Smith Breeden Associates

Smith Breeden Associates

Macroeconomic Outlook

May 12, 2003

Eugene F. Flood, President and CEO

Macroeconomic Outlook

• Historically unusual economic times• Suppose we assume the recovery began

January 2002• Industrial production at bottom end of

historical experience

Industrial Production Growth During Recession and RecoveryThin Lines are Peak to Trough (NBER Recession)

Thick Lines are Trough to + 14 months

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

Feb-

53

Feb-

55

Feb-

57

Feb-

59

Feb-

61

Feb-

63

Feb-

65

Feb-

67

Feb-

69

Feb-

71

Feb-

73

Feb-

75

Feb-

77

Feb-

79

Feb-

81

Feb-

83

Feb-

85

Feb-

87

Feb-

89

Feb-

91

Feb-

93

Feb-

95

Feb-

97

Feb-

99

Feb-

01

Feb-

03

Mon

thly

gro

wth

R53 R53+14 R57 R57+14 R60 R60+14 R69 R69+14 R75 R75+14R80 R80+14 R81 R81+14 R90 R90+14 R01 R01+15

Industrial Production Growth During RecoveryTrough to Trough +14 Months

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Mon

thly

gro

wth

R01+15 Average 9 recessions Average 6 recessions

Macroeconomic Outlook

• We have heard the term “jobless” recovery• Current experience is very unusual

Change in Nonfarm Payrolls During Recession and RecoveryThin Lines are Peak to Trough (NBER Recession)

Thick Lines are Trough to + 12 months

-80000.00%

-60000.00%

-40000.00%

-20000.00%

0.00%

20000.00%

40000.00%

60000.00%

80000.00%

100000.00%

120000.00%

140000.00%

Feb-5

3

Feb-5

5

Feb-5

7

Feb-5

9

Feb-6

1

Feb-6

3

Feb-6

5

Feb-6

7

Feb-6

9

Feb-71

Feb-7

3

Feb-7

5

Feb-7

7

Feb-7

9

Feb-8

1

Feb-8

3

Feb-8

5

Feb-8

7

Feb-8

9

Feb-9

1

Feb-9

3

Feb-9

5

Feb-9

7

Feb-9

9

Feb-0

1

Feb-0

3

Mon

thly

gro

wth

R53 R53+14 R57 R57+14 R60 R60+14 R69 R69+14 R75 R75+14R80 R80+14 R81 R81+14 R90 R90+14 R01 R01+15

Change in Nonfarm Payrolls During RecoveryTrough to Trough +14 Months

-400

-300

-200

-100

0

100

200

300

400

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Mon

thly

gro

wth

R01+15 Average 9 recessions Average 6 recessions

Percentage Change in Nonfarm Payrolls During RecoveryTrough to Trough +14 Months

-0.40%

-0.30%

-0.20%

-0.10%

0.00%

0.10%

0.20%

0.30%

0.40%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Mon

thly

gro

wth

R01+15 Average 9 recessions Average 6 recessions

Macroeconomic Outlook

• Employment gap:Jobs created since January 2002 = -594,000Jobs usually created in recovery = 1,473,000Gap = 2,000,000 jobs

• Insufficient capital spending – at levels of seven years ago

New Orders for Nondefense Capital Goods Scaled by PPI

0

10,000

20,000

30,000

40,000

50,000

60,000

Feb-92

Feb-93

Feb-94

Feb-95

Feb-96

Feb-97

Feb-98

Feb-99

Feb-00

Feb-01

Feb-02

Feb-03

Mill

ions

$

Nondefense Nondefense x aircraft

Macroeconomic Outlook

Why?• Largely a result of uncertainty induced by

geopolitical risk

ICRG Political Risk

Data from PRS

60

65

70

75

80

85

90

95

100

Equally-weighted world G-7xUS Switzerland United States

Macroeconomic Outlook

ICRG Political Risk

Data from PRS

60

65

70

75

80

85

90

95

100

Equally-weighted world Japan Switzerland United States

Macroeconomic Outlook

ICRG Political Risk

Data from PRS

6065707580859095

100

Equally-weighted world JapanGermany SwitzerlandUnited States

Macroeconomic Outlook

Macroeconomic Outlook

• Corporations have acted defensively on two fronts:– Option to wait is very valuable– Employment retrenchment

Macroeconomic Outlook

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

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)

Recent blip in consumer confidence

50

60

70

80

90

100

110

Michigan survey

Macroeconomic Outlook

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.

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

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)

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

Macroeconomic Outlook

• Insert graph of cuts in rates

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

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)

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.

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

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

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”

Macroeconomic Outlook

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

One-Year Forecast• One-year risk premium quite variable. Currently,

about 3.25%

0123456

6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-017-Jun-01 10-Sep-01 4-Dec-01 11-Mar-024-Jun-02 16-Sep-02 4-Dec-02 19-Mar-03

Macroeconomic Outlook

Ten-Year Premium• Ten-year risk premium is stable. Currently,

about 3.75%

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6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-017-Jun-01 10-Sep-01 4-Dec-01 11-Mar-024-Jun-02 16-Sep-02 2-Dec-02 19-Mar-03

Macroeconomic Outlook

Conclusions• To be added

Macroeconomic Outlook