US Economic Outlook Upgraded for 2012

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1 Market nsights By Blu Putnam, Chief Economist, CME Group 16 DECEMBER 2011 All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience. US Economic Outlook Upgraded for 2012 The economic outlook for the United States is materially improved. We are now forecasting real GDP to grow around 3.5% to 4.0% for 2012, with the unemployment rate declining below 8% by the end of the year. Core inflation, excluding food and energy, will continue to creep higher and be running around 3.5% by December In terms of real GDP, this is a substantial upgrade from our previous 1.5% to 2% forecast for We are not, however, revising our view that the US will average around 2% annual real GDP growth for the decade, but we have come to the conclusion that 2012 will be considerably above average. The good news may not last, as are fraught with fiscal and monetary policy risks that may bring the economic growth rate back down toward the expected average for the decade. And, this optimistic perspective on 2012 real GDP growth for the US comes even despite expectations for a recession in Europe and a significant growth deceleration in China. United States Economic Outlook Summary End of Year Inflation (Year over Year) Core Inflation: Excludes Food and Energy (Year over Year) Real GDP Growth (Annual Average over Annual Average) Federal Funds Rate Dec % 2.61% % Dec % 2.42% 1.91% 4.24% Dec % 1.75% -0.34% 0.1 Dec % -3.49% 0.12% Dec % 0.65% 3.03% 0.18% Dec % 2.34% 1.73% 0.20% Dec % 3.61% 3.54% 0.20% Dec % % Dec % % 4.00% Data Source: Bloomberg Professional for Historical Data, Forecasts by CME Research. 1 market insights

2 If our forecast for the US is in the right direction, there are important implications for many markets. US long-term bond yields could come under considerable upward pressure as the year develops, and a raging debate over Federal Reserve policy in the second half of the year could destabilize shorter maturities, such as the 2-year Treasury note. On the surface, this economic growth forecast would appear to be good news for US equity markets. One must remember that S&P 500 companies on average get half their cash flow from outside the US. The forecast for China and other emerging markets is for slower growth and for Europe the estimate is for a decline in real GDP. Nevertheless, strong growth in the US could be a decidedly calming influence on world equity markets, resulting in lower risk premiums and higher price-toearnings ratios, which might also portend reduced equity market volatility as the year progresses. What Has Changed? During 2011 we maintained a low, sub 2%, real GDP growth forecast for the US. We never adopted the pessimism of the double-dip recession camp, but we could not get very enthusiastic given the turbulence in world financial markets even if we did not think Europe would implode over its debt crisis. Our sluggish outlook for 2011 was based on a number of key factors, including (a) the drag from fiscal tightening at all levels of government, (b) the resulting State and Local government job losses, (c) the elevated levels of uncertainty over future government tax and spending policies, (d) the relative ineffectiveness of monetary policy in the aftermath of a financially-induced recession with the need for considerable deleveraging by all segments of the economy, and (e) the weakened state of the housing market. As we enter 2012, we see positive changes in our interpretation of each of these five factors. Fiscal Policy. The pressure to reduce spending at every level of government during 2010 and 2011 was intense. What we have come to appreciate, however, is the degree of progress made by State and Local Governments in getting their fiscal houses in order. Indeed, so much progress has already been made that we no longer expect higher taxes and further spending cuts at the State and Local level on average in 2012, which means that the job losses from this source have run their course. The situation at the Federal level is much more complex and the US Congress has simply decided to put off all the major spending and tax decisions until 2013 after the November 2012 elections. As it stands now, the failure of the Joint Super Committee on budget reform has triggered rather draconian spending cuts that will automatically go into effect in Fiscal Year 2013, unless Congress legislates otherwise. Also, the Bush era tax cuts will disappear at the end of This means that unless in early 2013 the newly elected Congress and President can get together on a grand compromise for fiscal policy, the US is looking at big spending cuts and tax hikes, which we think would translate into a dip back toward recession. At this point, as we survey prospects for the 2012 elections, we see a close election and the likelihood that Congressional stalemate may prevail into We have not yet become so pessimistic that there will be no mitigating legislation, we just think that all we can forecast at this time is that there may be some new legislation to push the decisions out further into the future. So, with the risks from fiscal policy very high as we enter 2013, we are forecasting a return to sluggish growth after a buoyant The Stimulatory Impact of Zero-Rates. Our perspective has been that the near zero Federal funds rate policy of the Federal Reserve has had little to no stimulatory impact on the economy because consumers and corporations have been focused on getting their balance sheets in order after the shock of the Financial Panic of We now see signs that both consumers and corporations are likely to be more interest rate sensitive in 2012 and beyond such that the efficacy of monetary policy will be enhanced slowly but surely over the course of the year. We believe that both consumers and corporations have done a very good job of adjusting to the new reality of lowered expectations and elevated uncertainty, and that this bodes well for market insights

3 On the consumer side, the slide in outstanding consumer credit halted in On the corporate side, profits recovered in In 2011, profit growth continued for non-financial companies, while the financial sector reached a plateau, primarily due to market volatility and regulatory uncertainty. With the deleveraging over, the remaining question in 2012, despite fiscal policy uncertainty that may not be resolved for years, is whether consumers will grow spending and corporations will increase investment activity. We are now prepared to give a cautious Yes answer for both sectors. Our reasoning is that now that the private sector has its balance sheet more or less back in order, it can also learn to live with more uncertainty over government policy, future taxes and regulations. Making decisions under conditions of uncertainty is part of life. A rise in the level of uncertainty requires adjustments and this transition process helped to keep growth sluggish in and unemployment high. We think this adjustment process is largely complete. This does not mean that consumers suddenly turn on the spending spigot or that corporations will go on an investment binge, but it does mean that with uncertainty and confidence recalibrated, risk-adjusted spending and investment decisions will no longer be on hold in Housing. We also see encouraging signs that the housing market may have a modest rebound in The overhang of already foreclosed houses and potential foreclosures is still substantial. Current market prices for homes, however, appear to have come to terms with the foreclosure supply, so that further downward pressure on average nationally is no longer likely. Interestingly, what the housing market now needs to see is a drop in the unemployment rate such that more 20-somethings (and some 30-somethings, too) will move out of their parent s home. That is, a drop in the unemployment is likely to be correlated with an increased demand for both new and rental single family housing. Since we are projecting a decrease in the unemployment rate to below 8% by the end of the year, this gives us a positive view on the housing market for the first time in quite a few years. Growth, Inflation, and Market Volatility in 2012 We when put it all together, we see an improved jobs picture from State and Local governments, the likelihood that zero-rates will provide some stimulus in 2012, the increased ability of consumers and corporations to cope with uncertainty over fiscal policy, and a modest rebound in housing. Despite slowing growth in China and other emerging markets, as well a recession in Europe, there are enough positives to forecast real GDP growth in the 3.5% to 4.0% range for Correspondingly, this increase in economic activity has the potential to reduce the unemployment rate to below 8% by the end of the year. The main risks to this more optimistic growth forecast lie in Europe (implosion due to debt crisis), Russia (political unrest), and China (growth slows even faster than we think). 1, , Non- Companies Source: Bloomberg Professional (CPBIDIFI, CPBIDINF) Financial Companies Source: Bloomberg Professional (CCOSTOT Index) 3 market insights

4 With the efficacy of monetary policy improved and the Federal funds rate remaining at zero for the whole year, as promised (subject to caveats) by the Federal Reserve, our more optimistic view on growth also comes with some inflation pressure. We see total and core (excluding food and energy) consumer price inflation converging in 2012 around a 3.5% year-on-year gain by December. We also see inflation expectations lagging actual inflation in the first half of 2012, until the growth picture becomes clearer. Should our views on economic activity and unemployment gain credence during the year, we would expect rising inflation expectations to characterize US financial markets in the second half of We have a somewhat nuanced view on inflation in terms of when markets start to focus on rising prices as a risk that the Federal Reserve may invoke its caveats and consider raising the Federal funds rate prior to mid-year Our current base case is that the Federal Reserve will keep the effective Federal funds rate at 0.25% until its June 2013 FOMC (Federal Open Market Committee) meeting, at which time the first rate rise may be announced since its late June 2006 decision to raise rates. The debate over when to start raising rates and how to exit from the swollen balance sheet caused by quantitative easing, however, will gain traction well before any rate decision. Indeed, we see the summer of 2012 as a potentially critical time for the Federal Reserve, when more and more board members and regional Federal Reserve Bank Presidents will become increasingly vocal about the need to start raising rates at least to realign rates with the expected inflation rate. If inflation is expected to run at 3.5% or higher in 2013, then this implies that the Federal Reserve will initiate a sequence of incremental rate increases from mid-2013 that will continue into 2014 and possibly beyond. This view that the debate over when to raise rates and how to exit quantitative easing moves into high gear in mid suggest the potential for considerable volatility in Treasury bonds, all along the yield curve, with even the 2-year getting involved. While the past is not necessarily a good guide to the future, a note of caution from economic history is worthy of consideration given that as we close out 2011 the current 10-year US Treasury yield is around 2%, and we are forecasting about 7% nominal GDP growth in During inflationary times ( ), the US Treasury 10-year bond yield traded at an average discount of 2.28% to nominal GDP growth as inflationary expectation lagged on the rising tide. 1 14% 12% 10% 8% 4% 2% Nominal GDP Growth Treasury Bond 10-Year Yield 0% Source: Bloomberg Professional (USGG10YR and GDP CUR$) Treasury Bond 10-Year Yield 10% 8% 4% 2% 0% -2% Nomimal GDP Growth -4% Source: Bloomberg Professional (USGG10YR and GDP CUR$) 4 market insights

5 During the disinflationary period ( ), the US Treasury 10-year bond yield traded at an average premium 0.91% to nominal GDP growth as inflationary expectations lagged on the ebbing tide. Our suggested summer timing of when this debate over future Federal Reserve policy engages is not strongly held, but we do believe that 3.5% real GDP growth and 7% nominal GDP growth, should they occur, will be a powerful catalyst, since once the Federal Reserve starts to align its rate policy with expected inflation, there is the possibility of the 10-Year Treasury bond yield moving back toward its traditional relationship with nominal GDP growth. The implications of a +3% real GDP growth year for equity market volatility is, interestingly, in the opposite direction for bond market volatility. From our perspective, equity markets will have to cope with conflicting forces, including rising economic activity in the US, a recession in Europe, and slowing economic activity in China and other emerging market countries. This may well create a lot of noise inside the stocks of the broad-based indices, and the correlations of the returns of different pairs of stocks may fall in 2012 as it becomes more a stock-pickers market. In addition, if economic growth prospects follow the course we are suggesting, then the probability of dire outcomes will diminish and risk premiums are likely to fall. A move toward less risk aversion, even if for only a year, may be associated with a less volatile stock market. As we have indicated, beyond 2012, the theme of fiscal retrenchment re-emerges as a dominant force in the US economic outlook, this time accompanied by rising short-term interest rates as the Federal Reserve gradually removes its relative accommodation of monetary policy. Consequently, with fiscal and monetary tightening on the horizon for 2013, our baseline case is that real GDP growth slides back toward our projected 2% average for the decade. We will, of course, be reviewing our 2013 forecasts as we observe the US political scene and get a better fix (or not) on future fiscal and monetary policy during the course of In the mean time, hopefully we can enjoy a better than average year for the US economy. Additional Resources Research and Analysis Visit for more economic and market research and analysis from thought leaders, educators and analysts from around the world. Trading Tools, Demos and Calculators Visit for a list of dynamic and interactive tools and resources to help you build a better portfolio. Product and Market Information Visit where you can explore a variety of strategy papers, market commentary, trading tools and product details covering Agriculture, Energy, Equity Stock Indexes, FX, Metals, Interest Rates and Alternative Investments. CME Group is a trademark of CME Group Inc. The Globe Logo, CME, Chicago Mercantile Exchange and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. New York Mercantile Exchange and NYMEX are registered trademarks of the New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this brochure. Additionally, all examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. Citation: Please reference as US Economic Outlook Upgraded for 2012 Bluford H. Putnam, CME Group Market Insights Series, December 2011, Copyright 2011 CME Group. All rights reserved. 5 market insights