Economic perspective — June 30, 2009

Russell T. Price, CFA — Sr. Economist

Second half recovery (albeit modest) is still on track.

• Are economic recovery prospects fading? Not necessarily. Some economic indicators have recently stalled in their pace of improvement, but we believe this lull should be temporary and a second half recovery remains on track.
• Inflation? Let's hope so! Some commentators have been sounding the alarm on inflation given the Federal Reserve's rapid expansion of the monetary base. We view these fears as premature and even somewhat misguided. Consumer deleveraging and vast stores of unused production capacity should keep inflation in check over the intermediate-term. Beyond this horizon, we hope to see some inflation pressures as evidence of a successful economic recovery.
• Rebound likely to be modest: The pace of U.S. economic expansion through 2012 could be modest in our opinion. The economy should slowly recover, but the harm that has been inflicted on the balance sheets of consumers, financial institutions, businesses and government has been significant and will take some time to repair.
• Corporate profit estimates rising: Corporate profit estimates have actually been rising in recent weeks. This is a positive signal, but we suspect some of the benefit estimates are seeing may stem from the removal of forecast losses at General Motors.
• Unemployment rising and going higher: We still expect the unemployment rate (a lagging economic indicator) to peak at about 10.2% by late 2009 /early 2010. Our research shows that stock prices have bottomed before the unemployment rate has peaked in every recession since 1945 with an average lead time of 8.3 months.

PLEASE NOTE: FOR IMPORTANT DISCLOSURES, INCLUDING POTENTIAL CONFLICTS OF INTEREST, PLEASE SEE THE LAST PAGE OF THIS PUBLICATION.

Economic conditions are firming ... but growth is still a few months away.

Investors seem to be taking a more cautious view of forward economic prospects of late. This is generally in-line with our comments from last month when we said a "lull" in the pace of improvement for various economic reports could lead to a near-term consolidation of investment sentiment. Indeed, over the last month some coincident economic indictors such as initial jobless claims and consumer confidence have shown difficulty in maintaining their prior momentum. Although we expect this "pause" in the pace of improvement for some economic indicators may continue for another month or two, we do not see this period as a material threat to our outlook for a second-half recovery. Temporary production shut-downs associated with the bankruptcy filings at General Motors and Chrysler are currently weighing on economic indicators at the margin, but these negative influences should abate by the end of July when production schedules are slated to resume.

Results on the consumer side are also facing tough comparisons with year-ago activity during which time consumer spending received a boost from government stimulus payments. Consumers are currently enjoying another round of income boosting government stimulus but this time around the checks are smaller and consumers are largely saving the cash. These influences, the auto sector shut-downs and the tough consumer spending comparisons, should ease over the next few months. As the summer wears-on, we anticipate the jobs picture to improve materially with fewer new claims for unemployment insurance, the inventory correction process should be closer to its end, and the economic benefit from federal government spending under the stimulus program should be having a more pronounced influence on economic activity (see chart at the top of page 3).

Some primary gauges of activity meanwhile have continued prior improvement trends. As shown in the charts at the bottom of this page, New Orders for Durable Goods have stabilized in recent months after falling a sharp 30% over the preceding 18 months. The Federal Reserve's regional surveys of manufacturing activity have also shown notable improvement over the last two months — despite the auto sector production cuts which have trimmed almost 300,000 units from total auto inventories in the month of May alone (slightly more than 10%). These inventory cuts enabled auto sector inventory levels to end the month of May at a near normal 67 days supply, versus 85 days supply at the end of April, according to data from Automotive News. Further inventory reductions during the months of June and July, combined with what we expect could be a slow improvement in light vehicle sales, should keep auto plants operating at much more efficient levels in the quarters ahead.

20 year view: New orders are down huge

Chart source: Baseline

2-year view: But order levels seem to be stabilizing

Chart source: Baseline

An analysis done by Moody's Economy.com shows that the vast bulk of spending as allocated under the Federal government's stimulus plan (the American Recovery and Reinvestment Act) has yet to actually see its way into the economy. However, these money flows should not be interpreted as a direct economic benefit. Over the near-term, much of the consumer income benefit from tax cuts will be diluted by further job losses, and state government allocations are largely making-up for lower state revenues from other sources.

Source: Moody's Economy.com

Looking to the horizon:

We have confidence in our forecast for a resumption U.S. economic expansion in the second-half of this year. However, the strength of economic recovery over the next few years is likely to be fairly weak in comparison to prior economic recoveries of the last half century. Most economic recovery periods are aided by an expansion of financial leverage. Typically this occurs as credit demand is stimulated via lower interest rates (i.e. borrowing costs). We came into this downturn, however, with consumer borrowing costs already near potential lows and on the heels of a borrowing binge. As such, economic growth potential during the recovery is likely to face the headwind of consumers trimming their debt exposures rather than expanding them. Consumers have already been making progress on this front. For the first time in more than 50 years, total household debt contracted in each of the last two quarters (Q1-2009 and Q4-2008) and the savings rate recently jumped to its highest level in more than 15 years (May's personal savings rate was 6.9%).

As we noted last month, we believe that total consumer debt loads are not as bad as the media often portrays. However, the severity of the recent economic experience has changed consumer attitudes about debt significantly and consumers are likely take actions to trim their debt loads over the intermediate-term. Debt has become a dirty word for those that can at all avoid it, and frugality has, at least temporarily, become the new consumer chic. Over time, we fully believe consumers will regain confidence in their spending, but it will take time for these attitudes to re-develop.

The Inflation / Deflation debate: Let's hope for some inflation.

As we near a potential bottom, and hopefully an eventual turning point in the economy, it seems as though there is a growing division in the investment community regarding which is the greater intermediate-term threat: deflation or inflation. Deflation was a serious legitimate concern amid the worst of the economic crisis. But amid the "green shoots" of April and May, many commentators took to the stump and proclaimed the impending economic threat of inflation. In our view any such inflation concerns are very pre-mature and must rely on expectations for a strong economic recovery — a view we find difficult to embrace at this stage. Deflation still remains the predominant concern over the intermediate-tem, although its long-term threat has been greatly reduced in our view. Federal Reserve officials seem to share this view and should thus remain in an accommodative stance until the economy shows tangible signs of standing on its own with sustainable growth prospects. One only needs to look to the Japanese experience of the last 20 years as a reminder of the consequences of removing stimulus too soon.

When citing inflation concerns commentators typically point to two primary issues, the sharp increase in money supply that has taken place over the last several months (see chart 4 on the next page) and, to a lesser extent, a weaker U.S. dollar. While we agree that a weaker U.S. dollar could offer some modest import price inflation over the next few years, we do not see this aspect as especially problematic to the inflation outlook. Any such decline in the dollar is likely to be moderate, and with imports accounting for just 17% of GDP, the impact should be muted.

The money supply angle is a little more complex, but it still lacks credence in our view. Any basic economic textbook will tell you that a rapid expansion of the money supply will, under normal circumstances, likely create inflationary pressures over time. These, however, are NOT normal circumstances.

What is the "money supply" and exactly how does it create inflation? In its simplest form, the money supply consists of currency in circulation and reserve funds held in the banking system (thus available for lending). The Federal Reserve adds to or subtracts from the monetary base primarily via the purchase or sale of U.S. Treasury securities. In adding to the monetary base (something they have been doing a lot of lately), the Fed pays for U.S. Treasury issued debt with currency, currency that then enters the financial system and becomes part of the money supply.

As shown in chart 4 on the next page, the Federal Reserve has been pumping significant amounts of money into system over the last several months. Most of this money has been used to temporarily bolster bank balance sheets, which were significantly weakened due to declining asset values. Normally, the banking system would take those additional funds and loan them out. As banks loan out the funds, the spending created by rising consumer and corporate borrowing can cause demand to overheat, thereby creating inflation. The magnitude of monetary base expansion is a direct function of how fast the pace of demand acceleration could be. Yet as we noted, a key component of this process is bank lending. In other words, its takes more than just money sitting on bank balance sheets to create inflation — it takes people willing to borrow it, leverage it, and spend it — conditions that seem far off at this point. Given our outlook for a protracted period of consumer deleveraging over the intermediate-term we believe the Federal Reserve will have ample time to remove these excess funds from the banking system as conditions slowly improve, thus avoiding an averse inflationary scenario.

Chart 4: The monetary base has exploded.

Source: Federal Reserve Bank of St. Louis

A commonly used economic measure used to see how fast the monetary base could be fueling activity in the broader economy is a metric called the "money multiplier". As shown in the chart below, the money multiplier has plunged in recent months amid the sharp drop in borrowing activity. There are some pockets of credit demand, most notably where other sources of credit have dried up (the securitized debt market for example), but borrowing demand in aggregate is contracting just as it typically does during a recession. As such, the cash being infused into the economy from the Federal Reserve is to a large extent just acting as a replacement for other fund sources that are no longer available.

Chart 5: But the leverage of that money has plunged.

Source: U.S. Federal Reserve Bank of St. Louis

Capacity utilization: The huge drop in U.S. capacity utilization further suggests that businesses will have little pricing power until production capacities return to near-normal levels.

Source: Baseline

HOPE for inflation: Over the intermediate-term we are actually hoping some inflation pressures will develop. Inflation pressures a year or two from now would imply that the actions taken to re-stimulate the economy have been successful. A lack of inflation pressures would imply that monetary and fiscal stimulus actions have not been successful, that the economy remains weak, and we are in deeper trouble than we currently foresee. As such, we believe it is much more important to err on the side of inflation risks at this stage.

Economic outlook: Q2 estimates look a bit lower, but second half recovery still on track.

We revised our estimate of Q2 GDP economic growth a bit lower since last month, but our outlook for the remainder of the year remains fairly intact. We now estimate Q2 U.S. Real GDP to contract by about 2.2% as compared to our prior estimate for a 1.2% decline. Further inventory cuts and a moderate weakening of the trade balance are the drivers behind our adjusted expectations.

We now see Q2 inventory cuts as totaling about $70 billion, compared to inventory cuts of $87 billion in the first quarter. Previously, we had estimated Q2 cuts to total about $50 billion. However, this was before the Commerce Department's update of Q1 inventory reduction efforts and announcement of extended auto sector production shut-downs associated with the bankruptcy filings at General Motors and Chrysler. Our estimate of inventory cuts in the period could still be too low depending on how much headway is made in "right-sizing" inventories in the autos space. As we have noted in prior commentaries, the faster inventory reduction efforts are completed and put into the rear-view mirror, the better. Lean inventory levels can be a strong source of fuel for an economy once demand stabilizes and businesses look to replenish shelves that that were previously taken down to the bare minimum.

Forward economic estimates: Consensus views of forward U.S. economic growth have improved slightly over the last month. The sharp inventory cuts seen in Q1 combined with the recent evidence of a bottoming process developing in the broader economy have offered some positive implications in our view. We expect further inventory reduction efforts in the second quarter, notably in the autos segment, but the total cuts should not be quite as drastic as they were in Q1.

Chart Source: Ameriprise Advisor Services, Commerce Dept.

Unemployment outlook also slightly higher: After holding steady in our two prior forecast updates, we raised our estimate of peak unemployment this past month. We now look for the unemployment rate to peak at 10.2% in the first quarter of 2010 as opposed to our prior outlook for a peak rate of 10%. Fortunately, however, non-farm payroll cuts have eased considerably in recent months. May non-farm payrolls were down 345,000 as compared to cuts of more than 500,000 in each of the preceding 6 months. Investors should also remember that unemployment is a lagging economic indicator. Historically the unemployment rate has peaked 8.7 months on average after the S&P 500 has hit its business cycle bottom during recessions going back to 1948.

We still expect the pace of initial claims to moderate in the weeks ahead as some automobile manufacturing comes back on line at Chrysler and its related supplier base. New claims however, may remain elevated until the final week of July when General Motors (GMGMQ; $1.09) plants come back on-line and Ford (NYSE; F; $6.07) also returns to work after its typical summer shut-down.

Corporate profits: S&P 500 profit estimates moving higher for the first time in many months.

S&P 500 forward earnings estimates have actually been seeing some modest upward adjustments in recent weeks. This is a positive sign in our view especially given that forward estimates typically trend slightly lower during the course of any given quarter. However, a closer look at changes at the sector level suggests that some of the gains could be as a result of the recent bankruptcy filing by General Motors (GM). Given its bankruptcy filing, GM shares have been removed from the S&P 500 Index. As such, the large losses the company was expected to incur have also been removed from forward S&P 500 estimates.

First Call consensus estimates currently look for Q2 earnings to be down about 30% yr/yr (as compared to a 33% decline forecast at this time last month) and Q3 estimates currently look for an 17% yr/yr decline (a four point improvement from the -21% estimated a month ago). Corporate profits for Q4 meanwhile are expected to show a strong 33% yr/yr gain — versus the 29% gain expected one month ago.

Current estimates for the S&P 500 and its components:

Although the forecast for Q4 may appear overly-optimistic at this point (and we do expect it may come-down a bit), there are legitimate factors which we believe should boost results on a yr/yr basis by year-end. First and foremost, the huge losses taken in the banking sector during the fourth quarter of 2008 will make for very easy comparisons in this year's final quarter. According to Bloomberg data, write-offs and charges in the financial sector peaked in Q4-2008 as companies took charges and write-downs totaling a massive $243 billion. By comparison, charges and write-offs dropped to $65.8 billion in Q1-2009. Energy sector profits should also recover somewhat in the second half of the year on stabilizing commodity prices, and companies in a broad range of industries should be seeing the benefit of today's drastic restructuring actions. Should these estimates for the year hold true, it would place trailing twelve-month S&P 500 earnings at a low of $53.95 by third quarters' end (we will refer to this figure later in our S&P 500 outlook) — a 42% decline from the cyclical high of $92.25 as attained in Q2-2007.

Stocks typically bottom long before the economy:

We have highlighted the following data in the table below for the last few months. We believe this historical view of stock performance during economic turning points offers valuable insights for investors at this stage so we intend to re-publish it for a few more months as well.

Our research, as reflected in the table, shows that in almost every recession since 1960 stock prices have hit bottom about 9 months prior to the eventual bottom in corporate profits. The lone exception to this was the recession of 2001 when stocks had much more to "give-back" from a valuation perspective.

Recessions and stock performance: A historical perspective

How to read the above table:

Taking the recession of 1990-1991 as an example: from peak to trough Real GDP in the recession of 1990-'91 declined by 1.3% and there were two quarters between said peak and trough. Corporate profits meanwhile fell 37.5% from their peak to their trough during this period and there were 37 months between these highs and lows. The S&P 500 declined a total of 14.8% from its high point to its low point during the period (based on month-ending values) and there were 4 months between these occurrences. The stock market hit its low 24 months before corporate profits saw their low for the period and unemployment rose by 2.6 percentage points, from a low of 5.2% to a high of 7.8%. Stock prices also bottomed 21 months ahead of the eventual peak in the unemployment rate.

Putting this data to work: As investors, how can we use this information and apply it to the current cycle? We also went back and looked at how valuation multiples performed during these periods. Given that our research (as outlined in the previous chart) indicated that stock prices typically begin to move higher 9.3 months ahead of the eventual bottom in corporate profitability, it equates that valuation multiples have historically also hit their low at the time of the stock market low. In other words, if February's month-ending close for the S&P 500 of 735.09 was indeed the low for this cycle, then we would expect the P/E ratio at that time to have also been the low for this cycle (i.e. because the denominator, earnings, are still falling). The P/E ratio at the end of February was 10.7. Historically, we have found that by the time corporate earnings did reach their lows (9.3 months later), P/E multiples were 68% higher on average. Excluding the 2001 recession when valuation multiples were still well above their historical norms, the average cycle low for the P/E metric was 11.3 with P/E ratios rising to an average of 18.3 by the time corporate profits hit their low. Thus, from these historical averages we can get a sense of where stocks prices could be headed. If we assume that the third quarter of this year will indeed mark the low in the current corporate profit cycle, and that current forward estimates are close to correct, we can follow the resulting math: $53.95 * (10.7 * 168% = 18.0) and get a possible value for the S&P 500 of 971 at third quarters end, equating to a possible 5% gain versus its close of 927 on June 29th. In this example the resulting P/E ratio equates to 18.0 — slightly below the historical average. Of course if corporate profit estimates continue to fall — to say $50.00, then numbers would suggest a value for the S&P 500 of approximately 900 at third quarter's end — or about 3% below current values. Our Senior Market Strategist, Marc Zabicki, CFA, has forecast a year-ending level for the S&P 500 of 980. Based on First Call full-year S&P 500 earnings estimates this equates to an estimated year-ending P/E of 16.8.

Housing market update:

We hear the term "housing market" a lot these days, but different currents have various parts of this sector moving in different directions. For instance, we expect new home construction to bottom this year but we still expect average selling prices for existing homes to decline into 2010. So is the "housing market" going to bottom this year or not? I guess it would depend on if you asked a home builder or a home seller.

Overall, we do believe the housing market is in the process of forming a bottom. As shown in the associated charts, builders have cut back substantially in their new construction activity over the last 3 years, allowing the number of completed new homes on the market to fall back near historical lows. Inventories are the key. New home inventories hit their historical support level in April and the pace of existing home sales should see further support from distressed sales. Home prices however, will likely not see their bottom until 2010.

First and foremost, builders must eliminate excess inventory before the sector is likely to see a legitimate bottom. Fortunately, we believe strong progress is being made on this front. During the month of April, builders started construction on the fewest number of new homes for any month since 1959, when records were first compiled.

Source: Ameriprise Advisor Services, Inc., Commerce Dept.

Over the last thirty years, the number of new homes available for sale has rarely fallen below the 300,000 level, regardless of economic conditions. We also note that the chart at right has NOT been adjusted for population growth (U.S. population has grown by approx. 50% over the period shown). Inventory levels ended the month of April at 296,000 — thus breaking below the 300,000 unit level a month earlier than we had forecast. We believe a moderate overcorrection is likely on this measure but given the growing population and household formation, we believe pent-up demand is building and thus will aid a recovery for the sector in the years ahead.

Chart source: Ameriprise Advisor Services, Inc., U.S. Commerce Dept.

Summary:

We still expect the U.S. economy to resume an expansionary pace by the second half of the year. We believe the growth drivers in the second half will come from a variety of factors. First, the vast bulk of spending under the Federal government's recently enacted stimulus legislation is slated to be allocated in the second half of 2009 and into 2010. Secondly, businesses have been cutting inventory levels aggressively and such actions will provide leverage to any improvement in demand. Third, consumer pent-up demand is building. As an example, U.S. light vehicle sales have been running at an average annualized pace of about 9.5 million over the last several months. By comparison, the United States scrapped 13 million light vehicles in 2007. Fourth, many consumers will face lower monthly mortgage costs due to recent mortgage refinancing activity, while higher stock prices should also help rebuild consumer confidence and perceptions of wealth. Fifth, consumers should enjoy comparatively lower energy costs in the months ahead. Notably, home heating bills should come as a welcome surprise to consumers next winter based on the recent collapse of natural gas prices (utility supply contracts are typically negotiated in the late Spring). Finally, corporate restructuring actions should boost corporate profitability in the quarters ahead, and leverage profits when demand improves.

RISKS:
While we have confidence in our economic outlook, we recognize that serious economic and financial market challenges remain. Recent credit market turmoil has widely been seen as the greatest risk to the global financial system in a generation. Despite what we believe are signs of improvement in this space, notable risks remain evident and the improvements could unexpectedly reverse due to any number of unforeseen circumstances. The ongoing correction in the U.S. housing market also raises the risk of a prolonged or deeper than expected economic contraction especially if consumer access to credit remains constrained. Commercial mortgage default rates are also rising and could pose yet another hit to the financial system in the quarters ahead. Given these uncertainties, stock prices are likely to remain volatile over the intermediate-term and we would look for an end to the current phase of downward estimate revisions before looking for a sustainable recovery for stocks. Additionally, we believe the government would be making a serious mistake with significant adverse economic consequences if the auto sector bailout is not handled properly. Terrorism and geopolitical turmoil are also significant factors capable of producing negative economic shocks.

Director of Research Lyle B. Schonberger
SECTOR ANALYSTS	PORTFOLIO STRATEGY ANALYSTS	FIXED INCOME LIAISON Marc A. Zabicki, CFA
Consumer Goods and Services Patrick Diedrickson, CFA	Economic Strategist Russell T. Price, CFA	ALTERNATIVE INVESTMENTS Timothy Witt
Energy / Utilities Leze Thaqi	Market Strategist Marc A. Zabicki, CFA	ADMINISTRATIVE ASSISTANT Robert Engle
Financial Services Lori Wilking	Model Portfolio Strategists Matthew J. Koellner, CFA Steven F. Shepich, CFA, CPA
Health Care E. Eugene Robinson	PACKAGED PRODUCT ANALYSTS
Industrials / Materials Frederick M. Schultz	Mutual Funds & Exchange Traded Funds (ETFs) Anthony M. Saglimbene
Technology / Telecommunication Justin H. Burgin

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