Smith Breeden Associates

1. Smith Breeden Associates Macroeconomic Outlook May 12, 2003 Eugene F. Flood, President and CEO

2. Macroeconomic Outlook • Historically unusual economic times • Suppose we assume the recovery began January 2002 • Industrial production at bottom end of historical experience

5. Macroeconomic Outlook • We have heard the term “jobless” recovery • Current experience is very unusual

9. Macroeconomic Outlook • Employment gap: • Jobs created since January 2002 = -594,000 • Jobs usually created in recovery = 1,473,000 • Gap = 2,000,000 jobs • Insufficient capital spending – at levels of seven years ago

11. Macroeconomic Outlook Why? • Largely a result of uncertainty induced by geopolitical risk

12. Macroeconomic Outlook ICRG Political Risk Data from PRS

13. Macroeconomic Outlook ICRG Political Risk Data from PRS

14. Macroeconomic Outlook ICRG Political Risk Data from PRS

15. Macroeconomic Outlook • Corporations have acted defensively on two fronts: • Option to wait is very valuable • Employment retrenchment

16. Macroeconomic Outlook • Recent FEI/Duke University survey showed 67% of CFOs had were being very cautious or putting capital spending “on hold”

17. Macroeconomic Outlook • Some mitigation of political risk with the short war in Iraq • Will lead to a boost in consumer confidence and some increases in employment (reversing the retrenchment of the last six months)

18. Macroeconomic Outlook Recent blip in consumer confidence

19. Macroeconomic Outlook • However, investors realize that the resolution of the war is not that simple • There is still considerable uncertainty about the political landscape in Iraq and the surrounding countries.

20. Macroeconomic Outlook • Fiscal stimulus unlikely to have a material effect in 2003 • There is enough disagreement on the logic of the tax cut that positive effects will likely be muted

21. Macroeconomic Outlook • Monetary policy has been consistent • Fed increasingly aware of risk of deflation • Deflation is a problem because it gives consumers and corporations the incentive to delay their purchases (until prices cheaper)

22. Macroeconomic Outlook • Federal Reserve is willing to make one final cut in rates if they perceive the economic risk increasing over the next few months

23. Macroeconomic Outlook • Insert graph of cuts in rates

24. Macroeconomic Outlook • However, there is unlikely to be much impact from cutting rates from a historical low of 125bp to another historical low of 75bp

25. Macroeconomic Outlook • Other downsides: • Might be perceived as a desperate move • Exercising an option that cannot be exercised again (even if it is really needed) • Specter of Japan comparisons • Further erosion in dollar might damage business confidence (even though exports become more competitive)

26. Macroeconomic Outlook • Globalization will not help the U.S. recovery – this time around: • “International diversification” of world economies only works when business cycles out of phase. • For example, if U.S. goes into recession but Japan and Germany are experiencing high growth, then a U.S. recovery can be export driven.

27. Macroeconomic Outlook • Japan has been in trouble for 14 years • Slowly deflating bubble • Unwilling to face up to the crisis in financial institutions • 100 Enrons

28. Macroeconomic Outlook • Germany paying the price of the Euro • If the DMark was still around, the Bundesbank would have slashed rates further than the ECB has

29. Macroeconomic Outlook • Don’t expect much from the stock market • Historically, the average return on the S&P 500 has been 9% above the Treasury bill rate (January 1926-December 2002). This is called the “risk premium”

30. Macroeconomic Outlook • Duke-FEI survey of CFOs over the past three years shows much different expectations

31. Macroeconomic Outlook One-Year Forecast • One-year risk premium quite variable. Currently, about 3.25%

32. Macroeconomic Outlook Ten-Year Premium • Ten-year risk premium is stable. Currently, about 3.75%

33. Macroeconomic Outlook Conclusions • To be added