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ECONOMIC OUTLOOK Insurer Investment Forum XII Strategic Asset Alliance March 29, 2012

ECONOMIC OUTLOOK Insurer Investment Forum XII Strategic Asset Alliance March 29, 2012. Bill Longbrake University of Maryland. 2012 Outlook. Optimistic View – Federal Reserve GDP grows 2.2% to 2.7% Unemployment falls to 8.2% to 8.5% Core inflation (PCE) stable: 1.4% to 1.8%

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ECONOMIC OUTLOOK Insurer Investment Forum XII Strategic Asset Alliance March 29, 2012

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  1. ECONOMIC OUTLOOKInsurer Investment Forum XIIStrategic Asset AllianceMarch 29, 2012 Bill Longbrake University of Maryland

  2. 2012 Outlook • Optimistic View – Federal Reserve • GDP grows 2.2% to 2.7% • Unemployment falls to 8.2% to 8.5% • Core inflation (PCE) stable: 1.4% to 1.8% • Pessimistic View – B of A, Goldman, Bill • GDP grows about 2.1% to 2.3% • Unemployment remains near 8.3% (8.2% to 8.4%) • Core inflation falls to 1.3% to 1.7% • Consumer spending growth edges up slightly • Business investment growth slows

  3. 2012 OUTLOOK – Topics • Households – (71% of GDP) • Employment • Income • Spending • Investment – (13% of GDP) • Residential Housing (2.4% of GDP) • Nonresidential Structures (2.5% of GDP) • Equipment and Software (8.6% of GDP) • Fiscal Policy – Massive Shock Coming in 2013 • Monetary Policy • Policy Stance • Inflation • Interest Rates

  4. 2012 OUTLOOK – Significant Risks • China • Growth Strategy • Long-Term Risks • Near-Term Risks • Europe • Banks – Liquidity & Solvency • Recession • Germany’s Policy Agenda • Future of Euro Zone & European Union • U.S. Fiscal Policy • 2012 Policy Uncertainty • 2013 – potential for 4.5% negative GDP shock

  5. U.S. GDP – 2011 Q4 and 2012 • 2012 Q1 • Tracking near 2.0% • Much weaker than market perception of accelerating growth • 2012 • Market optimism rising • Most expect 2012 GDP growth = 2.5% to 3.0% • Strong case for much weaker growth • Bank of America/Merrill Lynch expects growth to slow substantially in second half to < 2%

  6. CHART 1 – Real GDP Growth Forecasts(percentage change over previous 12 months)

  7. CHART 2 – GDP Output Gap Forecast: 1980-82 and 2007-09 Recessions Q4/82 Q3/09 Q4/11 Q1/85 Q4/15 Q1/81 Q4/07 Q1/89

  8. Households • Employment (Weaker Growth Ahead) • Slower growth in payrolls coming after strong start to the year • Little or no improvement in unemployment rate during remainder of the year • Income (Weak Growth Continues) • Depends on employment growth • Growth in hourly wages stuck at 2% nominal; 0% real • Government transfer payments shrinking • Spending (Acceleration Not Likely) • In long run depends on income growth • In short run can grow faster than income, if savings reduced, but this is not sustainable for long

  9. CHART 3 – Employment Growth (annual rate of change)

  10. CHART 4 – Monthly Employment Growth Following 1981-82 and 2008-09 Recessions (Index = 100: January 2008 and July 1981) 12/85 7/85 7/81 1/08 7/82 1/12 6/09

  11. CHART 5 – Unemployment Rate

  12. CHART 6 – Nominal Disposable Income Growth(12-month rate of change) 1st stimulus

  13. CHART 7 – Hourly and Weekly Wages(annual rate of change) Source: Bureau of Labor Statistics

  14. CHART 8 – Hourly Wages – Nominal and Real(real wages = nominal wages deflated by the PCE price index)

  15. CHART 9 – Nominal Disposable Income and Consumption Growth(12-month rate of change)

  16. CHART 10 – Real Consumer Spending Growth (percentage change over previous 12 months)

  17. CHART 11 – Consumer Saving Rate (quarterly average)

  18. Investment – Residential Housing • Residential (Bottoming) • 1 to 2 years of excess supply • excess vacancies declining • New construction has bottomed • limited improvement in 2012 • Foreclosures will peak in 2012 and 2013 • Housing fairly valued • prices likely to fall a little more because of foreclosures • Price declines negatively affect consumer spending • Multi-family – Improving trend for apartment construction

  19. CHART 12 – Number of Housing Units Above 1994-2000 Average

  20. CHART 13 – Cumulative Real Housing Price Appreciation Relative to Long-Term Trend (1975-2014) Nominal prices fall 4%; inflation-adjusted prices fall 7% Nominal Housing Prices: FHFA 1975-2011 Inflation: PCE Total Index

  21. 2012 OUTLOOK – Business Investment • Nonresidential Structures • 2.7% of GDP • 5.9% of GDP growth over last four quarters • Equipment & Software • 7.4% of GDP • 44.3% of GDP growth over last four quarters • Slowdown in Growth Likely in 2012 • Goldman Sachs expects growth to slow to single digits in 2012 • ISI survey indicates approximately 5% growth rate in 2012

  22. 2012 OUTLOOK – Fiscal Policy • Federal and State/Local – will reduce real GDP growth by about 1% in 2012 • No Further Action on Fiscal Policy in 2012 Likely • Uncertainty will build toward end of 2012 • 4.5% Negative GDP Shock Hits January 1, 2013

  23. 2012 OUTLOOK – Monetary Policy • Policy Stance – economy looks increasingly strong; but is momentum sustainable? • Policy on hold – completing Operation Twist • Communications – published forecast of fed funds rate • QE3 – second half of 2012, if economy (and inflation) slows – decision likely at June meeting • Inflation • Slowing core inflation • Trend in total inflation depends on oil prices • Limited threat of deflation • Interest Rates • No increase in short-term rates until late 2014 • Long-term rates have bottomed but will remain low during 2012

  24. CHART 14 – Core PCE Inflation Forecasts(percentage change over previous 12 months)

  25. CHART 15 – Federal Funds Rate Forecast

  26. CHART 16 – 10-Year Treasury Rate Forecasts

  27. 2012 OUTLOOK – Significant Risks – China • China’s Growth Strategy • Currency management • Exports and infrastructure investment • Aggressive credit expansion • Long-Term Risks • Unbalanced GDP – outsized dependence on trade and investment • Short-Term Risks • Property bubble bursting • Skilled labor shortage • Rapidly rising wages • Inflation • Slowing growth • European recession and slowing global growth

  28. 2012 OUTLOOK – Significant Risks – Europe • Fiscal Compact • Fiscal Discipline • -0.5% annual budget deficit • -3.0% annual budget deficit • 60% Debt/GDP • Stabilization Mechanisms • EFSF – leverage • ESM - €500 billion • IMF - €150 billion ??? • Flaws • Austerity – exacerbates developing recession • Country differences in competitiveness • Banks • Capital and loan loss requirements • Credit crunch – moderated by LTRO

  29. 2012 OUTLOOK – Significant Risks – Europe • Recession • ECB 2012 GDP: -0.5% to 0.3%; median -0.1% • Bank of America/Merrill Lynch GDP: -0.6% • Risks to downside • Austerity will deepen recession • Germany’s Economic Strategy Is a Problem • Intentional trade surplus creates disabling imbalances • Competitive imbalances cannot easily be resolved • Euro Zone Cannot Survive in Current Form • Nationalism vs. European integration • Economic distress will undermine European political elite

  30. 2012 OUTLOOK – Significant Risks – U.S. Fiscal Policy • U.S. Budget Deficit • $1.3 trillion deficit in fiscal 2011 • $1.2 trillion deficit likely in fiscal 2012 • Public Debt/GDP = 68.2% at end of 2011 • Reinhart-Rogoff: Danger point reached between 70%-90% • Deficit Math • Debt/GDP ratio stable if deficit % = nominal GDP growth % • Fiscal 2011 GDP growth = 3.9%; deficit = 8.7%; Debt/GDP ratio increased 4.7% • To stabilize Debt/GDP ratio, assuming 4.5% nominal growth, requires deficit to be reduced $600 billion • $500 billion in taxes and/or spending • $100 billion in interest

  31. 2013 Fiscal Policy Shock • Enormous Fiscal Shock ($535 billion) Hits January 1, 2013 • Expiration of Bush tax cuts = $255 billion • Budget Control Act automatic spending cuts = $109 billion • Obama Health Car Act = $21 billion in Medicare taxes • Payroll tax reduction = $112 billion • Alternative minimum taxes = $38 billion

  32. CHART 17 – Total Federal Public Debt to GDP(percentage of nominal GDP) 2011 66.7%

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