Economic Insights.120312 - Walter Unger CCIM

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December 3, 2012

THE US ECONOMY

THE FED AND THE MARKETS

Annualized qtrly. % change, unless noted otherwise

Percent

2012 Q3

Q4

2013 Q1

Real GDP 2.7 2.0 Final sales (Made in USA) 1.9 2.4 Final sales 1.7 2.4 Consumers 1.4 1.3 Inventory ch. ($b ar) +$61.3 +$47 Nonfarm ($b ar) +$89.7 +$44 Farm ($b ar) -$19.4 -$5 Real Gross Domestic Income 1.7 2.5 Real compensation 1.6 3.4 Real pretax profits 12.1 2.5 Aggregate hours worked 0.7 2.9 Nonfarm payrolls 1.3 1.4 Ave. monthly ch. (’000) 174 140 Industrial production 0.0 -0.7 Manufacturing output -0.7 -2.9

3.5 3.3 3.8 3.0 +$54 -$9 +$25 4.0 2.6 5.7 1.2 0.9 86 4.5 3.7

Unemployment (% at quarter end)7.8

7.9

7.9

Chain PCE prices (% yoy¹) 1.6 Food (% yoy¹) 0.9 Energy (% yoy¹) 3.2 Core (% yoy¹) 1.6 CPI (% yoy¹) 2.0 Core (% yoy¹) 2.0 Petroleum, WTI ($ / barrel) 94.7

0.8 1.0 -4.6 1.5 1.3 1.9 85

-0.6 1.6 -17.9 1.2 -0.3 1.7 78

__________________________________________________________________________

¹ Change from 12 months earlier at the end of the quarter. Notes: bold figures are Chase forecasts; “ar” = annual rate. Sources: US Deps. of Commerce and Labor; API.

Markets & the Economy: Weekly Insights

Current Federal funds rate target 0-¼% Fed funds futures contracts n.a.

Dec. 12¹ 0-¼% 0.14

3-month Libor 0.31 Spread vs 3-month OIS 0.17 3-month OIS² 0.14

0.31 0.18 0.13

2-year Treasury yield 10-year Treasury yield

0.25 1.62

0.25 1.75

US dollar/euro Yen/US dollar

1.30 82.0

1.25 85

Wilshire 5000 14,848.1 % year-over-year 13.5% Price/after-tax earnings 10.4 Ave. P/E since 1980 12.3 S&P 500 % year-over-year

End-2012 15,292 16% 10

1,416.2 13.8%

1,459 16%

__________________________________________________________________________

¹ The next FOMC meeting. ² Option indexed swap rate, effectively the market expectation of the funds rate over the horizon indicated.

THIS WEEK’S ECONOMIC CALENDAR  It will be difficult to disentangle storm damage from this week’s key economic reports, including the November jobs figures, which most see coming in on the soft side. The bounceback from storm damage likely will be visible in the November vehicle sales figures and the receding applications for unemployment insurance benefits.

MARKET FOCUS: Profits  GDP profits, the most credible measure of business earnings, continue to surprise on the upside.

ECONOMIC FOCUS: Inventories As the Tide Rises  It’s too soon to know how the economy is doing in the fourth quarter. If that seems like an exaggeration, recall the grim sense of things back in August that goaded the Fed into another round of asset purchases by mid-September. As it turned out, the economy grew almost 3 percent annualized in the third quarter. Forecasters are cutting Q4 real GDP growth estimates, after learning that inventories surged this summer and to reflect storm damage in the Northeast and uncertainty about the fiscal cliff. Of all the potential negatives, inventories are likely to be the least problematic for a number of reasons. And the repairs for storm damage will generate a burst of activity in coming months, just as it did in Japan last year. Finally, the fiscal cliff issue is likely to be settled shortly. Market participants are right to look over the horizon, to what things may look like by spring.

Sources: Federal Reserve Board; Bloomberg.

Commercial Banking

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December 3, 2012

MARKET FOCUS: Profits

SHE’S STILL SINGING … Economic profits* and S&P 500 earnings (percent of Gross Domestic Income)

14 13

Last week’s revised Q3 GDP figures accompanied the first

14 Pretax GDP profits from current production

13

estimate of GDP-based business profits—that is, economic profits—in the third quarter. These estimates rarely attract that

much attention in financial markets, because the majority of

12

12

11

11

10

10

third-quarter results. Nonetheless, the GDP estimate of profits

9

9

is more informative than the widely-followed S&P 500

8

8

operating earnings . It is more comprehensive: earnings of the

7

7

500 companies represent only 60 percent of all business

6

6

profits. In addition, the GDP estimates offer better information

5

5

for making apples-to-apples comparisons, given the many

4

the companies in the S&P 500 universe have already reported

4

different methods companies use to adjust inventory

3

After-tax GDP profits from current production

3

valuations for price changes and given the distortions caused

2

After-tax S&P 500 operating earnings

2

by reporting depreciation for tax purposes. GDP figures

1

1

translate reported depreciation into economic depreciation.

0

0

1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012

Pretax profits rose 14.8 percent annualized in the third quarter, 13.7 percent after taxes. Naturally, the year-over-year growth is slowing down, following the robust growth in the

* Adjusted to standardize for treatment of inventory valuation (translated to LIFO accounting) and to restate depreciation for tax purposes in terms of economic depreciation.

Sources: Standard and Poor’s; US Department of Commerce. Updated through 2012 Q3.

early days of the recovery. Pre-tax earnings have slowed to 8.7 percent from the double-digit growth of last year. And

after-tax GDP profits have slowed to a 4 percent pace from four quarters earlier.

Markets & the Economy: Weekly Insights

Commercial Banking

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December 3, 2012

Still, because corporate earnings grew far faster than the 5.5

percent annualized growth of nominal GDP in the third quarter, profit margins, which are already in record territory,

… AND HAS A LOT OF COMPANY After-tax economic* profits (percent of Gross Domestic Income)

rebounded. The current 12.7 percent ratio of pre-tax profits to nominal Gross Domestic Income is far above the 8 percent

0.05

0.09

0.04

After-tax GDP profits of nonfinancial companies and profits earned from abroad (right)

0.08

0.03

After-tax GDP profits of financial companies (left)

0.07

norm of the old days.

The robust performance of profits is most visible for the nonfinancial sector. Still, despite the many headwinds the financial sector faces, the earnings of the financial services

sector remain strong by historical comparisons.

0.02

0.06

0.01

0.05

0.00

0.04

-0.01 1960

0.03

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

•Adjusted to standardize for treatment of inventory valuation (translated to LIFO accounting) and to restate depreciation for tax purposes in terms of economic depreciation.

Sources: Standard and Poor’s; US Department of Commerce. Updated through 2012 Q3.

Markets & the Economy: Weekly Insights

Commercial Banking

4

December 3, 2012

ECONOMIC FOCUS: Inventories As the Tide Rises

code than the virtually flat pace forecasters were predicting by August, a perception that contributed to the Federal Open Market Committee’s

Summary: It’s too soon to know how the economy is doing right now. If that

decision in the middle of September to undertake the latest round of

seems like an exaggeration, recall the grim sense of things back in August that

asset purchases. That is a reminder that the reality of the fourth quarter

goaded the Fed into another round of asset purchases by mid-September. As it

could be quite different than perception held today.

turned out, the economy grew almost 3 percent annualized in the third quarter. Forecasters are cutting Q4 real GDP growth estimates, after learning that inventories surged this summer and to reflect storm damage in the Northeast and uncertainty about the fiscal cliff. Of all the negatives, inventories are likely to be

What’s the worry about inventories? Businesses accumulated nonfarm inventories in the third quarter at an $89.7 annualized rate. That was

the least problematic for a number of reasons. And the repairs for storm damage

faster than the $30 billion to $50 billion pace of accumulation that is

will generate a burst of activity in coming months, just as it did in Japan last year.

needed to hold the level of inventories even with the pace of final sales

Finally, the fiscal cliff issue is likely to be settled shortly. Market participants are

when the economy is in steady state and real final sales are expanding 2

right to look over the horizon, to what things may look like by spring.

to 3 percent, respectively, at an annual rate. As a result, the ratio of inventories to sales rose, meaning that inventories became more burdensome.

In recent years, with economic disappointments more commonplace than

Nonetheless, if the economy turns out to be slow in the final quarter of

favorable surprises, observers have become accustomed to interpreting

the year—it’s way too early to know this and in fact the information

a buildup of inventories as a bad thing, a sign that the economy will slow

available through October points to a fairly good pickup in aggregate

in the days ahead. So, forecasters found little to cheer when the

hours worked—it will have little to do with inventories and much more to

government last week revised up its estimate of Q3 real GDP growth,

do with the temporary disruptions related to the late October storm that

from 2 percent annualized to 2.7 percent, because the upward revision

hit the Northeast. In fact, the inventory accumulation in the third quarter

accompanied a markdown of final sales and an upward revision to the

provides little insight about the future for several reasons. The new

pace of inventory accumulation. As an aside, notwithstanding the

product cycle for mobile phones required a massive buildup prior to the

composition of growth, the third quarter turned out to be in a different zip

fall introduction. Inventories are at all-time lean levels. And expectations

Markets & the Economy: Weekly Insights

Commercial Banking

5

December 3, 2012

that sales will be rising together with low financing

INVENTORIES ARE ABOUT AS LEAN AS THEY’VE EVER BEEN

costs imply that inventory-sales levels ought to be

Selected inventory-sales ratios

rising.

Ratio of real private inventories to real final sales (left scale)

2.7

4.5

The telecom product cycle The mobile phone industry introduced a major

2.6

4.4

2.5

4.3

new product cycle this fall, with the buzz around Apple’s iPhone 5 getting considerable attention but others also introducing new models. Such

2.4

4.2

2.3

4.1

2.2

4.0

2.1

3.9

events require the industry to ramp up production

and inventories in advance of the marketing blitz. In this case, it would be expected that inventories

would surge, even if they are difficult to track. And the inventory build would have occurred in the

Ratio of real nonfarm inventories to real final sales (left scale)

2.0

3.8

Ratio of real nonfarm inventories to real final sales of goods and structures (right scale)

1.9 1.8

Inventories are historically lean

3.7 3.6

1997

1999

2001

2003

2005

2007

2009

2011

third quarter.

2013

A buildup in business inventories would be problematic if the level of inventories were high

relative to the pace of sales. It is difficult to know what level of inventories is desirable, and

businesses have become more adept at managing inventories to keep their costs down. One popular

metric for gauging the burden of inventories is the Source: US Department of Commerce. Updated through 2012 Q3.

Markets & the Economy: Weekly Insights

ratio of real inventories to the pace of real

Commercial Banking

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December 3, 2012

demand. Several metrics calculated by the US

SURE, INVENTORIES GROW WHEN GDP EXCEEDS FINAL SALES …

Department of Commerce are illustrated in the

Real GDP and real final sales (billions of chained 2000 dollars)

figure on the previous page and relate real

inventories to several measures of real final sales

14,000 When the level of real GDP is in the orange zone--that is, above the level of real final sales--the level of real business inventories expands

13,800 13,600

14,000

(final demand).

13,800

As the figure on the previous page shows, the ratio of inventories to sales has been declining on

13,600

a secular basis, owing to improved inventory management techniques, and currently most

13,400 13,200

13,400

Real GDP

measures are at all-time record lows. In other words, business inventories are quite lean. To

Final sales

13,200

keep inventories in line with sales, the level of national output (real GDP) must exceed the level

13,000

13,000

of demand (as it is in the illustration on this page) and by enough of a margin to expand inventories

When the level of GDP is in the green zone (below final sales), the level of business inventories declines

12,800 12,600 2008

12,800 12,600

2009

2010

2011

2012

2013

in line with sales (the figure on the following page illustrates the key levels of real GDP that signify that inventories are rising too quickly relative to

sales). With the level of real nonfarm business inventories valued at $1,667 billion, they would

have to expand by $33 billion annually to keep pace with 2 percent growth in real final sales and

by $50 billion annually to remain in line with 3 Source: US Department of Commerce. Updated through 2012 Q3.

Markets & the Economy: Weekly Insights

percent expansion of real final sales. By the way,

Commercial Banking

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December 3, 2012

this is the justification for the forecast, illustrated in

... BUT RISING I-S RATIOS AREN’T A THREAT WHEN THE SALES TIDE IS RISING

the figure on the following page, that inventory

Real GDP and real final sales (billions of chained 2000 dollars)

accumulation will begin to run somewhat higher

than steady-state levels for a little while and that

14,000 13,800

14,000

When the level of real GDP lies above real final sales plus or minus the change in inventories needed to keep inventories in line with sales (the orange zone), the business inventory-sales ratio rises, signalling that inventories are accumulating faster than sales.

the inventory-sales ratio will edge up slightly as a result.

13,800 Today, a jump in the level of inventories relative to

13,600

13,600

sales, or a rise in the inventory-sales ratio (I-S ratio), likely is not viewed by business as

13,400

Lines: Real GDP

13,200

Final sales

13,400

the I-S ratio was higher.

13,200

13,000

13,000

12,800

12,800 The business inventory-sales ratio falls when GDP is in the green zone, a signal that inventories are becoming ever leaner

12,600 2008

2009

2010

2011

2012

12,600 2013

negatively as it might have been in the past when

Target inventories, expected sales and carrying costs In addition, businesses take their cue from expected future sales, not current sales, when determining the desired level of inventories. When demand is shrinking and sales are expected to be

weak, businesses will be cutting inventories in anticipation of slower activity in the future. If sales

are rising, however, as they have been since the end of 2008 (see the illustrations on the previous

page and on this page), business planners likely Source: US Department of Commerce. Updated through 2012 Q3.

Markets & the Economy: Weekly Insights

will be upgrading their expectations for sales in the

Commercial Banking

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December 3, 2012

future. In that case, they would be expected to

BUT OPTIMISTIC SALES ECPECTATIONS LIFT DESIRED RATIOS Inventory-sales ratio

react less promptly to temporary slowdown in

Nonfarm inventories (quarterly change in billions of dollars annualized)

sales than they would have in the past when sales

were generally expected to be weak, especially

2.8

Quarterly change in private inventories (right) Ratio of real inventories to real business final sales (left)

2.7

150 100

with inventories currently at historically lean levels.

Moreover, when sales are expected to climb, at some point businesses have to plan ahead and

2.6

50

this would force them to allow inventories to rise relative to current sales.

2.5

0

2.4

-50

2.3

-100

expectations about sales, because surprises, both

2.2

-150

to stock goods in inventory can lead to a lost sale.

Business determinations about the desired stock

of inventories usually is dominated by

positive and negative, can be quite costly. Failure

But it is costly to hold idle inventory. In fact, the

2.1

-200

cost of carrying inventories also is a key consideration. When interest rates are high and

2.0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

-250

carrying costs prohibitive, businesses will try to keep their inventories lean. When interest rates

are at negligible levels as they are today, however, financing costs are not prohibitive and

the level of inventories would be expected to be Source: US Department of Commerce. Updated through 2012 Q3.

Markets & the Economy: Weekly Insights

higher relative to sales compared with other

Commercial Banking

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December 3, 2012

periods when interest rates have been at more

INVENTORIES HELD BY MANUFACTURERS

normal levels.

Real inventory-sales ratios for selected items held by manufacturers

Entrails 5.5

Transportation other than cars

5.0

5.5 5.0

Trends in inventory-sales ratios by type of product offer a few insights into the character of the rise in inventories this summer. The illustrations on this

4.5

4.5

4.0

4.0

and the following two pages focus on inventories held at the manufacturing, wholesale, and retail level. And the lines in the figures trace the

Leather products

3.5

3.5

evolution of the real inventory-sales ratios for specific items. Real I-S ratios are more informative

3.0

3.0

2.5

2.5

2.0

2.0

commodities.

1.5

1.5

The figure on this page focuses on inventories

1.0

1.0

than nominal I-S ratios, because they remove the distortion caused by rising prices, which can be

0.5

0.5 2007

2008

2009

2010

2011

2012

quite significant especially for certain

held by manufacturing businesses. As the lines

clustered near the bottom of the figure indicate, there is no perceptible trend in the real I-S ratios

for most items. Inventories for a handful of items like computers are up slightly, but for most are

steady. Two items that stand out and that are Source: US Department of Commerce. Updated through August 2012.

Markets & the Economy: Weekly Insights

labeled in the figure reflect the benefits of the

Commercial Banking

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December 3, 2012

recovering motor vehicle industry.

INVENTORIES HELD BY MANUFACTURERS Real inventory-sales ratios for selected items held by wholesale distributors

A similar conclusion could be reached looking at

the trends in wholesale trade inventories. The rise 3.5

3.5

in inventories of farm products likely is a reflection of favorable trends, given the robust activity of the

3.0

3.0

earnings this year despite the damage from the

Machinery

2.5

agriculture sector, which likely will see record

2.5 Farm products

summer drought. And the uptrend in machinery, because it comes off of a very low level last year

likely is a response to the recovery emerging in

2.0

2.0

the real estate sectors.

1.5

1.5

The trends in retail inventories, at least through August (real inventory-sales estimates are

1.0

1.0

available with a slight lag) are inconclusive. Inventories of motor vehicles ought to be rising, because sales have been recovering and faster

0.5

0.5

than industry predictions had been calling for. With

sales reaching 15 million units at an annual rate 0.0

0.0 2007

2008

2009

2010

2011

2012

and likely to head still higher, toward 16 million in

the coming year, as the economy recovers and an aging fleet on the road begins to be upgraded,

dealers would be expected to aim to hold more Source: US Department of Commerce. Updated through August 2012.

Markets & the Economy: Weekly Insights

vehicles in stock. And with financing costs

Commercial Banking

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December 3, 2012

negligible, they face an even greater incentive to

INVENTORIES HELD BY MANUFACTURERS

stock up.

Real inventory-sales ratios for selected items held by retail outlets

Over the horizon 2.75

2.75

2.50

2.50

2.25

2.25

The mood among forecasters, if not in the stock market, is quite cautious and predictions of more of the same in 2013—that is, continued slow 2 percent real GDP growth—are the consensus.

Cars Apparel Building materials

2.00

And to be fair, it is difficult to have a lot of confidence when the negotiations over the fiscal

2.00

cliff in the final hours sound like the opening bell. Nonetheless, even if there is not enough time to

1.75

1.75

and a couple of handshakes simply to move the

Food

1.50

reach a grand fiscal bargain, it takes two minutes

1.50

goal post forward a few yards and that is likely what will happen before the year is out. If the

1.25

Electronics

1.25

economy confronts a new danger, it is not likely to be a human-made problem. And at present, there

1.00

1.00

aren’t many dangers on the horizon. Two

thousand thirteen can’t get here quickly enough. 0.75

0.75 2007

2008

2009

2010

2011

2012

Source: US Department of Commerce. Updated through August 2012.

Markets & the Economy: Weekly Insights

Commercial Banking

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December 3, 2012

APPENDIX: LONGER-TERM ECONOMIC FORECASTS Real GDP

Annualized percent change over the quarter

Percent change over the four quarters of each year

3Q12

4Q12

1Q13

2Q13

3Q13

2012

2013

2014

2015

2016

3.1

3.1

3.8

3.9

4.3

3.1

4.2

4.7

4.8

4.6

U.S.

2.7

2.0

3.5

3.0

4.0

2.0

3.6

4.0

4.0

4.5

Europe

0.9

0.0

1.3

1.7

2.0

0.2

1.8

2.6

2.7

2.7

0.7

-0.6

0.9

1.4

1.7

0.0

1.4

2.3

2.4

2.4

4.3

4.9

5.6

5.6

5.7

5.0

5.9

6.5

6.6

5.9

Japan

-2.0

-0.8

1.4

1.6

1.3

-0.1

1.7

2.8

2.7

2.7

China

7.7

8.2

8.0

8.2

8.2

7.4

8.2

8.5

8.0

7.5

India

5.2

5.0

6.2

5.8

6.0

5.3

6.5

7.5

7.5

7.5

3.5

3.7

4.0

4.0

4.2

3.7

4.1

4.3

4.4

4.4

3Q12

4Q12

1Q13

2Q13

3Q13

2012

2013

2014

2015

2016

Global

EU-27 Asia

Other

U.S. Key Metrics 2007

FOMC real GDP Forecast¹ Real consumer spending Unemployment rate (% of labor force at year end)

Unemployment ratio (% of population at year end)

Petroleum (WTI, $ per barrel at year end)

1.7 - 2.0 2.5 - 3.0 3.0 - 3.8 3.0 - 3.8 1.4

1.3

3.0

2.9

3.2

7.8

7.8

7.7

7.8

7.7

41.3

41.2

41.2

41.1

41.0

94.7

85.0

77.5

75.0

75.0

n.a.

1.7

3.0

2.9

2.7

2.8

4.5

7.8

7.8

7.5

7.3

6.7

37.3

41.2

40.9

40.5

40.0

39.4

85

75

75

75

75

Note: bold figures related to the US are Chase forecasts, except in the case of the FOMC forecasts for the US economy; global forecasts are J.P. Morgan forecasts. ¹ FOMC forecast range as of 9/13/12. Global and National Economic Outlook

Commercial Banking

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Economic Insights.120312 - Walter Unger CCIM

December 3, 2012 THE US ECONOMY THE FED AND THE MARKETS Annualized qtrly. % change, unless noted otherwise Percent 2012 Q3 Q4 2013 Q1 Real GD...

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