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 Recovery
Thin Lines are Peak to Trough (NBER Recession)
Thick Lines are Trough to + 14 months
4.00%
3.00%
2.00%
1.00%
Monthly growth
0.00%
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
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
R53 R53+14 R57 R57+14 R60 R60+14 R69 R69+14 R75 R75+14
R80 R80+14 R81 R81+14 R90 R90+14 R01 R01+15
Industrial Production Growth During Recovery
Trough to Trough +14 Months
1.50%
1.00%
0.50%
Monthly growth
0.00%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
-0.50%
-1.00%
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 Recovery
Thin Lines are Peak to Trough (NBER Recession)
Thick Lines are Trough to + 12 months
140000.00%
120000.00%
100000.00%
80000.00%
60000.00%
Monthly growth
40000.00%
20000.00%
0.00%
53
55
57
59
61
63
65
67
69
71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
-20000.00%
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
-40000.00%
-60000.00%
-80000.00%
R53 R53+14 R57 R57+14 R60 R60+14 R69 R69+14 R75 R75+14
R80 R80+14 R81 R81+14 R90 R90+14 R01 R01+15
Change in Nonfarm Payrolls During Recovery
Trough to Trough +14 Months
400
300
200
100
Monthly growth
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
-100
-200
-300
-400
R01+15 Average 9 recessions Average 6 recessions
Percentage Change in Nonfarm Payrolls During Recovery
Trough to Trough +14 Months
0.40%
0.30%
0.20%
0.10%
Monthly growth
0.00%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
-0.10%
-0.20%
-0.30%
-0.40%
R01+15 Average 9 recessions Average 6 recessions
Macroeconomic Outlook
• Employment gap:
Jobs created since January 2002 = -594,000
Jobs usually created in recovery = 1,473,000
Gap = 2,000,000 jobs
• Insufficient capital spending – at levels of
seven years ago
New Orders for Nondefense Capital Goods Scaled by PPI
60,000
50,000
40,000
Millions $
30,000
20,000
10,000
0
92
93
94
95
96
97
98
99
00
01
02
03
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
b-
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Fe
Nondefense Nondefense x aircraft
Macroeconomic Outlook
Why?
• Largely a result of uncertainty induced by
geopolitical risk
ICRG
Ja
60
65
70
75
80
85
90
95
100
n
Political Risk
Fe -01
M b-01
a
A r-0
p 1
M r-0
ay 1
Data from PRS
Ju -01
n
Ju -01
A l -0
ug 1
Se -01
O p-01
c
Equally-weighted world
N t-01
o
D v-0
ec 1
Ja -01
n
Fe -02
M b-02
a
A r-0
p 2
G-7xUS
M r-0
ay 2
Ju -02
n
Ju -02
A l -0
ug 2
Se -02
O p-02
c
N t-02
Switzerland o
D v-0
ec 2
Ja -02
n
Macroeconomic Outlook
Fe -03
M b-03
a
A r-0
p 3
M r-0
ay 3
Ju -03
n-
03
United States
ICRG
Ja
60
65
70
75
80
85
90
95
100
n
Fe -01
M b-01
a Political Risk
A r-0
p 1
M r-0
ay 1
Data from PRS
Ju -01
n
Ju -01
A l -0
ug 1
Se -01
O p-01
c
N t-01
o
Equally-weighted world
D v-0
ec 1
Ja -01
n
Fe -02
M b-02
a
A r-0
p 2
Japan
M r-0
ay 2
Ju -02
n
Ju -02
A l -0
ug 2
Se -02
O p-02
c
Switzerland
N t-02
o
D v-0
ec 2
Ja -02
n
Macroeconomic Outlook
Fe -03
M b-03
a
A r-0
p 3
M r-0
ay 3
Ju -03
United States
n-
03
ICRG
Ja
60
65
70
75
80
85
90
95
100
n
Fe -01
M b-01
a Political Risk
A r-01
M pr-0
ay 1
Data from PRS
Ju -01
n
Ju -01
A l -0
u 1
Se g-01
p
O -01
Germany
c
N t-01
o
United States
D v-0
ec 1
Ja -01
n
Fe -02
M b-02
a
Equally-weighted world
A r-0
p 2
M r-0
ay 2
Ju -02
n
Ju -02
A l -0
Japan ug 2
Se -02
p
O -02
c
N t-02
o
Switzerland
D v-0
ec 2
Ja -02
n
Macroeconomic Outlook
Fe -03
M b-0
a 3
A r-03
p
M r-0
ay 3
Ju -03
n-
03
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)
Macroeconomic Outlook
Recent blip in consumer confidence
110
100
90
80
70
60
50
2
02
2
3
03
3
2
2
02
03
02
-0
-0
l-0
-0
-0
-0
n-
n-
p-
b-
ct-
ar
ug
pr
ec
ov
Ju
Ju
Ja
Se
Fe
M
O
A
D
A
N
Michigan survey
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
Macroeconomic Outlook
One-Year Forecast
• One-year risk premium quite variable. Currently,
about 3.25%
6
5
4
3
2
1
0
6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-01
7-Jun-01 10-Sep-01 4-Dec-01 11-Mar-02
4-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%
6
5
4
3
2
1
0
6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-01
7-Jun-01 10-Sep-01 4-Dec-01 11-Mar-02
4-Jun-02 16-Sep-02 2-Dec-02 19-Mar-03
Macroeconomic Outlook
Conclusions
• To be added