The Trust Company - San Antonio, Tx.

January 2012 PRINTABLE VERSION

The Federal Reserve/Monetary Policy

Fed policy accommodative. Fed funds rate near zero through at least 2012.
A one-in-three chance the economy stalls in 2012 and the Fed responds with a third asset acquisition program (QE3).
Money supply growth slowed to 3.6% in past three months, but the big 9.6% yr/yr M2 jump (see link below to charts) should be enough to finance 4+% 2012 aggregate dollar demand (nominal dollar GDP) growth. Bank loans up in the past six months, paced by a rise in business loans.
To better anchor market expectations and possibly increase its influence on the economy, the Fed will publish more detail regarding its outlook for interest rates, the economy and monetary policy following its policy meeting on January 25. Bernanke will explain the expanded data in a press conference. Longer run, greatly increased Fed transparency over the past decade has been a positive.
Major fiscal policy change is unlikely this election year. The payroll tax cut and extended unemployment insurance may well continue through 2012. Pending automatic 2013 spending cuts and expiration of Bush tax cuts at year end 2012 will eventually force some action. The United States is still funding deficits at minimal interest rates – which could end abruptly someday. Recent better-than-expected economic data and a lower unemployment rate have political implications – if this continues, the economy becomes less of an issue and favors incumbents – voters have short memories.

The Economy/Inflation

Aggregate dollar demand likely to rise 4% to 5% in 2012 vs. 4.2% in 2010 and 4% in 2011.
The 31 month-old economic expansion should continue in 2012. Real GDP should grow 2% to 3% in 2012 (see table below) assuming better supply conditions than 2011 when the tsunami and high oil prices cut output/raised inflation. While there are significant risks to the downside - Europe, election-year fiscal uncertainty, $100+ crude oil, wealth loss, the stretched consumer – the recession chance is one-in-three at most. 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 to the upside.
Inflation news mixed: the core PCE price index was up a moderate 1.7% yr/yr in November. The CRB commodity price index has risen the past three weeks, but remains 4.3% below a year ago – but crude oil is up a sharp 15% yr/yr. The dollar has been strong in foreign currency markets the past five months. Inflation expectations have increased some, but remain moderate - the 10-year inflation forecast implied in inflation-protected Treasuries (TIPs) was 2.14% at Friday close, up from a low of 1.85% in late November.

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, bonds benefited over the past year. The weakest area was foreign stocks. The S&P 500 stock index was unchanged in 2011, providing a 2.1% total rate of return – higher on a taxable equivalent basis since dividends are taxed at a lower rate than interest income. Utilities, the most bond-like of stocks, were the best performing stock sector in 2011.
Despite Uncle Sam borrowing a near record amount, the top investment in 2011 was, of all things, the 30-year Treasury bond. Tax-exempt bonds did very well, especially considering the fiscal problems of state and, especially, local governments.
Stocks appear moderately undervalued vs. Baa bonds on a comparative yield basis (stock market barometer in chart link below).
Based on trailing four quarter earnings, at Friday close the S&P 500 P/E was 13.2, 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 (see chart in link below). Importantly, earnings growth has slowed sharply.
Robust dividend increases a support for stock prices and the S&P 500 dividend will reach a record high this quarter. The dollar dividend on the S&P 500 is up 30% from its August, 2009 low and 18.3% yr/yr despite deeply depressed bank dividends. Dividend paying stocks greatly outperformed non-dividend payers over the past year.
Share buybacks also supporting stock prices – buybacks up 49% yr/yr in the third quarter!
Credit quality yield spreads up a little (Bond Market Barometer in charts link below). On a comparative yield basis, tax-exempt bonds – despite their recent out performance - 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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	January 2012 PRINTABLE VERSION The Federal Reserve/Monetary Policy Fed policy accommodative. Fed funds rate near zero through at least 2012. A one-in-three chance the economy stalls in 2012 and the Fed responds with a third asset acquisition program (QE3). Money supply growth slowed to 3.6% in past three months, but the big 9.6% yr/yr M2 jump (see link below to charts) should be enough to finance 4+% 2012 aggregate dollar demand (nominal dollar GDP) growth. Bank loans up in the past six months, paced by a rise in business loans. To better anchor market expectations and possibly increase its influence on the economy, the Fed will publish more detail regarding its outlook for interest rates, the economy and monetary policy following its policy meeting on January 25. Bernanke will explain the expanded data in a press conference. Longer run, greatly increased Fed transparency over the past decade has been a positive. Major fiscal policy change is unlikely this election year. The payroll tax cut and extended unemployment insurance may well continue through 2012. Pending automatic 2013 spending cuts and expiration of Bush tax cuts at year end 2012 will eventually force some action. The United States is still funding deficits at minimal interest rates – which could end abruptly someday. Recent better-than-expected economic data and a lower unemployment rate have political implications – if this continues, the economy becomes less of an issue and favors incumbents – voters have short memories. The Economy/Inflation Aggregate dollar demand likely to rise 4% to 5% in 2012 vs. 4.2% in 2010 and 4% in 2011. The 31 month-old economic expansion should continue in 2012. Real GDP should grow 2% to 3% in 2012 (see table below) assuming better supply conditions than 2011 when the tsunami and high oil prices cut output/raised inflation. While there are significant risks to the downside - Europe, election-year fiscal uncertainty, $100+ crude oil, wealth loss, the stretched consumer – the recession chance is one-in-three at most. 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 to the upside. Inflation news mixed: the core PCE price index was up a moderate 1.7% yr/yr in November. The CRB commodity price index has risen the past three weeks, but remains 4.3% below a year ago – but crude oil is up a sharp 15% yr/yr. The dollar has been strong in foreign currency markets the past five months. Inflation expectations have increased some, but remain moderate - the 10-year inflation forecast implied in inflation-protected Treasuries (TIPs) was 2.14% at Friday close, up from a low of 1.85% in late November. 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, bonds benefited over the past year. The weakest area was foreign stocks. The S&P 500 stock index was unchanged in 2011, providing a 2.1% total rate of return – higher on a taxable equivalent basis since dividends are taxed at a lower rate than interest income. Utilities, the most bond-like of stocks, were the best performing stock sector in 2011. Despite Uncle Sam borrowing a near record amount, the top investment in 2011 was, of all things, the 30-year Treasury bond. Tax-exempt bonds did very well, especially considering the fiscal problems of state and, especially, local governments. Stocks appear moderately undervalued vs. Baa bonds on a comparative yield basis (stock market barometer in chart link below). Based on trailing four quarter earnings, at Friday close the S&P 500 P/E was 13.2, 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 (see chart in link below). Importantly, earnings growth has slowed sharply. Robust dividend increases a support for stock prices and the S&P 500 dividend will reach a record high this quarter. The dollar dividend on the S&P 500 is up 30% from its August, 2009 low and 18.3% yr/yr despite deeply depressed bank dividends. Dividend paying stocks greatly outperformed non-dividend payers over the past year. Share buybacks also supporting stock prices – buybacks up 49% yr/yr in the third quarter! Credit quality yield spreads up a little (Bond Market Barometer in charts link below). On a comparative yield basis, tax-exempt bonds – despite their recent out performance - 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 >