The Trust Company - San Antonio, Tx.

Mid December 2011 PRINTABLE VERSION

The Federal Reserve/Monetary Policy

Fed policy accommodative. Fed funds rate near zero through at least 2012.
On Tuesday the Fed said: “…Strains in the global financial markets continue to pose significant downside risks to the economic outlook…” There is a 40% chance the Fed will respond to such risks with a third Fed asset acquisition program (QE3) in 2012.
QE1 and QE2 helped boost aggregate dollar demand (nominal dollar GDP) to a still modest 4.2% in 2010 and 4% in 2011 and the Fed will try to stimulate aggregate demand growth of 4+% in 2012. But linkages between Fed actions and aggregate demand are very uncertain – the Fed cannot fine tune the economy and would be better off with a single inflation mandate rather than its dual employment/inflation mandate.
The 2008-2011 period of a near zero Fed funds rate is unprecedented. It is taking a great deal of Fed accommodation to overcome the trauma of the Great Recession and stimulate aggregate demand growth.
As the world economy has become more integrated, central bank actions have become more coordinated. In recent months, many central banks have become more accommodative.
Money supply growth slowed to 3.4% in past three months, but the big 9.6% yr/yr M2 jump (chart in link below) should be enough to finance 4+% 2012 aggregate dollar demand (nominal dollar GDP) growth. Bank loans began rising rapidly in June, paced by a jump in business loans.
Fiscal brinkmanship continues in D.C. with the can being kicked down the road a month or two at a time. Pending automatic 2013 spending cuts and expiration of Bush tax cuts at 2012 year end will eventually force some action. The United States is benefiting from its safe-haven privilege to fund deficits at minimal interest rates which could end abruptly some day.

The Economy/Inflation

Aggregate dollar demand likely to rise 4% to 5% in 2012 vs. 4.2% in 2010 and 4% in 2011.
Real GDP should grow 2% to 3% in 2012 (table below) assuming better supply conditions than 2011 when tsunami and high oil prices cut output/raised inflation. But risks to the downside, i.e. Europe, election-year fiscal uncertainty, possible $100+ crude oil; wealth loss; sluggish income growth and stretched consumer. Recession chance one in three. Strongest sectors: business investment in structures and, especially, software/equipment; exports; and autos.
Core personal consumption (PCE) price index should again rise 1% to 2% in 2012 vs. 1.5% in 2010 and 2011, but inflation risks are on the upside.
Inflation news mixed: the CPI was up 3.4% yr/yr in November, less food and energy it was up 2.2%. There should be some slowing in the coming months. The CRB commodity price index is off 20% from its April peak and 8% yr/yr, but crude oil is up 7% yr/yr. The dollar has been up in currency markets the past five months. The 10-year inflation forecast implied in inflation-protected Treasuries (TIPs) was a moderate 1.97% at Friday close.

Financial Markets

The Fed’s monetary policy is bullish for asset prices, i.e. the Fed maintaining negligible short-term interest rates that keep investors seeking higher returns in stocks, bonds, commodities and real estate—prices of gold, oil and, especially, high-quality bonds benefited in this year’s “flight to quality.” Bond prices unexpectedly rose (yields fell); stocks vice-versa.
At Friday close, the S&P 500 was off 3% YTD; the DJ Global ex-U.S. stock index was off a much worse 18.5%. Foreign stocks appear reasonably priced at about a 10 P/E and a 3.5% average yield – prudent diversification for most investors would include some international exposure.
Stocks appear somewhat undervalued vs. Baa bonds on a comparative yield basis (stock market barometer in charts).
Based on trailing four quarter earnings, at Friday close the S&P 500 P/E was 12.9, cheap vs. a 19-average over the past 24 years. However, earnings (the E in the P/E) may fall short of expectations, especially since profit margins are at a record (probably unsustainable) high (chart below).
Robust dividend (tax-advantaged) increases a support for stock prices. The dollar dividend on the S&P 500 is up 30% from its August, 2009 low and 18.6% yr/yr despite deeply depressed bank dividends. In 2007, financial companies paid out 30% of the S&P 500 dollar dividend vs. 12% now. Dividend paying stocks have substantially outperformed non-dividend payers this year.
Credit quality yield spreads up a little (Bond Market Barometer in charts). On a comparative yield basis, tax-exempt bonds and Baa corporate bonds appear undervalued vs. U.S. Treasury securities.
Long-term interest rates are at or near record lows, including mortgage rates. Refinancing will reduce debt burden for those who qualify.

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	Mid December 2011 PRINTABLE VERSION The Federal Reserve/Monetary Policy Fed policy accommodative. Fed funds rate near zero through at least 2012. On Tuesday the Fed said: “…Strains in the global financial markets continue to pose significant downside risks to the economic outlook…” There is a 40% chance the Fed will respond to such risks with a third Fed asset acquisition program (QE3) in 2012. QE1 and QE2 helped boost aggregate dollar demand (nominal dollar GDP) to a still modest 4.2% in 2010 and 4% in 2011 and the Fed will try to stimulate aggregate demand growth of 4+% in 2012. But linkages between Fed actions and aggregate demand are very uncertain – the Fed cannot fine tune the economy and would be better off with a single inflation mandate rather than its dual employment/inflation mandate. The 2008-2011 period of a near zero Fed funds rate is unprecedented. It is taking a great deal of Fed accommodation to overcome the trauma of the Great Recession and stimulate aggregate demand growth. As the world economy has become more integrated, central bank actions have become more coordinated. In recent months, many central banks have become more accommodative. Money supply growth slowed to 3.4% in past three months, but the big 9.6% yr/yr M2 jump (chart in link below) should be enough to finance 4+% 2012 aggregate dollar demand (nominal dollar GDP) growth. Bank loans began rising rapidly in June, paced by a jump in business loans. Fiscal brinkmanship continues in D.C. with the can being kicked down the road a month or two at a time. Pending automatic 2013 spending cuts and expiration of Bush tax cuts at 2012 year end will eventually force some action. The United States is benefiting from its safe-haven privilege to fund deficits at minimal interest rates which could end abruptly some day. The Economy/Inflation Aggregate dollar demand likely to rise 4% to 5% in 2012 vs. 4.2% in 2010 and 4% in 2011. Real GDP should grow 2% to 3% in 2012 (table below) assuming better supply conditions than 2011 when tsunami and high oil prices cut output/raised inflation. But risks to the downside, i.e. Europe, election-year fiscal uncertainty, possible $100+ crude oil; wealth loss; sluggish income growth and stretched consumer. Recession chance one in three. Strongest sectors: business investment in structures and, especially, software/equipment; exports; and autos. Core personal consumption (PCE) price index should again rise 1% to 2% in 2012 vs. 1.5% in 2010 and 2011, but inflation risks are on the upside. Inflation news mixed: the CPI was up 3.4% yr/yr in November, less food and energy it was up 2.2%. There should be some slowing in the coming months. The CRB commodity price index is off 20% from its April peak and 8% yr/yr, but crude oil is up 7% yr/yr. The dollar has been up in currency markets the past five months. The 10-year inflation forecast implied in inflation-protected Treasuries (TIPs) was a moderate 1.97% at Friday close. Financial Markets The Fed’s monetary policy is bullish for asset prices, i.e. the Fed maintaining negligible short-term interest rates that keep investors seeking higher returns in stocks, bonds, commodities and real estate—prices of gold, oil and, especially, high-quality bonds benefited in this year’s “flight to quality.” Bond prices unexpectedly rose (yields fell); stocks vice-versa. At Friday close, the S&P 500 was off 3% YTD; the DJ Global ex-U.S. stock index was off a much worse 18.5%. Foreign stocks appear reasonably priced at about a 10 P/E and a 3.5% average yield – prudent diversification for most investors would include some international exposure. Stocks appear somewhat undervalued vs. Baa bonds on a comparative yield basis (stock market barometer in charts). Based on trailing four quarter earnings, at Friday close the S&P 500 P/E was 12.9, cheap vs. a 19-average over the past 24 years. However, earnings (the E in the P/E) may fall short of expectations, especially since profit margins are at a record (probably unsustainable) high (chart below). Robust dividend (tax-advantaged) increases a support for stock prices. The dollar dividend on the S&P 500 is up 30% from its August, 2009 low and 18.6% yr/yr despite deeply depressed bank dividends. In 2007, financial companies paid out 30% of the S&P 500 dollar dividend vs. 12% now. Dividend paying stocks have substantially outperformed non-dividend payers this year. Credit quality yield spreads up a little (Bond Market Barometer in charts). On a comparative yield basis, tax-exempt bonds and Baa corporate bonds appear undervalued vs. U.S. Treasury securities. Long-term interest rates are at or near record lows, including mortgage rates. Refinancing will reduce debt burden for those who qualify. MORE >