Outlook and Market Review - Second Quarter 2011

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The economy continues to muddle along with low growth and high unemployment in what hardly feels like the start of the third year of a recovery. According to the advanced announcement by the Bureau of Economic Analysis, second quarter GDP grew at an anemic 1.3% rate (which is already being revised downward as new data come in). Worse yet, first quarter growth was revised down from 1.9% to only 0.4%. Revisions show that the recession in 2008 and 2009 was worse than originally reported. Peak to trough, real GDP fell 5.1% rather than the 4% decline reported in prior announcements. With the revisions, U.S. GDP still remains shy of its pre-recession level. On a year-ago basis, real GDP rose 1.6% in the second quarter, well below the 3% to 4% rate needed to expand jobs. Unemployment remains high with a 9.1 unemployment rate and a falling labor force participation rate. Payroll employment fell by almost 9 million during the downturn while the economy has added back fewer than 2 million jobs, even with massive fiscal and monetary stimulus. Most analysts expected 2011 to be the transition year where GDP growth would exceed 3%. Now, economic conditions in 2011 raises doubt about the sustainability of the recovery with a one in three chance of falling back into a recession.

Financial markets were relatively stable earlier this year with the CBOE Volatility Index (VIX) trading in a narrow range (14.6 - 18.4) prior to June. Global and macroeconomic events starting in June shocked the markets causing the VIX to trade near 25. The tsunami in Japan created a temporary disruption in the global supply chain, largely concentrated in the automobile industry. Concerns over sovereign debt grew worse as the U.S. demonstrated an inability to come to grips with an unsustainable and growing debt burden while the Eurozone debt crisis became more severe. With signs of a weaker than expected U.S. economy, the weight of these events created a roller coaster ride for equities. Neither concerns over a weak economy nor uncertainty over sovereign debt conditions will go away soon, setting a stage for a continued tug of war between risk and reward in financial markets.

Going forward, sentiment and expectations must improve if the economy is to continue on the path of modest expansion. For the remainder of the year, GDP growth should rebound slightly to about 2%. Inflation continues to rise, but at a rate that will not cause alarm for the Fed or derail the Fed’s plan to keep rates low throughout the year. The flight to safety is keeping interest rates low and the Fed will try to quash any upward movement that would make a recovery more difficult. A real improvement in the fiscal deficit and corresponding reduction in the rate of growth in government debt is unlikely, causing more drag on the economy (see the discussion in the First Quarter Outlook).