U.S.

Economic Outlook

2011-12

Dimitri Delis, Ph.D.

The intoxicated Federal Reserve chairman informs bar patrons of the dangers of reckless spending.

The Four Economic Perils

It has Been a Very Long and Slow Recovery And..

1.04 1.04 1.02 1.02 1.00 1.00 0.98 0.98

Normalized GDP Normalized GDP levels

start of recessions start of recessions
2001 2001 1990 1981 1980 1980 1973 1973

2007-09 2007-09

0.96 0.96

0.94 0.94 1 1
Source: Bureau of Economic Analysis

3 3

5 5

7 9 7 9 time (quarters) time (quarters)

11 11

13 13

15 15

Household Wealth is Still Below Pre-crisis Levels

130% 120%

Normalized Net Worth Levels

1980 1982

start of recessions

110%
1990

1973

100% 90% 80% 70% 0

Source: Bureau of Economic Analysis

2001

2007-09

time (quarters)

10

15

Did the Fiscal Stimulus Work?

11 10 9 8

actual unemployment rate

without recovery plan with recovery plan

7 6 5 4
Jan-07 Dec-07 Nov-08 Oct-09 Sep-10 Aug-11 Jul-12 Jun-13

Source: Office of Management and Budget

Job Creation Remains Extremely Challenging

40

66

average duration of unemployment

30

employment / population ratio

64

62

weeks

20

60 58

10
56

0 Jan-48 Jan-57 Jan-66 Jan-75 Jan-84 Jan-93 Jan-02 Jan-11

54

Jan-48

Jan-57

Jan-66

Jan-75

Jan-84

Jan-93

Jan-02

Jan-11

Source: Bureau of Labor Statistics

Beveridge Curve Says Unemployment is Structural

90

3.8
12/1/82 - 06/1/84

Help Wanted Index

Job Openings (%)

80 70 60 50 40 7 8 9 10 11 6/1/81 - 11/1/82

3.3 2.8 2.3

12/1/07 - 06/1/09

07/1/09 - present

1.8 1.3 4 6 8 10

Unemployment Rate (%)

Unemployment Rate (%)

Source: Bureau of Labor Statistics

True Unemployment Rate Higher Than Reported

68

unemployment rate(%) with

labor force participation rate

66

12%

a 66% participation rate

10%
64

8%
62

official unemployment rate(%)

60

6%

58

Jan-48 Jan-57 Jan-66 Jan-75 Jan-84 Jan-93 Jan-02 Jan-11

4% Jan-06

Nov-06

Sep-07

Jul-08

May-09

Mar-10

Jan-11

Source: Bureau of Labor Statistics

Housing Is Double Dipping

1400

New Home Sales

200

S&P/Case -Shiller USA Home Price Index

1200

180
1000

800 600

160

140

400

120
200

double dip
Jan-79 Jan-90

double dip
Jan-01 Jan-12

Jan-68

100 Mar-01

double dip
Mar-03 Mar-05 Mar-07 Mar-09 Mar-11

Source: US Census Bureau

The Supply Overhang Is Alarming

6
4.5

existing home inventory

(millions)

(millions)

3.5

shadow inventory

2.5

1.5 Jan-99

May-01

Sep-03

Jan-06

May-08

Sep-10

0 Mar-79

Mar-85

Mar-91

Mar-97

Mar-03

Mar-09

Source: Bloomberg/ National Association of Realtors

Excess Inventories Imply Further Price Drops

25
Case/Shiller home price change (yoy%) (5m lag)

2 4 6 8

15

-5

existing homes supply

10 -15 12 -25 Jan-01 Mar-03 May-05 Jul-07 Sep-09

Source: National Association of Realtors/ Case-Shiller

Months of supply

Price change (%)

How Low Can Home Prices Go?

200 180 160 140 120 100 80 60 1890 another 10-15% drop

real home price index

40% drop thus far

1910

1930

1950

1970

1990

2010

Source: Irrational Exuberance, Robert Shiller

Real And Nominal Oil Prices Are High

160 140 120

Oil Prices

Nominal Real

100

80 60 40 20 0

Jan-74

Jan-80

Jan-86

Jan-92

Jan-98

Jan-04

Jan-10

Source: Bloomberg

Measuring Oil in Terms of Working Hours

hours/barrel

hours needed to work to buy a barrel of oil

0 Jan-74

Jan-80

Jan-86

Jan-92

Jan-98

Jan-04

Jan-10

Source: Bloomberg

Barreling Towards Another Recession

250% 200% 150%

Recessions

% change

100% 50% 0% -50% 24-month oil price change -100% Sep-71 Sep-78 Sep-85 Sep-92 Sep-99 Sep-06

Source: Bloomberg

Household Remains Elevated

16000 14000 12000 10000 8000 6000 4000 2000 0 Jul-53

Household Debt

Jul-62

Jul-71

Jul-80

Jul-89

Jul-98

Jul-07

Source: Federal Reserve

Households Are Still Deleveraging

30%

Household Debt/ Net Worth

26%

22%

18%

14%

10% Oct-60
Source: Federal Reserve, BMO

Oct-67

Oct-74

Oct-81

Oct-88

Oct-95

Oct-02

Oct-09

Transferring Debt From Private to Public

100%

90%

household debt/GDP ratio

80%

70%

60% Oct-90

Oct-94

Oct-98

Oct-02

Oct-06

Oct-10

95%

85%

federal debt/GDP ratio

75%

65%

55% Oct-90

Oct-94

Oct-98

Oct-02

Oct-06

Oct-10

Source: Federal Reserve

A Brewing Debt Bomb But

140% 120% 100% 80% 60% 40% 20%

Jan-40 Sep-53 May-67 Jan-81 Oct-94

CBO alternative

US federal debt/GDP ratio

CBO baseline

Jun-08

Source: Federal Reserve, CBO

There Is Still Time To Diffuse It

25%

21%

US interest/total revenues

CBO alternative

17%

13%
CBO baseline

9%

5% Jan-40

Jan-54

Jan-68

Jan-82

Jan-96

Jan-10

Source: Office of Management and Budget, CBO

The Markets Still Believe In The US

350 300 250 200 150 100 50 Aug-10 Sep-10 Nov-10

5-yr CDS spreads

Italy

Germany

USA

Dec-10

Feb-11

Apr-11

May-11

Jul-11

Sep-11

Source: Bloomberg

A Downgrade Is Not The End Of The World

2.5

S&P downgrade to AA+ S&P downgrade to AA-

1.5

0.5

Japanese 10-year rates

Fitch and S&P downgrade to AA

0 Jan-00

Sep-02

Jun-05

Mar-08

Dec-10

Source: Bloomberg

Debt Crises Keep Rates Low For Long

US 10-year rate
5

(1873-1893)

2 1873

1877

1881

1885

1889

1893

US 10-year rate (1927-1952)

1 1927

1932

1937

1942

1947

1952

Tracking The Japanese Rates

2007 10

2012

2017

2022

2027
6

US 10-year rate
8

(2007-2011) Japenese 10-year rate (1990-2011)

4
2

0 1990

1994

1998

2002

2006

2010

Source: Bloomberg

The Taylor Rule Says: Monetary Policy is Just Right

Fed Funds
6

Taylor Rule

%
2

Fed Funds + QE1 + QE2

-2 Jun-91

Jun-95

Jun-99

Jun-03

Jun-07

Jun-11

Source: Bloomberg, BMO

Equities, Commodities and the End of QE2

360

Commodity Index (CRY)

1400

Equity Index (S&P)

1200

320

QE 2
280

QE 2

1000

240

800

QE 1

QE 1
200 12-Sep

12-Mar

12-Sep

12-Mar

12-Sep

12-Mar

600 12-Sep

12-Mar

12-Sep

12-Mar

12-Sep

12-Mar

Source: Bloomberg, BMO

Real Rates, Breakevens and the End of QE2

3.5 3 2.5 2 1.5 1

10-yr Treasury real rate (%)

2.5

QE 2
1.5

10-yr breakeven inflation (%)

QE 1
0.5 0 Sep-08

QE 1
0.5

QE 2
Mar-09 Sep-09 Mar-10 Sep-10 Mar-11
0 Sep-08

Mar-09

Sep-09

Mar-10

Sep-10

Mar-11

Source: Bloomberg, BMO

The End Of QE2 May Be Followed By Lower Rates

3.6

3.2

2.8 10-yr Treasury rate (%) 2.4 QE 1 2 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 QE 2 Mar-11

Source: Bloomberg, BMO

Conclusions

Underlying trends within the labor market, such as declining wage growth and rising duration of unemployment underscore the structural problems confronting the US economy The current imbalance in housing between high supply and weak demand points to a sustained fall in prices

The recent rise in oil prices poses a significant risk to sustainable growth since it acts like a tax on consumption. Should oil prices remain elevated near $100 to $110/bbl economic growth for 2011 may drop below 2%
The adjusted Fed Funds rate is currently right in line with the Taylor rule suggesting that the Fed will complete its QE2 program and we do not expect the Fed to hike rates until 2013 When QE2 ends we believe that prices for both commodities and equities will drop as they did after the end of QE1. This should help lower inflationary expectations and ultimately drive rates lower. Given the substantial slack in resource utilization we expect rates to drift lower over the course of the year with the10-yr trading close to 2.50%.