US Market Watch

November 2012Markus Schomer, CFA, Chief Economist

M A R K E T C O M M E N T A R Y

OVERVIEW

I thought I would hold off on writing the November Market Watch until after the elections, but the world does not really look much different post-November 6 than it did before.

The good news is the US economy is holding up, though a 2% growth trend is not enough to accelerate the normalization in unemployment. There are also signs that global growth is starting to improve, particularly in Asia, and, of course, the Federal Reserve just started a new round of quantitative easing (QE3) whose effects are not fully felt yet.

The bad news is that the looming fiscal cliff is just about six weeks away. Evidently, politics will continue to trump economics, as it has done for most of the year, which of course was the major theme of my 2012 economic outlook.

Financial markets started to react well ahead of the elections. The S&P 500 lost 2% in October and is already down more than that in the first week of November alone. Less than halfway into the fourth quarter, stock markets have erased all of the robust gains they enjoyed over the summer. Year-to-date returns for the S&P 500 are back below 10%, notably less than the Barclays Capital High Yield Bond Index, which had positive performance in each of the four quarters this year (so far) and is outperforming stocks by about 400 basis points. Ten-year Treasuries have fallen back to the lower end of their recent trading range, but need to break

more decisively through 1.60% to start a new bull trend. Finally, the US dollar benefits from greater uncertainty and, not surprisingly, rallied strongly after the election, especially versus the euro and other European currencies.

ECONOMY

The recent economic data flow has given mixed signals about the current recovery momentum. On the one hand, US consumer confidence surged to a five-year high in October and job growth has accelerated notably in the past few months, with a 173,000 monthly average between July and October compared with 86,000 in the prior four months. On the other hand, business activity remains weak. Core factory orders have fallen in five of the past seven months and the manufacturing industry’s Purchasing Managers Index (PMI) has trended close to the neutral 50 level since June. Retail sales had surprised on the upside in recent months, but sharply weaker auto sales in October indicate fourth quarter GDP is not likely to improve on the 2% pace from the previous three-month period.

Looking ahead, I still believe the sluggish recovery will not improve until the fiscal cliff uncertainty is removed. The greater likelihood of a post-election deal has reduced the probability of a damaging government shutdown. Hence, I have raised my US GDP forecasts slightly for next year and am now expecting about a 1.5% growth in the first half, followed by about 2.6% in the second half. Failing to address the uncertainty over tax rates and spending levels is likely to slow payroll growth again in the coming months. Real disposable household income growth has remained depressed

in the past few months, suggesting that the bullish consumer sentiment will not last. It is easy to see how even at a modest 2%, the current recovery trend is still extremely fragile and downside risk may prevail in the near term.

POLICY

The stage is set for the fiscal cliff drama to unfold. I am somewhat less pessimistic, despite the fact that the status quo of divided government has not changed. However, the Democrats got as much of a win as could have been expected and the Republicans missed on almost all of their pre-election goals. Still, there is not enough for a clear mandate, but rather a strong message for compromise. Americans voted for deficit reduction, but also for using all available tools, spending AND revenues. Initial statements from both sides of the political spectrum are encouraging, but I still believe negotiations will be very protracted and a solution may not be reached before the summer. After that, the US recovery is poised to take off, with fiscal policy uncertainty removed, extremely accommodative monetary policy and ample pent-up demand in both business and consumer sectors.

The fiscal cliff may be overshadowing monetary policy right now, but after implementing QE3 the next decision before the Federal Open Market Committee (FOMC) is what to do with the expiring Operation Twist, the Fed’s program of selling short dated Treasuries on its balance sheet for bonds with longer maturities. Unless the fiscal cliff is resolved in the next few weeks, the Fed is likely to increase QE3 by another US $30 billion to account

Past performance is not indicative of future results.

for the stimulative effect of Operation Twist. The election also removed some of the unceasing conversation about the future Fed leadership. Chairman Bernanke may still not return in 2014, but President Obama is likely to appoint a successor who will continue current policy or err on the side of too much policy accommodation as long as unemployment remains high and inflation relatively close to target.

INTEREST RATE STRATEGY Our duration strategy framework had turned more bearish in the last few months, indicating that upward pressure on US Treasury yields was increasing. The initial reaction to the election outcome saw bonds rally and stocks sell off, as investors reacted to the growing fiscal cliff risk. However, a more sustained decline in Treasury yields proves that negotiations are failing. We have not changed our year-end forecast for 10-year Treasuries and still expect yields to trade around 1.75%. There is some downside risk during the fiscal cliff negotiation period, and yields may fall to 1.50% in the first half of next year. From that lower base, yields should then start to trend gradually higher as the economic recovery accelerates. However, I still expect the Fed to manage the process of yield normalization for several more years, gradually shrinking its balance sheet while stepping back into the market when yields rise too quickly.

Written on 9 November 2012

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Markus Schomer, CFA Chief Economist PineBridge Investments New York

Markus Schomer is responsible for providing macroeconomic forecasts, analysis and commentary for all PineBridge Investments groups, with a focus on global economic trends and their impact on financial markets. He holds degrees in Economics from the University of Bonn in Germany and the University of East Anglia in the UK. He also studied at the London School of Economics and is a CFA charterholder.

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