Outlook and Market Review - Third Quarter 2010

Summary: 

The economy remained soft in the third quarter with real GDP growth of 2.5%, according to the revised estimate by the Bureau of Economic Analysis. Advanced estimates are constructed without data for the last month of the quarter. Growth must exceed 2.5% to gain any ground on the employment front. With slow growth in the past few quarters the unemployment rate remains stuck at 9.6%. Housing inventory remains too large for stabilization of housing prices and borrowers find it difficult to qualify for loans even as banks hold high levels of liquidity. Manufacturing and new orders have slowed from the pace set earlier in the recover.

The economy shows signs of strengthening, but the pace of improvement is painfully slow. Households are deleveraging, allowing room for higher consumer spending going into 2011. Household debt as a percentage of income is now below 120% compared to the 136% mark set in 2008. If the trend continues the percent of debt to income will hit 100% in 2011, returning back to the levels of the 1980s. Third quarter earnings tended to offer surprises on the upside but prospects for the fourth quarter are more subdued. Additional “quantitative easing” by the Fed is underway with a plan for at least $600 billion in purchases of Treasury securities. The move is controversial, but it is intended to boost bank liquidity, lower lending rates, encourage more lending, and ultimately stimulate private domestic spending. Historically low interest rates are likely to go lower for the intermediate maturities of five to ten years. Eventually, the concern is that inflationary pressures will build as the economy gains traction unless the Fed is able to execute a flawless exit for quantitative easing.

Economic data have taken a slightly better turn in recent weeks. The job market, retailing, and housing statistics all appear a bit better than they did in the summer. Financial conditions have also improved with a rally bringing stocks close to the level reached before Europe’s sovereign debt crisis. Credit spreads have stabilized and there are some signs that banks may react to improved credit quality by opening up lending. While the economy’s growth is not positioned to accelerate significantly, it is unlikely to decelerate. Real GDP growth is tracking below the estimated potential of 2.75%. Job gains are averaging about 100,000 per month, which is still short of the 150,000 needed just to keep the unemployment rate from rising further.

Fourth quarter growth is not likely to exceed the 2.5% rate of the third quarter. The economy will see sluggish growth as the boosts from inventories and fiscal stimulus fade. Growth should pick up later in 2011. Unemployment may creep up rather than down as more workers enter the workforce looking for jobs. Inflation will remain below 2% on an annual rate basis, but specific prices in food, energy, and healthcare are likely to increase. Quantitative easing should bring rates lower in intermediate maturity segments of the yield curve, but longer term rates may edge up due to higher inflation expectations. The dollar will continue its decline with more downward pressure from quantitative easing by the Fed.