Outlook and Market Review - Third Quarter 2012

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Third quarter 2012 real GDP growth was revised upward by the Bureau of Economic Analysis to 2.7% from the preliminary announcement of 2%. Second quarter GDP growth was 1.3% after revision. Few segments of the economy performed well in the third quarter and much of the 2.7% gain was due to unexpected increases in government spending and unexpected increases in businesses inventory investment. Real final sales of domestic product, GDP less change in private inventories, increased only 1.9%. Consumer spending contributed to growth in the third quarter but was not supported by a commensurate increase in disposable income, resulting in a drop of the savings rate. The housing market improved with housing prices rising 1.3% on a year over year basis for the 10-city index and 2% for the 20-city index. Housing starts and sales were both up and builder optimism improved. International trade and business investment continue to a drag on the economy.

Job growth improvement in the third quarter was offset by an increase in the labor force participation rate and population growth, moving the unemployment rate from 7.8% to 7.9%. Long-term unemployed, non-voluntary part time workers, and marginally attached workers remain at historic levels. Even with an improvement in the overall economy, it will be difficult to address what has now become structural unemployment where worker skills no longer match labor market needs. Average hourly compensation over the past year has barely kept up with inflation, offering further evidence of the weakness in the labor market. Employment costs increased only 1.1% over the past year due to the combination of higher labor productivity and modest compensation increases. Even so, businesses are reluctant to add new workers due to rising benefit costs, uncertainty over taxes and regulation, difficulty of forecasting future sales, and a generally hostile environment for business.

Inflation remains at or below the Fed’s target of 2%, allowing the Fed to stay the course on its mortgage buy-back program. As long as inflation remains below target, Fed policy will be fully dedicated to the goal of stimulating employment and economic growth. Real interest rates have been negative for most of the last year creating an environment where investment should pick up if prospects for a more certain long run future can be developed.

The fourth quarter of 2012 and all of 2013 will see sluggish performance at best. If automatic tax increases and budget cuts occur on January 1 the economy will likely have two quarters of negative growth. Fourth quarter growth is likely to be close to 2% and growth in 2013 is not likely to exceed 2% until late in the year. GDP growth for 2013 should be between 2% and 2.25%. Interest rates are expected to remain low and just above the inflation rate at the 10-year Treasury bond maturity. Inflation should continue to be below the Fed’s target of 2% but volatility of energy costs may introduce hardships for households.