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Vectra Bank Expert Jeff Thredgold

US Economic Outlook Spring 2010

Written by Jeff Thredgold, President, Thredgold Economic Associates

The American Economy
…still fighting headwinds

Modest U.S. economic growth returned during 2009’s third quarter, followed by more robust performance during the October to December period, the strongest growth in six years. Positive growth seems on tap during 2010, with the economy still fighting the “headwinds” of housing and commercial real estate anxiety, high unemployment, and consumer angst about the expansion of government and mind-boggling budget deficits.

The fourth quarter’s solid 5.6% real (inflation adjusted) annual growth pace seems likely to be followed by a roughly 3.0% pace during 2010. When final determinations are made in coming months, the Great Recession will have lasted perhaps 20-22 months…the longest, deepest, most painful, most costly and most pervasive since the Great Depression.

us real gdp

Deficit Spending
…simply too much

The Obama Administration inherited a very sick economy with a structural deficit reaching $1.4 trillion ($1,400,000,000,000) in fiscal year 2009, which ended last September 30, three times the prior record. The proposed deficit this year is $1.6 trillion…or a $182,000,000 deficit every 60 minutes.

Budget deficits averaging $1 trillion annually in coming years are Obama’s and the Democratic Congress’s alone…and are simply not affordable. The Administration and the Congressional leadership face major opposition to Obama’s aggressive spending agenda by members of his own party, many who greatly fear upcoming elections.

…more job gains

The U.S. economy seems on the verge of solid job gains during upcoming months, with occasional disappointments. Total employment has plunged by more than eight million since the recession began in December 2007, with millions more shifted involuntarily to part-time employment.

The current 9.7% U.S. jobless rate could return to 10.0% in coming months, even as the economy adds jobs. Why? As more stories of job availability become widespread, hundreds of thousands of people who formerly left the labor force could return…and unless and until they find a job, they will be counted as unemployed.

US unemployment rate

…the debate continues

The Consumer Price Index (CPI) rose 2.7% during 2009, following a 0.1% rise during 2008, the smallest increase since 1954. Most forecasts expect the CPI to rise roughly 2.0%-2.5% this year.

Where we go from there remains the subject of intense debate. One view sees major inflation pressures about to unfold, resulting from highly aggressive monetary policy and massive budget deficits. The other major view sees a Japanese-style deflation unfolding in coming years, tied to weak real estate values, strong productivity gains, major slack in labor markets, and nervous consumers.

US consumer price index

The Federal Reserve
…how to exit

The federal funds rate, the most important of all short-term interest rates, has been at an all-time low of 0.00%-0.25% since December 2008. Most forecasts see the Fed beginning to push this rate modestly higher before yearend.

During the past three years, the Fed enacted one program after another, collectively known as “quantitative easing,” to address the near-paralysis that, at times, plagued financial markets. The Fed’s success, as well as that of other major central banks around the globe, in “exiting” these steps during the next 18 months will be critical.

Long-Term Interest Rates
…time to refinance

NOW remains a very attractive time to refinance a mortgage or buy a new home or foreclosed property, while recognizing that one in four U.S. homeowners is “underwater” on their mortgages…owing more than the home is worth. Rates for conventional loans have been near 40-year lows.

Such rates could move higher later this year as the Fed has concluded its massive purchase of mortgage-backed securities. Mortgage finance for higher-priced homes remains spotty.

The Global Economy
…growth has resumed

Overall global economic growth returned during 2009’s final few months, led by an Asian rebound. Renewed growth follows the first global recession in more than 60 years.

Impressive Japanese economic gains during the ’60s, ’70s, and ’80s gave way to the “lost decades” of the past 20 years. Japan’s most painful recession since just after World War II very recently gave way to a return of modest economic growth.

China’s economic growth returned to an 8.0%-10.0% annual rate in recent quarters, following sluggish performance a year ago. Such growth was fueled by massive government spending, aggressive bank lending, and strong export growth. China is making efforts to boost domestic demand within its economy while also attempting to slow inflation.

The Indian economy also picked up speed in recent quarters, with solid growth likely over the balance of the year. India is attempting to boost exports as a means of lessening dependence on domestic demand, with rising inflation also of concern.

Europe’s mid-year 2009 rebound from recession gave way to weaker growth in recent months. Investor doubts about the ability of Greece to handle its massive national debt have boosted similar anxiety in Spain, Portugal, and Italy.

Russia continues to struggle with an overdependence upon energy and commodity prices. Africa? Solid performance in recent quarters places Africa second only to Asia on the economic growth scale.

Expect to hear more about Brazil in coming years as its global clout in agriculture and energy rises. Most other South American nations have seen conditions improve, tied to global rebound.

Mexico’s serious recession could give way to modest growth later this year. Declining oil production and drug trafficking violence remain serious challenges. Canada appears to have emerged from recession. Leading the way in the gold medal count at the Vancouver Winter Olympics will be a source of pride for years to come.

The Bottom Line?
The Great Recession has given way to a reasonable U.S. economic growth pace, although serious challenges remain. We also expect…unprecedented budget deficits in coming years…better employment news…modest inflation this year…extremely low short-term and attractive long-term interest rates…and a growing, but still wobbly, global economy.

A Shot Across the Bow

Financial developments within Greece should be considered “a shot across the bow” for similar smaller nations such as Portugal, Spain, and Italy. Such a warning shot regarding high debt levels should also be taken seriously by larger nations, including the United Kingdom and the United States.

The nation of Greece is facing a financial crisis, tied in part to the short-term impact of the deep European and global recession just ended. The implication of living too long above its financial means is now coming home to roost.

Investor concerns about the quantity and quality of debt issued by the Greek government, known as sovereign (or national) debt, have risen sharply during 2010. High debt levels as they relate to the nation’s gross domestic product (GDP) have heightened the issue of potential default, or at least the painful reality of the sharply declining value of Greek debt securities.

Greece is currently running a budget deficit estimated at 13% of GDP. Such a massive deficit runs contrary to the mandates of “euro zone” membership, which limit annual budget deficits to no more than 3% of GDP.

The greatest threat regarding the current Greek debt solvency debate is the possible domino effect involving other nations. A Greek default on its debt, or a painful plunge in the value and marketability of Greek debt securities, would likely be followed by similar debt issues for other nations.

The role of stronger European nations in lessening financial market anxiety regarding Greek debt is being hotly debated in Berlin and Paris. Any financial support provided by Germany and France would be most unpopular with their own citizens, while strong trade unions within Greece would oppose economic and financial conditions placed upon Greece by the stronger euro zone players.

At the same time, German and French financial support for Greece would effectively be seen as a similar level of support, if necessary, for Spain, for Italy, and for Portugal, with Ireland and Belgium possibly not far behind. Needless to say, the Germans and the French are extremely wary of such “moral” guarantees of financial assistance.

Larger Nations
Current sovereign debt issues at play in smaller European nations should be a wake up call for London and Washington, D.C. While political leaders in the U.K. and the U.S. see no real chance of similar financial market anxiety regarding U.K. and U.S. debt levels, caution is advised.
Unprecedented annual budget deficits in the U.S. and elsewhere lead to rapidly expanding sovereign debt. The U.S. simply cannot afford to run massive and irresponsible trillion dollar budget deficits for years to come without consequence.

The possible domino effect is real. Financial markets function effectively when confidence levels of investors are high. Investors are willing to buy debt securities issued by corporations or municipalities or nations if they feel highly confident in the repayment ability of the issuer.

If you earn $60,000 annually but spend $90,000, life is good, with plenty of extras. If the following year you earn $70,000 but spend $100,000, life is also good. However, you are dependent upon someone to believe in your ability to repay borrowed money. You are also subject to higher and higher financing costs.

When potential lenders (or investors) eventually ratchet up the price of credit, or suspend access to any additional credit, life is no longer so good. At that point, the creditors can make many painful demands to reduce your “quality of life” and enhance their ability to be repaid.

Such is true at your house and mine. Such is true for corporations and municipalities that issue debt. Such can eventually be true for various nations…Greece today…and possibly the U.S. in coming years.

federal budget surpluses or deficits

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