and the President work out a feasible plan. The consensus across a variety of professional forecasts is in line with 2.2% to 2.5% growth in 2013 and 2014, if there are no other major shocks.

The official unemployment rate is 7.7% with an estimated 18% underemployment rate. The economy is adding jobs at an improved rate of around 160,000 per month, but this rate of expansion of the market is hardly keeping pace with population and productivity growth. Inflation remains moderate with the CPI and PCE indexes growing at less than the 2% target of the Fed. While specific price spikes in energy and food are likely, overall inflation pressures remain low, allowing the Fed to stay on a course of easy money in line with announced intentions. Ten-year bond yields continue to hover around 2% and are likely to remain there for the remainder of the year. Outflows from the bond market to the stock market are largely being offset by inflows of international capital, due to a stronger and relatively more secure dollar.