US Economic Outlook: The Debt HangoverThe Hangover Will Last Into 2010 and Beyond II III Recovering From Recession I ØGovernment Spending Is Aspirin Providing Temporary Relief ØA

August/September 2009

333 South Grand Avenue Los Angeles, CA 90071

US Economic Outlook: The Debt Hangover

ContentsContents

I Recovering From Recession

Consumers and Businesses Are On the Wagon

The Hangover Will Last Into 2010 and Beyond

II

III

Recovering From Recession

I

Ø Government Spending Is Aspirin Providing Temporary Relief

Ø A Recovery Is Probably Underway

Ø The US Economy Still Lacks Balance

Ø Private Demand Will Determine Whether the Recovery Has Legs

3

F:\GRAPHICS\Economics\USO\August 2009\USO August 2009 The Hangover.ppt

Recovering From Recession

95

97

99

101

103

Q0 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9

Quarters

Rea

l GD

P In

dexe

d to

100

at O

nset

of R

eces

sion

2008 Recession 2001 Recession 1990 Recession1981 Recession 1973 Recession

Since World War II, the average peak to trough decline in real gross domestic product during a recession has been on the order of 1.9%. The last two recessions in 1990 and 2001 were much milder with declines of 1.3% and 0.2%, respectively. This time around, we are forecasting a peak to trough decline in real GDP of 3.2%, making this one of the most severe recessions during the post-war era.

2008-2009 Recession Forecast Compared to Prior Recessions

Recession Begins

Where We Are Today

Sources: Commerce Department, Payden & Rygel Estimates

* Real GDP is indexed to 100 at the onset of the recession.

4


Government Spending Is The Aspirin Providing Relief

$288

$111

$43

$202

$144

Allocated

Only $102 billion of the $787 billion fiscal stimulus has been spent through July 2009. The bulk of the package is expected to hit the US economy over the next four quarters, which will help boost economic growth through the first half of 2010.

Source: Recovery Accountability and Transparency Board* As of July 9th, 2009** Other transfer payments includes education and training, health care, and emergency funds for TALF and COBRA programs

$43

$30

$28

>$1

>$1

Fiscal Stimulus Spending in Billions of US Dollars

Spent*

Total:$787 Billion

Total:$102 Bn

**

5


A Recovery Is Probably Underway

2005 2006 2007 2008-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Qua

rter

-ove

r-Q

uart

er A

nnua

lized

Per

cent

Cha

nge

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0 Quarter-over-Q

uarter Annualized Percent C

hange

Sources: The Conference Board and The Commerce Department

Composite index of 10 leading indicators (Left)Real Gross Domestic Product (Right)Recession Periods - United States

Composite of 10 Leading Economic Indicators and Real Gross Domestic Product (GDP)

The Conference Board’s Leading Economic Index (LEI) has led turning points in the economy by an average of 7 months over the past 40 years. The range of lead times has varied from as long as 12 months in the 1960 recovery to as little as two months in the 1991 recovery. At the present time, the LEI is pointing to real GDP growth of more than 3% in Q3 2009.

6


The US Economy Still Lacks Balance

Source: The Commerce Department

The only two positive contributors to economic growth in the second quarter of 2009 were trade and government spending. Unfortunately, the improvement in net exports was the byproduct of collapsing US demand rather than a pick up in exports. Greater balance in the composition of growth is necessary if a sustainable economic recovery is to take hold.

1.6%

0.8%

0.4%

-0.7% -0.7%

-1.4%

-1.2%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

Net Exports FederalSpending

State/LocalSpending

HousingInvestment

ConsumerSpending

BusinessInvestment

PrivateInventories

Per

cent

age

Poi

nt C

ontri

butio

n to

Rea

l GD

P 2009 Q2 Real GDP Growth = -1.0%

Contribution to Real GDP by Component

7


Private Demand Will Determine Whether the Recovery Has Legs

Jan-05 Jan-06 Jan-07 Jan-08-6

-4

-2

0

2

4

6

8

10

Year

-ove

r-Ye

ar P

erce

nt C

hang

e

Source: US Department of Commerce

Federal Government Spending Final Sales to Private Domestic Purchasers Recession Periods - United States

Government Spending and Gross Domestic Product (GDP)

Spending by the federal government, which accounts for 8% of GDP, rose 6.4% in the second quarter of 2009 from a year earlier. By contrast, private demand, which represents more than 80% of GDP, declined 5.2% over the same period.

Government

Spending

Private Demand

8


The Ingredients of a Private Demand Cocktail

Household Spending

Key Indicators

§ Consumer Confidence

§ Income/Employment

§ Household Balance Sheet

Business Spending

Key Indicators

§ Business Sentiment

§ Corporate Profits

§ Corporate Balance Sheet

Private demand is a measure of demand for goods and services from the non-government sector. It is critical to generating sustainable growth.

It has two primary ingredients:

9


2009-2010 Base Line Economic Forecast

9.09.39.810.09.99.69.38.1Unemployment Rate(percent)

2009Actual Forecast

2010Forecast

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4Real GDP(quarter-to-quarter annualized percent change)

-6.4 -1.0 3.0 2.0 2.2 2.5 1.5 2.0

Headline CPI Inflation(year-over-year percent change)

-0.2 -0.9 -1.6 1.6 2.0 1.7 1.5 1.4

Core CPI Inflation(year-over-year percent change)

1.7 1.8 1.6 1.3 1.1 1.0 1.2 1.4

Federal Funds Rate(percent)

<0.25 <0.25 <0.25 <0.25 <0.25 0.50 0.75 1.00

10-Year Treasury(percent)

2.67 3.53 3.60 3.75 3.85 4.00 4.20 4.35

Consumers and Businesses Are On the Wagon

II

Ø Households Abstaining From Consumption

Ø Consumer Fundamentals Look Shaky

Ø Corporate Cost Cutting Creates Another Headache

Ø Businesses Did Not Get As Drunk On Debt As Consumers

11


Households Are Feeling Better, Just Not Well Enough to Consume

1999 2002 2004 2007 200920

40

60

80

100

120

Inde

x

-2

-1

0

1

2

3

4

5

6

Year-over-Year Percent Change

Sources: The Conference Board and The Commerce Department

The Conference Board Consumer Confidence Expectations (Left)Real Consumer Spending (Right)

Consumer Expectations Six Month Hence and Real Consumer Spending

Consumers have become increasingly optimistic about the economic outlook as the panic in global financial markets subsides. Consumer expectations for the economy six months hence have risen sharply over the past six months. Over the past decade, this series has had an 85% correlation with consumer spending.

12


Non-Farm Payroll Employment and the Wages and Salaries Component of Personal Income

Consumer Fundamentals Still Look Shaky

The pace of job losses is slowing from an average of 556,000 per month in the first half of the year to 247,000 in July 2009. If the US economy begins growing again by the third quarter, then job growth could resume by year end. Historically, wages and salaries have begun to increase between four and six months after the economy has started generating jobs.

1994 1996 1997 1999 2001 2002 2004 2006 2007 2009

-800

-600

-400

-200

0

200

400

600

Mon

thly

Cha

nge

(Tho

usan

ds)

-6

-4

-2

0

2

4

6

8

10


Sources: The Labor Department and the Commerce Department

Non-farm Payroll Employment (Left)Wages and Salaries (Right)Recession Periods - United States

Six-Month Lag Between Job Growth

and Wage Growth

13


Corporate Profits and Unemployment

During recessions, corporations will often work to reduce costs as a means of improving profit margins. This implies laying off workers and slashing capital expenditures. Though corporate profits continue to decline at an alarming rate, the good news is that the number of companies reporting upside earnings surprises has risen sharply. According to Standard & Poor’s, 75% of the companies in the S&P 500 stock index reported better-than-expected earnings for the second quarter.

Corporate Cost Cutting Creates a Headache for Workers

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

4

5

6

7

8

9

Perc

ent o

f Lab

or F

orce

-20

-10

0

10

20

30


Source: The Commerce Department and the Labor Department

Corporate Profits with Inventory and Capital Consumption Adjustment (Right)Unemployment Rate (Left)Recession Periods - United States

14


US Household Debt Today and Japanese Non-Financial Corporate Debt in the 1990s

Household leverage, as measured by the ratio of debt to personal disposable income, doubled from 65% in the mid-1980s to 130% by 2008. Private nonfinancial firms in Japan managed to reduce leverage by 30 percentage points over ten years following the bursting of their bubbles in stocks and real estate in the early 1990s.

Households Need To Purge Their Debt

80

90

100

110

120

130

140

Y-9 Y-6 Y-3 Y0 Y+3 Y+6 Y+9

Years from Peak

Per

cent

Japanese Non-Financial CorporateLoan Debt to GDP

US Household Debt/DisposableIncome

Source: San Francisco Federal Reserve

15


Americans Are Likely to Save More and Spend Less

1994 1996 1997 1999 2001 2002 2004 2006 2007 2009-2

-1

0

1

2

3

4

5

6

Perc

ent

Sources: The Commerce Department and the Federal Reserve

Personal Savings as a Percent of Disposable Income Year-over-Year Percentage Change in Consumer Spending Recession Periods - United States

Personal Savings as a Percentage of Disposable Income and Consumer Spending

The San Francisco Fed estimates that households need to reduce their debt to income ratio from 130% to 100% over the next decade. To achieve this feat, Americans would need to increase their savings rate from 4.6% today to 10% by 2018 and 80% of those savings would have to be used debt repayment. This could shave between 0.75% and 1% from consumption growth over the next decade.

16


Businesses Did Not Get As Drunk On Debt As Consumers

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

20

25

30

35

40

Perc

ent o

f Net

Wor

th a

t Mar

ket V

alue

Source: Federal Reserve

Corporate Debt to Net Worth (Commercial paper, Bank loans, & Corporate bonds) Recession Periods - United States

Non-Financial Corporate Debt to Net Worth At Market Value

The bursting of the technology bubble in the late 1990s forced the non-financial corporate sector to repair its balance sheets and reduce debt in the form of commercial paper, corporate bonds, and bank loans.

Corporations Cleaned Up Balance Sheets Earlier This Decade

17


Non-Financial Corporations Have Little Need For Additional Funds

1959 1963 1966 1970 1973 1977 1980 1984 1988 1991 1995 1998 2002 2005 2009

$-80

$-60

$-40

$-20

$0

$20

$40

$60

$80

$100B

illio

n of

US

Dol

lars

Source: Federal Reserve

Nonfarm Nonfinancial Corporate Business - Financing Gap

Corporate Financing Gap

The corporate financing gap is equal to capital expenditures less internal funds and inventory valuation adjustments. When this figure is negative, as it was in the first quarter of 2009, businesses have excess cash on their balance sheets.

Meeting Financing Needs With

Internal Cash

Borrowing Externally to Meet Financing Needs

18


ISM Purchasing Managers Index and Non-Residential Business Investment

The Institute of Supply Management’s Index of Manufacturing Activity has risen dramatically since the end of last year as businesses succeed in trimming unwanted inventories and reducing their workforces to enhance future profitability.

Businesses Are Feeling Better About Their Prospects

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

-20

-15

-10

-5

0

5

10

Year

to Y

ear P

erce

nt C

hang

e

35

40

45

50

55

60

Index

Sources: Insti tute for Supply Management and the Commerce Department

ISM Manufacturing Index (Right)Business Investment (Left)Recession Periods - United States

The Hangover Will Last Into 2010 and Beyond

III

Ø The Debt Party Is Over: Lower Growth & Higher Unemployment

Ø The Tab: Higher Taxes & Higher Interest Rates

20


The Debt Party Is Over: Lower Economic Growth Likely

Potential output is a measure of how fast the economy can grow without generating inflation when its capital and labor resources are fully utilized.

Here is a simple formula for calculating potential GDP:

Potential GDP = Output per Hour + Hours Worked

1990s 3.2% = 2.7% + 0.5%

Today 2.5% = 2.0% + 0.5%

Overinvestment in housing; Underinvestment in technology

Leverage reduced in financial system from 30:1 to 20:1

Households increase savings and paying down debt

21


-5.0 -2.5 0.0 2.5 5.0 7.5 10.0Real Gross Domestic Product (Year-over-Year Percent Change)

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

Une

mpl

oym

ent R

ate

(Per

cent

of L

abor

For

ce)

Sources: The Commerce Department and the Labor Department

Lower Growth Potential Implies Higher Unemployment

Unemployment Rate and Real Gross Domestic Product

The non-accelerating inflation rate of unemployment (NAIRU) is the lowest unemployment rate the economy can achieve without generating price pressures through faster wage growth. Over the past decade, many economists believed this level had fallen to 5%. However, if potential GDP growth has indeed fallen to 2.5%, the NAIRU could be much higher.

2.5% Potential GDP Growth

6.0% Natural Rate of Unemployment?

50 Year Linear Trend Line

22


Income Tax Rates and the Budget Deficit

The 2010 fiscal year budget deficit is expected to reach $1.8 trillion or nearly 13% of GDP –the largest its been since the Second World War. Although a pick up in economic growth should lead to an increase in tax revenues in the next year, tax rates are likely to have to rise in order to pay down the budget deficit. During 1944 and 1945 the top rate reached an all-time high of 94% on incomes above $200,000 ($3 million in 2007 dollars) and the bottom rate peaked at 23%.

Exactly Who Is Going to Pay For All of This?

0

10

20

30

40

50

60

70

80

90

100

1930 1940 1950 1960 1970 1980 1990 2000 2010

Per

cent

-35

-30

-25

-20

-15

-10

-5

0

5

10

Percent of G

DP

First Tax Bracket (left) Top Tax Bracket (left) Budget Deficit (right)

Sources: Government Accountability Office and the Tax Foundation

US Tax Rates Peak in 1944-45

Higher Tax Rates Likely

23


Higher Debt to GDP Implies Higher Long-Term Interest Rates

0

1

2

3

4

5

6

2 Year 3 Year 5 Year 10 Year 30 Year

Maturity

Per

cent

Treasury Yield Curve with Debt to GDP at 70%Treasury Yield Curve with Debt to GDP at 100%

The Congressional Budget Office expects the US debt to GDP ratio to increase from 70% in 2008 to 100% by the end of 2010. According to a study by the Federal Reserve, each percentage point increase in the debt to GDP ratio adds 4 to 5 basis points to long-term interest rates over a five year span. This suggests that long-term US Treasury yields could be 120 to 150 basis points higher than would otherwise be the case in equilibrium.

Treasury Yield Curve

150 Basis Points

Sources: The Federal Reserve and Payden & Rygel Estimates

24


The Jury Is Still Out On A Recovery in Private Demand

Household Spending

Key Indicators Current Signal

Consumer Confidence Positive

Income/Employment Negative

Household Balance Sheet Negative

Business Spending

Key Indicators Current Signal

Business Sentiment Positive

Corporate Profits Negative

Corporate Balance Sheet Positive

Private Demand

25


The headline consumer price index (CPI) has slipped further into negative territory, falling 1.9% on a year-over-year basis in July. Core inflation, which excludes food and energy prices, increased by 1.6% over the previous year.

Headline inflation should turn positive again by year-end as the base effect of declining commodity prices recedes. However, core inflation will likely drift lower due to the output gap, the difference between potential and actual economic growth.

US Economic Outlook

Economic Growth The US economy shrank at an annual rate of -1.0% in Q2 2009. This was a dramatic improvement over the prior two quarters when the economy contracted at annual rates of -5.4% in Q4 2008 and -6.4% in Q1 2009.

Real GDP growth is expected rebound strongly in Q3 as businesses move to rebuild inventories. Beyond that, the question will be whether a sustainable rebound in private demand will materialize before the impact of fiscal and monetary stimulus fade in late 2010.

Forecast:

Inflation

Forecast:

Interest Rates The Federal Reserve left its benchmark interest rate unchanged in a range between 0% and 0.25% at the conclusion of its August meeting. In its policy statement, the Fed reiterated that economic conditions were likely to warrant a low federal funds rate for an “extended period,” despite signs that the US economy is “leveling out.”

We expect the Fed leave its benchmark rate unchanged until the second half of 2010. However, central bank may choose to exit parts of its credit easing program sooner. For instance, the Fed has already suggested it may end its $300 billion Treasury purchase program in October.

Forecast:

Documents

US Economic Outlook: The Debt HangoverThe Hangover Will Last Into 2010 and Beyond II III Recovering From Recession I ØGovernment Spending Is Aspirin Providing Temporary Relief ØA