The Trust Company - San Antonio, Tx.

Mid-January 2012 PRINTABLE VERSION

The Federal Reserve/Monetary Policy

Fed policy accommodative. Fed funds rate near zero through at least 2012.
A somewhat improved outlook and rapid money supply growth reduce the chance of a third Fed asset acquisition program (QE3) to one in four from one in three.
Internationally, monetary policy has tended to become more accommodative in recent months, including European Central Bank lending to banks.
Money supply growth (a leading economic indicator) has accelerated sharply over the past 18 months and is up a large 9.8% yr/yr (see chart in link below). This should be enough to finance 4+% 2012 aggregate dollar demand (current dollar GDP) growth, but note that both money supply growth and the link between money growth and current dollar GDP growth (velocity of money chart in link) are highly variable. Bank loans began rising rapidly 10 months ago, paced by business loans (a lagging economic indicator).
To better anchor market expectations and possibly increase its influence on the economy, the Fed will publish even more detail regarding its outlook for interest rates, the economy and monetary policy following its policy meeting this Wednesday, January 25. Bernanke will try to explain (not an enviable task!) the expanded data in a 2:15 PM press conference – short-run financial market swings might result. Longer run, greatly increased Fed transparency over the past decade has probably been a positive (when I worked in the relative secrecy of the St. Louis Fed 47 years ago, no one would have imagined current Fed transparency).
Major fiscal policy change is unlikely this election year. 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 is 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 (table below) assuming better supply conditions than in 2011. While there are significant risks to the downside - Europe, election-year fiscal uncertainty, $100 crude oil, and stretched consumer – the recession chance is only one in four. Strongest sectors include: business investment in structures and, especially, software/equipment; autos; and exports (refined petroleum now exceeds aircraft as America’s top dollar export).
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 given 9.8% yr/yr money supply growth.
The Consumer Price Index was unchanged in December and the yr/yr CPI rise declined from 3.4% in November to 3% in December. The core CPI was 2.2% above a year ago. The CRB commodity price index has changed little in recent weeks and is 7% below a year ago despite a 10% yr/yr rise in crude oil and 24% rise in gold yr/yr. Inflation expectations have increased a little, but remain moderate - the 10-year inflation forecast implied in inflation-protected Treasuries (TIPs) was a 2.05% at Friday close vs. 1.85% in late November.
Oil, natural gas and coal have proved to be poor energy substitutes in the short run. Normally, oil would sell for about 12 times the price of natural gas – at Friday close, oil was 42 times the natural gas price. Longer run, this price spread will shrink.

Financial Markets

The “flight to quality” has eased. The S&P 500 has jumped 13.5% since late November and 4.6% year-to-date. Contrary to 2011, the biggest gains have been in higher-risk areas – small caps (+ 5.7% YTD) and foreign (+5.4% YTD) vs. utilities (-3.5% YTD). U.S. Treasury bonds and the dollar have weakened on less “safe haven” demand, raising the yield on the 10-year Treasury from a December low of 1.82% to 2.03% at Friday close.
On a comparative yield basis, stocks still appear a little undervalued vs. Baa corporate bonds, but much less so than in late November (Stock Market Barometer in chart link).
The Fed’s monetary policy is bullish for asset prices, i.e. the Fed’s maintaining negligible short-term interest rates keeps investors seeking higher returns in stocks, bonds, commodities and real estate – stocks have benefited recently, but bond and commodity prices have also rallied strongly in recent years due to the Fed’s policy.
Based on trailing four quarter earnings, at Friday close the S&P 500 P/E was 13.6, inexpensive 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 in link below). Fewer companies have beaten fourth quarter earnings estimates and fourth quarter S&P 500 earnings estimates have been lowered. Earnings growth has slowed sharply following the rebound from the Great Recession.
Robust dividend increases a support for stock prices and the S&P 500 dividend will reach a record high this quarter. The dividend payout ratio is only about 30% now compared to about 50% historically and corporations hold a lot of cash. The dollar dividend on the S&P 500 is up 31% from its August 2009 low despite deeply depressed bank dividends.
Share buybacks also supporting stock prices.
Based on credit quality yield spreads (Bond Market Barometer in chart link below), Baa corporate bonds and tax-exempt bonds appear a little cheap vs. Treasuries, but tax-exempts much less so following their recent rally.
Although most bond yields bounced off their recent lows, mortgage rates remain at or near record lows (the Fed’s purchases of longer-term bonds and mortgage-backed securities seems to have worked). Refinancing will reduce debt burden for those who qualify.
The lower are long-term interest rates, the less likely they will fall farther (more likely they will rise). There is considerable price risk in bonds in the long run.

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	Mid-January 2012 PRINTABLE VERSION The Federal Reserve/Monetary Policy Fed policy accommodative. Fed funds rate near zero through at least 2012. A somewhat improved outlook and rapid money supply growth reduce the chance of a third Fed asset acquisition program (QE3) to one in four from one in three. Internationally, monetary policy has tended to become more accommodative in recent months, including European Central Bank lending to banks. Money supply growth (a leading economic indicator) has accelerated sharply over the past 18 months and is up a large 9.8% yr/yr (see chart in link below). This should be enough to finance 4+% 2012 aggregate dollar demand (current dollar GDP) growth, but note that both money supply growth and the link between money growth and current dollar GDP growth (velocity of money chart in link) are highly variable. Bank loans began rising rapidly 10 months ago, paced by business loans (a lagging economic indicator). To better anchor market expectations and possibly increase its influence on the economy, the Fed will publish even more detail regarding its outlook for interest rates, the economy and monetary policy following its policy meeting this Wednesday, January 25. Bernanke will try to explain (not an enviable task!) the expanded data in a 2:15 PM press conference – short-run financial market swings might result. Longer run, greatly increased Fed transparency over the past decade has probably been a positive (when I worked in the relative secrecy of the St. Louis Fed 47 years ago, no one would have imagined current Fed transparency). Major fiscal policy change is unlikely this election year. 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 is 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 (table below) assuming better supply conditions than in 2011. While there are significant risks to the downside - Europe, election-year fiscal uncertainty, $100 crude oil, and stretched consumer – the recession chance is only one in four. Strongest sectors include: business investment in structures and, especially, software/equipment; autos; and exports (refined petroleum now exceeds aircraft as America’s top dollar export). 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 given 9.8% yr/yr money supply growth. The Consumer Price Index was unchanged in December and the yr/yr CPI rise declined from 3.4% in November to 3% in December. The core CPI was 2.2% above a year ago. The CRB commodity price index has changed little in recent weeks and is 7% below a year ago despite a 10% yr/yr rise in crude oil and 24% rise in gold yr/yr. Inflation expectations have increased a little, but remain moderate - the 10-year inflation forecast implied in inflation-protected Treasuries (TIPs) was a 2.05% at Friday close vs. 1.85% in late November. Oil, natural gas and coal have proved to be poor energy substitutes in the short run. Normally, oil would sell for about 12 times the price of natural gas – at Friday close, oil was 42 times the natural gas price. Longer run, this price spread will shrink. Financial Markets The “flight to quality” has eased. The S&P 500 has jumped 13.5% since late November and 4.6% year-to-date. Contrary to 2011, the biggest gains have been in higher-risk areas – small caps (+ 5.7% YTD) and foreign (+5.4% YTD) vs. utilities (-3.5% YTD). U.S. Treasury bonds and the dollar have weakened on less “safe haven” demand, raising the yield on the 10-year Treasury from a December low of 1.82% to 2.03% at Friday close. On a comparative yield basis, stocks still appear a little undervalued vs. Baa corporate bonds, but much less so than in late November (Stock Market Barometer in chart link). The Fed’s monetary policy is bullish for asset prices, i.e. the Fed’s maintaining negligible short-term interest rates keeps investors seeking higher returns in stocks, bonds, commodities and real estate – stocks have benefited recently, but bond and commodity prices have also rallied strongly in recent years due to the Fed’s policy. Based on trailing four quarter earnings, at Friday close the S&P 500 P/E was 13.6, inexpensive 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 in link below). Fewer companies have beaten fourth quarter earnings estimates and fourth quarter S&P 500 earnings estimates have been lowered. Earnings growth has slowed sharply following the rebound from the Great Recession. Robust dividend increases a support for stock prices and the S&P 500 dividend will reach a record high this quarter. The dividend payout ratio is only about 30% now compared to about 50% historically and corporations hold a lot of cash. The dollar dividend on the S&P 500 is up 31% from its August 2009 low despite deeply depressed bank dividends. Share buybacks also supporting stock prices. Based on credit quality yield spreads (Bond Market Barometer in chart link below), Baa corporate bonds and tax-exempt bonds appear a little cheap vs. Treasuries, but tax-exempts much less so following their recent rally. Although most bond yields bounced off their recent lows, mortgage rates remain at or near record lows (the Fed’s purchases of longer-term bonds and mortgage-backed securities seems to have worked). Refinancing will reduce debt burden for those who qualify. The lower are long-term interest rates, the less likely they will fall farther (more likely they will rise). There is considerable price risk in bonds in the long run. MORE >