Five Key Questions

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This report is available on www.wachovia.com/economics and on Bloomberg at WBEC

SPECIAL COMMENTARY February 10, 2

Five Key Questions for Decision-Makers

John Silvia, Chief Economjohn.silvia@wachovia.

704-374-

Executive Summary1For decision-makers in both the private and public sectors there are five economic

issues that demand our attention. Each of these five areas will be reviewed in turn inthis report.2

First, the strength and character of the general economy Second, the specific issues associated with housing Third, the role of financial and credit markets Fourth, the impact of fiscal stimulus Fifth, the international response to our economic and policy choices

I. Signs of Recovery and the Changing Character of Domestic DemandWe expect below-trend

growth for the next twoyears.

Since the credit bubble burst in August 2007, banks and other lenders have grownincreasingly restrictive in their lending practices. As a result, our outlook is framedby the character of Americas credit cycle, which will dictate the pace and nature ofthe economic recovery. The pattern of this credit cycle and its focus on riskavoidance dictates a deleveraging of the American financial system on both thedemand and supply sides. On the demand side, consumers must strengthen theirbalance sheets by paying down debt, boosting savings and rebuilding equity in theirhomes. All of this will require the consumer to reduce spending. On the supply side,the banking system must rebuild its capital base, which means it must sell stock andrestrain lending. The result is below-trend growth for the next two years (Figure 1).

Deleveraging compels strapped consumers to repair their balance sheets. Real

personal consumption expenditures tumbled at nearly a four percent annual rate forthe second half of last year. We look for further retrenchment over the next fewquarters. Consumers have turned exceptionally cautious in light of the recent spikein the unemployment rate and abrupt tightening in credit. Significant declines inhouse and equity prices this past year have eroded household wealth, which has and

1 Presentation to the American Bankers Associations LLAC Winter Conference, Feb. 5, 2009 inWashington, DC. Thanks are due to Sam Bullard, Jay Bryson, Azhar Iqbal, Mark Vitner and Adam Yorkfor their contributions.2These five questions were suggested as the focus for my comments by the ABA staff.
mailto:[email protected]:[email protected]


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Five Key Questions for Decision-MakersFebruary 10, 2009 SPECIAL COMMENTARY

should continue to weigh on consumer spending. Consumers are not the only onesfeeling rattled. Businesses will likely tighten spending in reaction to depresseddemand by continuing to pare back fixed investment spending and by drawingdown inventories, which will depress growth in coming quarters.

Figure 1

Real GDPBars = Compound Annual Growth Rate Line = Yr/Yr Percent Change

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

2000 2002 2004 2006 2008 2010

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

GDPR - CAGR: Q4 @ -3.8%

GDPR - Yr/Yr Percent Change: Q4 @ -0.2%

Forecast

Figure 2

Real Personal Consumption ExpendituresBars = Compound Annual Growth Rate Line = Yr/Yr Percent Change

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

2000 2002 2004 2006 2008 2010

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

PCE - CAGR: Q4 @ -3.5%

PCE - Yr/Yr Percent Change: Q4 @ -1.3%

Forecast

Source: U.S. Department of Commerce and Wachovia

U.S. Consumer: From Economic Driver to Economic DragThe combination ofdeterioratingemployment prospectsand tightening credit isa powerful one-two

punch.

Consumer spending is expected to be a significant drag on economic growththroughout 2009 (Figure 2). During the previous recession, consumer spendingremained steady thanks to the solid underpinning of rising home prices and easycredit. This cycle will be different as home values have dropped and creditavailability has been cut. Consumers have turned exceptionally cautious in light ofthe recent spike in the unemployment rate and the abrupt tightening of credit. Thecombination of deteriorating employment prospects and tightening credit is apowerful one-two punch that has led to substantial cutbacks in discretionarypurchases (Figure 3). Spending for big-ticket items has been hit hardest, especially

motor vehicle sales. Consumers are also ratcheting back purchases of big-ticket itemssuch as furniture, household appliances and home electronics.

Figure 3

Consumer Discretionary SpendingShare of Total Consumption

42.0%

43.0%

44.0%

45.0%

46.0%

47.0%

1998 2000 2002 2004 2006 2008

42.0%

43.0%

44.0%

45.0%

46.0%

47.0%

Discretionary Share: Dec @ 42.8%

Figure 4

Discretionary Spending

Furniture &

HHEquip

4%

Recreation

4%

Clothing & Shoes

4%

Alcohol & Tobacco

3%

Motor Vehicles

3% Food Away from

Home

5%

Housing Away

from Home

1%

Other

Discretionary

19%

Non-Discretionary

57%

December-2008

Source: U.S. Department of Commerce and Wachovia

Consumers have also cut back on restaurant dining, travel, clothing purchases andare making fewer trips to the shopping mall. Despite lower prices for manyconsumer goods, purchasing power will likely still be constrained by slower incomegrowth. The wealth effect will also cut into purchasing power, with falling homeprices and the stock market collapse cutting household wealth. A conservative

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estimate of the wealth effect would cut spending between $300 and $400 billion thisyear.

A retrenchment in consumer spending is long overdue, in our opinion. Consumerspending had risen faster than income during the past several years, with purchasing

power being bolstered by abundant and inexpensive credit. The credit boom helpedto send the saving rate to roughly zero percent. At its peak, consumer spending andresidential investment accounted for 76.5 percent of GDP, some three percentagepoints above the average maintained since 1990. The ending of the housing boombegan to send the consumption/GDP ratio back toward its historic norm. Evenwhen spending begins to rise again, we expect the rate of growth to remain slightlybelow income growth, thereby allowing for the saving rate to gradually recover.

Recession Probability Dictates Continued RecessionUnfortunately, the probability of recession for the next six months remains high(Figure 5). Our model looks at a very broad set of predictors and these suggest thecurrent recession will likely continue through at least the first half of this year. 3Economic problems began to show up in our model in the fourth quarter of 2007 as

the recession probability rose sharply to 75 percent and since then the probability hasremained extremely high.

Figure 5

Recession Probability Based on Probit ModelTwo-Quarter Ahead Probability

0%

20%

40%

60%

80%

100%

80 84 88 92 96 00 04 080%

20%

40%

60%

80%

100%

Two-Quarter Ahead Recession Probability: Q4 @ 99.4%

Source: Wachovia

3 John E. Silvia, Huiwen Lai, and Sam Bullard, Forecasting U.S. Recessions with Probit StepwiseRegression Models, Business Economics, January 2008, pp. 7-18.

The current recessionwill likely continuethrough at least the

first half of this year.


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Figure 6

ISM

Manufacturing

Index

Corporate

Profits

Initial Claims

First-time jobless claims remain at a very high

600,000+ level. We would expect these claims to begin to drop

towards 500,000 sometime in the spring suggestingthat job losses will diminish as the year moves

along.

The index is computed such that a reading of 50 isconsidered break-even. This monthly survey iscurrently in the mid 30s.

We would expect this index to remain below 50

through the second quarter and show signals of

expansion by midsummer.

Profits are a longer lagging indicator, and atpresent are declining at a 20 percent-plus pace.

We expect the year-over-year declines to turnaround. Improvement by midsummer would

signal growth in employment and businessinvestment by early next year.

Signs of a Recovery: Indicators to Watch

ISM

Manufacturing

Index

Corporate

Profits

Initial Claims




along.








ISM

Manufacturing

Index

Corporate

Profits

Initial Claims

ISM

Manufacturing

Index

Corporate

Profits

Initial Claims




along.











along.











along.








Signs of a Recovery: Indicators to Watch

Source: Wachovia

II. Housing Markets: Prices, Inventories and Regional ImpactsRising unemployment,plunging stock pricesand tight creditconditions are hardly a

formula for increasedhome sales.

One of driving factors of the credit crunch was the housing market as the lack ofavailable credit made it tougher for potential homebuyers and builders to qualify fornew loans. This put downward pressure on housing prices and led to even tighterlending standards making it tougher still for potential homebuyers to qualify. Thisvicious cycle is still playing out as home values are falling across the country and thepool of qualified potential homebuyers is growing smaller. New home constructionis likely to fall further. Rising unemployment, plunging stock prices and tight creditconditions are hardly a formula for increased home sales.

Housing remains a very weak link in the U.S. economic outlook. Not only isresidential construction activity continuing to decline, but falling house prices andrising mortgage delinquency rates also continue to put pressure on credit markets

(Figure 7). A vicious negative feedback loop has been in play for some time.Tightening credit conditions will likely lead to a further slowdown in sales. This willbe followed by additional economic weakness, resulting in larger home pricedeclines, higher mortgage delinquency rates and culminating in even tighter lendingstandards. We expect a much deeper and drawn out housing cycle with a bottomstill a ways off. New and existing home sales are both expected to bottom bysummer with housing starts to follow (Figure 8). Residential construction shouldbottom this year. The bottom, however, will now be significantly lower than

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previously thought, as tighter credit conditions for home buyers and builders willsend activity well below recent lows.

Figure 7

Home PricesYear-over-Year Percentage Change

-24%

-20%

-16%

-12%

-8%

-4%

0%

4%

8%

12%

16%

20%

24%

97 99 01 03 05 07

-24%

-20%

-16%

-12%

-8%

-4%

0%

4%

8%

12%

16%

20%

24%

Median Sale Price: Dec @ $174,700

Median Sales Price 3-Month Mov. Avg.: Dec @ -12.4 %

FHFA (OFHEO) Purchase Only Index: Nov @ -8.7 %

S&P Case-Shiller Composite 10: Nov @ -19.1 %

Figure 8

Housing StartsMillions of Units

0.0

0.3

0.6

0.9

1.2

1.5

1.8

2.1

2.4

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

0.0

0.3

0.6

0.9

1.2

1.5

1.8

2.1

2.4

Dashed Line is Underlying Demographic Trend

Source: National Association of Realtors, FHFA, S&P Corp. , U.S. Dept. of Commerce and Wachovia

Understanding where we are in the housing correction is critical in developing acoherent outlook for the broader economy. The current housing cycle is largelywithout precedent in timing, depth and breadth. Past housing slumps tended tofollow the business cycle. The construction slump preceded the broader economicslump by about two years, with sales tumbling once easy and inexpensive mortgagecredit disappeared. The initial tightening of credit followed a dramatic increase indelinquency rates on most subprime mortgages, which were poorly underwrittenand thinly collateralized. As a result, delinquency rates soared well ahead of anynoticeable slowing in the broader economy, which is something never seen before.By contrast, the more recent rise in mortgage delinquency rates and defaults is theresult of the deteriorating economic environment. Unfortunately, the continuing risein the unemployment rate will send delinquency rates still higher.

Unusual Breadth: Regional ImpactThe breadth of this housing slump is also unusual, but the bulk of the housing boomand bust took place in just a handful of statesFlorida, California, Arizona, andNevada, which accounted for the greatest amount of speculative home-buying andalso saw the largest price gains and declines in the country. Other notable hot spotsthat turned brutally cold include the outer suburbs of Washington, D.C., the greaterNew York area, the greater Boston area and some of the coastal metropolitan areas inthe Carolinas and Georgia. There are also a few places where prices have slumpedeven though they never enjoyed a housing boom. Most of these areas are in theMidwest, and include the areas in and around Detroit and Cleveland. Housingprices have fallen precipitously in these areas largely due to extremely depressedeconomic conditions, a disproportionate amount of subprime lending anddeteriorating demographics.

III. Credit MarketsWe have seen the patterns of credit move toward a deleveraging of the economyagainst the prevailing pattern of the past 25 years. What forces account for thismomentum shift in the credit cycle and what does it mean for 2009?

Credit expansion has characterized economic growth over the past few decadesespecially during the recent economic upturn that lasted from 2001 to 2007 (Figure 9).Innovation in the credit markets resulted in an apparent solution for every situation.A vast number of credit instruments were developed during the expansion to fill in

Understanding where

we are in the housingcorrection is critical indeveloping a coherentoutlook for the broadereconomy.

The breadth of thishousing slump is alsounusual, but the bulk ofthe housing boom andbust took place in just ahandful of states.


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the gaps of creditor and borrower needs. In many ways, it appeared that creditmarkets were becoming more complete. They could meet the credit needs of bothborrowers and creditors across the spectrum. In addition to a long period of low,short-term interest rates, credit expansion was also enhanced by easier creditstandards, which effectively meant a greater supply of credit at any interest rateacross the risk spectrum.

Figure 9

Domestic Nonfinancial DebtAs Percent Of GDP

125%

150%

175%

200%

225%

250%

82 84 86 88 90 92 94 96 98 00 02 04 06 08

125%

150%

175%

200%

225%

250%

Nonfinancial Debt: Q3 @ 228.4%

Figure 10

U.S. Household DebtU.S. Household Liabilities to Net Worth

14%

16%

18%

20%

22%

24%

26%

28%

82 84 86 88 90 92 94 96 98 00 02 04 06 08

14%

16%

18%

20%

22%

24%

26%

28%

Liabilities to Net Worth: Q3 @ 25.8%

Source: Federal Reserve Board, U.S. Department of Commerce and Wachovia

Near the end of the past economic expansion, excesses in credit markets wererampant and were characterized by easy lending standards. Consumers benefitedfrom this credit environment as housing finance became democratized and autoloans and credit cards were widely available (Figure 10). Businesses large and smallbenefited from this accommodative lending environment as well. Some borrowersoverstated their income and some lenders never bothered to check. Over the pastyear and a half, however, we have witnessed significant backtracking which has ledto a sharp curtailment of credit and to the current economic downturn.

Credit markets are stillsearching for a newbalance between riskand reward.

Credit markets are still searching for a new balance between risk and reward. Thereis also a trend toward a more conservative view of risk-taking in general. Over thepast few months, we have already witnessed significant declines in the federal fundsrate and Treasury yields, but private-sector borrowing rates have not yet receded,especially those farther out on the yield and credit curves.

Figure 11

LIBOR to Federal Funds Effective Rate SpreadBasis Points

-50

0

50

100

150

200

250

300

350

400

2004 2005 2006 2007 2008 2009

-50

0

50

100

150

200

250

300

350

400

LIBOR to Federal Funds: Jan @ 94 bps

Figure 12

TED SpreadBasis Points

0

50

100

150

200

250

300

350

400

450

2004 2005 2006 2007 2008 2009

0

50

100

150

200

250

300

350

400

450

TED: Jan @ 103 bps

Source: Federal Reserve Board, British Bankers Association and Wachovia

At the short end of the curve, rates are still driven by the Federal Reserve. Ourexpectation that the recession will continue and that consumer spending and housing

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will continue to struggle lead us to believe that the Fed will continue on its liquidityprovision path until next year. Short-term interest rates in general will remain lowfor an extended period of time. Moreover, we have seen in recent weeks animprovement in private market spreads such as the LIBOR-to-Federal funds and theTED spread (Figure 11 & Figure 12). This suggests that credit supply may be comingback into the market and that the worst of the credit problem may have passedatleast at the short end of the curve.

The Other End of the Maturity StreetFinancial markets have evidenced only modest improvement in credit spreads andcredit supply at the long end. In addition, the benchmark 10-year Treasury yield hasdrifted upward since the start of this year. In the credit sphere, the recession andpoor earnings continue to limit issuance in the face of a skeptical market buyer. As aresult, we have seen very little improvement in bond spreads over Treasuries (Figure13). Over the next three months we expect very little improvement. The Fed hascertainly been helpful in areas such as mortgage backed securities, where it has beena direct buyer, but such help has not spread much wider.

We remain concerned about the middle to long end of the Treasury curve. For now,the safe haven trade appears to be working. Longer term, we are concerned thatfiscal deficits, inflation expectations and anti-China/trade rhetoric will dictate risingrates. We also have concerns that yields on longer-dated debt instruments will driftupward as inflation expectations rise and the flight-to-safety trade falls away. Inaddition, dollar weakness may reappear as this year ages and this would add to ourinflation concerns as well as introduce currency risk into the mix.

Figure 13

Aaa and Baa Corporate Bond SpreadsOver 10-Year Treasury, Basis Points

0

100

200

300

400

500

600

700

90 92 94 96 98 00 02 04 06 08

0

100

200

300

400

500

600

700

Aaa Spread: Jan @ 253 bps

Baa Spread: Jan @ 563 bps

Figure 14

Consumer Loan Delinquency RateSeasonally Adjusted

2.5%

3.0%

3.5%

4.0%

4.5%

1991 1994 1997 2000 2003 2006

2.5%

3.0%

3.5%

4.0%

4.5%

Consumer Loans: Q3 @ 3.7%

Source: Federal Reserve Board and Wachovia

On net, the changes in risk versus reward calculations by both borrower and lenderdictate that the growth in consumer spending over the outlook period will besluggish relative to the trend of prior expansions. Residential construction and

business equipment spending will exhibit sub-par growth in the period ahead, in ouropinion. Consumer delinquencies are expected to continue to rise (Figure 14).Moreover, if taxes are raised (windfall profit taxes, corporate taxes, dividend andcapital gains taxes, for example), then the after-tax reward for risk-taking would befurther diminished. The net result is that the demand for credit would be limited.Weak U.S. and foreign growth suggests that the supply of credit through savings andprofits would also be very limited relative to prior recoveries.

Financial markets haveevidenced only modestimprovement in creditspreads and creditsupply at the long end.


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8

IV. Fiscal Stimulus: Help Today but Burden Tomorrow?In an effort to revive the ailing economy, various policy measures will be considered.A second stimulus program, which should provide a boost to growth at least in theshort run, is likely to be passed in coming weeks. However, unintended

consequences of the policy mix could offset much of the stimulus. Higher taxes ondividends and capital gains as well as increased income taxes for higher-incomeindividuals could provide a disincentive to work. A more interventionistgovernment could alter private risk/reward calculations, which could be negativefor long-run growth prospects. What little economic growth we had in 2008 wasmade possible by strong global growth. With housing and consumer spendingstruggling, we project that the severity of the current recession will be somewherebetween the 1973-75 downturn and 1980-82 twin recession periods. Unemploymentis likely to rise to 9.5 percent by late 2010. Given this economic background, we haveseen a rapid rise in federal spending and a rapid rise in the federal deficit since therecession began (Figure 15 & Figure 16).

Figure 15

Federal Government Spending Ex. Interest PaymentsYear-over-Year Percent Change, 12-Month Moving Average

-5%

0%

5%

10%

15%

20%

25%

30%

1970 1975 1980 1985 1990 1995 2000 2005

-5%

0%

5%

10%

15%

20%

25%

30%

Spending Ex. Interest Payments: Dec @ 20.3%

Figure 16

Federal Budget Surplus or DeficitAs a Percent of GDP, 12-Month Moving Average

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

70 75 80 85 90 95 00 05

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

Surplus or Deficit as a Percent of GDP: Dec @ -5.9%

Source: U.S Department of the Treasury, U.S. Department of Commerce and Wachovia

Unfortunately, the use of policy stimulus in the past (such as the 1970s) did not havethe desired result, but rather stagflation was the reality of the day. Attempting toascertain the implications of a change in economic policy solely on the basis ofrelationships observed in historical data which tends to be highly aggregated, isunadvisable.4 Individual behavior can change in reaction to policy initiatives, whichcould render those initiatives ineffective. We had a real-life example of this last yearwith the Economic Stimulus Act of 2008. While the stimulus did lead to a brief pick-up in retail spending, it did not generate an ongoing economic recovery. Certainlythere were other factors involved, but the basic lesson was that such rebates weresimply handouts that did not alter individual incentives to work, save or invest. Inthe short run, policy endeavors may appear effective at the macro level, but withoutany change in individual incentives, there is no long term stimulus to the economy.

Debt/GDP: Flexibility or Trap Door?One argument for the flexibility of fiscal policy to adopt a large stimulus withassociated large fiscal deficits is that the current U.S. federal debt to GDP ratio ismodest compared to nations such as Japan (Figure 17). We are not convinced thatthis is effective reassurance primarily for two reasons. First, we depend on foreign

4 Lucas, Robert (1976). Econometric Policy Evaluation: A Critique. Carnegie-Rochester ConferenceSeries on Public Policy 1:19-46.

Attempting to ascertainthe implications of achange in economic

policy solely on thebasis of relationshipsobserved in historicaldata, which tends to behighly aggregated, isunadvisable.


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investors for much of the financing; nearly 60 percent of marketable debt is currentlyheld by foreigners. Despite a recent up-tick in domestic savings we will needforeigners to foot a considerable portion of the coming bill. Second, futuredeficits/debts are expected to rise quickly due to the entitlement spending boomassociated with the retirement of the baby boom generation. In our opinion, thecurrent low ratio of debt to GDP is a trap door which could lead to a much heavierburden on future generations.

Figure 17

Government DebtAs Percent of Nominal GDP

35%

55%

75%

95%

115%

135%

155%

175%

1991 1993 1995 1997 1999 2001 2003 2005 2007

35%

55%

75%

95%

115%

135%

155%

175%

United States: 2008 @ 68.6%

Japan: 2008 @ 166.5%

Germany: 2007 @ 65.0%

Source: Global Insight and Wachovia

V. International Implications: Global Economy, Dollar, and Capital FlowsNet exports helped prop up U.S. GDP growth in 2008 despite weakness in domesticdemand. However, that support is winding down. Every major foreign economy iseither already in recession or about to slip into one, due in large part to thepernicious effects of the global credit crunch. Economic growth in the developingworld has also slowed this year. Global GDP will likely expand an abysmally slowone percent in 2009, the slowest year for global growth since records at the IMFbegan in the 1970s.

Outlook for the Dollar: Best Among a Weak BunchThe U.S. dollar followed a downward trend against most major currencies betweenearly 2002 and mid-2008 (Figure 18). There are a number of reasons for the dollarsdecline. For starters, the large U.S. current account deficit exerted downwardpressure on the greenback. Interest rate differentials moved against the UnitedStates, which reduced the relative attractiveness of U.S. assets to foreign investors. Inaddition, dislocations in credit markets caused new issuance of structured fixed

Every major foreigneconomy is eitheralready in recession orabout to slip into one,due in large part to the

pernicious effects of theglobal credit crunch.


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income products, which foreign investors had purchased in droves, to plummetstarting in the autumn of 2007.

Figure 18

Trade Weighted DollarMajor Curency Index, 1973 = 100

65.0

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

110.0

115.0

2000 2002 2004 2006 2008 2010

65.0

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

110.0

115.0

Trade Weighted Dollar : Q4 @ 79.41

Forecast

Source: Federal Reserve Board and Wachovia

We project that the dollar will continue to trend higher against most major currencies

in the coming year, before turning in 2010. The current account deficit is about to getsignificantly smaller, which will exert fewer headwinds on the greenback. Theunderlying trade deficit has narrowed markedly as real exports have grown muchfaster than real imports. Now that oil prices have collapsed, the nominal trade deficitshould decline rapidly. In addition, foreign central banks probably will be cuttingrates more than the Federal Reserve in the months ahead. As interest ratedifferentials narrow, foreign capital inflows should strengthen, which should lead todollar appreciation.

The value of emerging market currencies has depreciated over the past three monthsas risk aversion has spiked and deleveraging has soared. As risk aversion retreatsfrom extreme levels, many emerging market currencies could recoup some of theirlosses. That said, we project that the dollar will grind higher next year versus most

emerging currencies as central banks in developing countries cut rates due toslowing economic growth and receding inflation.

Capital Flows Favor Only the Safest Assets: Risks, Regulation and TaxesThe latest Treasury International Capital System data indicate that not only didforeign investors continue to eschew (Figure 19) riskier U.S. assets such as corporatebonds and agency securities, but investors were net sellers of U.S. securities inNovember (Figure 20). Strong foreign purchases of very safe Treasury bills kept totalcapital inflows positive in November. Net purchases of long-term securities declined

10


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for the second consecutive month. The $56.0 billion decline in foreign purchases ofU.S. securities was offset by the $34.3 billion drop in U.S. purchases of foreignsecurities. Foreign investors continued to eschew agency securities and corporatebonds in November. Purchases of short-term securities, especially Treasury bills,remained strong. In the current environment, investors are flocking to the safestassets.

Figure 19

Foreign Private Purchases of U.S. Securities12-Month Moving Sum, Billions of Dollars

-$100

$0

$100

$200

$300

$400

$500

$600

98 99 00 01 02 03 04 05 06 07 08

-$100

$0

$100

$200

$300

$400

$500

$600

Treasury: Nov @ $221 Billion

Corporate: Nov @ $50 Billion

Equity: Nov @ $37 Billion

Agency: Nov @ $12 Billion

Figure 20

Monthly Net Securities PurchasesBillions of Dollars

-$80

-$40

$0

$40

$80

$120

$160

2004 2005 2006 2007 2008

-$80

-$40

$0

$40

$80

$120

$160

Net Securities Purchases: Nov @ -$22 Billion

3-Month Moving Average: Nov @ $14 Billion

Source: U.S Department of the Treasury and Wachovia

Looking ahead, the risk avoidance trade will have a lasting impact on keepingforeign investors away from many corporate issues. In addition, the threat of greaterregulation and higher taxes on capital gains and dividends suggest that capital flowswill likely decline relative to earlier this decade. After the flight-to-safety tradeevaporates, the cost of credit to the U.S. is likely to rise. This will be evident inhigher interest rates, lower price-earnings ratios or depreciation in the dollar relativeto earlier this decade.

Conclusion

In sum, further declines in consumer spending, business fixed investment andresidential construction translate into continued contraction in real economic activity.By the time the economy hits bottom in late 2009, real GDP will probably havecontracted more than three percent, the worst downturn since 1981-82. Employmentmay post the worst performance in 50 years, with declines topping five million jobs,or more than four percent of total employment. Underlying our forecast, however, isthe assumption that policymakers will take the necessary steps to prevent the globalfinancial system from locking up again. Should that assumption prove overlyoptimistic, global economic growth would end up even weaker than our alreadybleak outlook projects.

In the currentenvironment, investorsare flocking to thesafest assets. After the

flight-to-safety tradeevaporates, the cost ofcredit to the U.S. islikely to rise.


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Wachovia Economics Group

ohn E. Silvia, Ph.D. Chief Economist (704) 374-7034 [email protected]

Mark Vitner Senior Economist (704) 383-5635 [email protected]

Jay H. Bryson, Ph.D. Global Economist (704) 383-3518 [email protected]

Sam Bullard Economist (704) 383-7372 [email protected]

Anika Khan Economist (704) 715-0575 [email protected]

Azhar Iqbal Econometrician (704) 383-6805 [email protected]

Adam G. York Economic Analyst (704) 715-9660 [email protected]

Tim Quinlan Economic Analyst (704) 374-4407 [email protected]

Kim Whelan Economic Analyst (704) 715-8457 [email protected]

Yasmine Kamaruddin Economic Analyst (704) 374-2992 [email protected]

Wachovia Corporation Economics Group publications are distributed by Wachovia Corporationdirectly and through subsidiaries including, but not limited to, Wachovia Capital Markets, LLC,Wachovia Securities, LLC and Wachovia Securities International Limited.

The information and opinions herein are for general information use only. Wachovia does notguarantee their accuracy or completeness, nor does Wachovia assume any liability for any loss thatmay result from the reliance by any person upon any such information or opinions. Such informationand opinions are subject to change without notice, are for general information only and are notintended as an offer or solicitation with respect to the purchase or sales of any security or as

personalized investment advice. 2009 Wachovia Corp.

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Five Key Questions