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6 The Current State of the U.S. Economy and a Look Towards the Future Christopher Douglas, Ph.D. Associate Professor and Chair Department of Economics, UM-Flint The Economic Forum December 9, 2016

7 Quick and Dirty Overview Average 2016 net new job creation: 180,000/month 2015: 225,000/month November 2016 unemployment rate: 4.6% November 2015 unemployment rate: 5.0% Average 2016 economic growth: 0.8% for q1, 1.4% for q2, 3.2% for q3 2015: 2.0% for q1, 2.6% for q2, 2.0% for q3 Interest rates imply the market expects 2% inflation over the next 10 years Economic indicators look decent, but the overall recovery remains disappointing. Predict basically the same economic performance for 2017

8 Predictions and Observations Expect inflation to remain below 2% so long as the bond market continues to be willing to loan the federal government money Expect interest rates to continue to be low The government cannot afford higher interest rates. 67% of the federal debt has a maturity of 5 years or less If interest rates revert back to historical averages, interest cost on the national debt would more than double ($223 billion to $505 billion) This would increase the budget deficit by 50% Balancing the budget is impossible without entitlement reform. Zeroing out all non-defense discretionary federal spending barely would balance the budget

9 More Predictions and Observations Obamacare is in an unsustainable death spiral Average premium increase: 22% Problem: many people are only buying health insurance when they need it. The Obamacare penalty is too low (2.5% of income with a min. of $695). Without serious Medicaid reform, health care spending will chew up an everincreasing share of the state budget Public pensions will also drain state and local budgets These two expenditures will leave little room for anything else

10 Why Economic Growth is Important

11 Historical Economic Growth Rates Post-WWII (1947) to present: 3.2% Income doubling every 32 years (assuming 1% population growth rate) Post-WWII (1947) to 1973: 4.1% Income doubling every 23 years : 2.7% Income doubling every 42 years : 2.1% Income doubling every 63.3 years

12 Historical Per Capita Income Year Real Per Capita Income 1947 $13, $25, $51,505 Source: Federal Reserve Per capita income doubled between 1947 and 1973 (26 years) It then took 43 years for per capita income to double between 1973 and 2016 Had the growth rate not slowed down in 1973, per capita income would be about $42,000 higher today! Any policy or regulation that slows down economic growth has substantial future costs!

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15 Conclusions Low growth, low employment, low inflation, and low labor force participation is the new normal. Government budgets are a disaster at all levels of government Policies that hinder economic growth have substantial costs, and this cost is hard to see.

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17 State of the US free trade agreements Anti-trade rhetoric in election campaigns: Bernie Sanders Donald Trump Hillary Clinton Barrack Obama Bill Clinton

18 State of the US free trade agreements Existing FTAs: Israel (1985) North American FTA (NAFTA, 1994): Canada, Mexico Jordan (2001) Singapore (2004) Chile (2004) Australia (2005) Morocco (2006) Bahrain (2006) Central America-US FTA (CAFTA-DR, 2006): Dominican Rep., Guatemala, Honduras, Nicaragua, El Salvador Peru (2009) Oman (2009) Panama (2012) Colombia (2012)

19 State of the US free trade agreements FTA negotiations/unratified: Transatlantic Trade and Investment Partnership (TTIP): Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Rep., Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom Trans-Pacific Partnership (TPP): Old trade partners: Australia, Canada, Chile, Mexico, Singapore, Peru New trade partners: Brunei, Japan, Malaysia, New Zealand, Viet Nam

20 State of the US free trade agreements Transatlantic Trade and Investment Partnership (TTIP): Annual trade ~ $1 trillion, bilateral investment ~ $4 trillion Not a typical trade deal (average tariff rates=3% 0.4% GDP in EU, 1% in US) Reduction of non-tariff barriers 3% GDP in EU & US Established mutually recognized standards Strategic

21 State of the US free trade agreements TTIP Opportunities for Michigan: Automotive: 36% of MI exports to the EU at $2 billion. EU s tariff rates are as high as 22%. Chemicals: 13% of MI exports to the EU at $725 million. EU s tariff rates are as high as 6.5% Machinery: 10% of MI exports to the EU at $550 million. EU s tariff rates are as high as 9.7%.

22 State of the US free trade agreements European opposition to TTIP: Massive demonstrations in EU, particularly (59%) Germany and Austria, 34% EU-wide opposition. Resistance to change in Germany, threat to social welfare, consumer rights, too much power to corporations. TTIP-free zones declared in some localities Regulatory cooperation: Incompatible rules on product testing/safety, particulary food Hope: reduction in prices; harmonizing standards benefits small companies; create more jobs; some progress on GMOs, single drug testing boosting pharmaceuticals, agreed standards on electric cars creating vast markets/infrastructure, common

23 State of the US free trade agreements Trans Pacific Partnership (TPP): 40% of world GDP Tariffs on average low, but selective high in some:18,000 tariffs would be eliminated, including in agriculture Free trade in services: elimination of non-tariff barriers. Protection of workers/environment Fair competition: no protection of state-owned enterprises Boosting world GDP by $225 billion Negotiations complete, not ratified

24 State of the US free trade agreements TPP Opportunities for Michigan: 71% of MI exports to TPP at $38 billion (88% are small/medium companies) Chemicals: $480 million; tariffs as high as 35% Automotive: $325 million; tariffs as high as 75% Machinery: $136 million; tariffs as high as 59% Health products: $127 million; tariffs as high as 30% High tech instruments: $72 million; Additional market access in agriculture and services

25 Opposition to TPP: State of the US free trade agreements Difficult ratification in Canada Unlike TTIP, strong opposition in the US

26 State of the US free trade agreements Who benefits from free trade? Falling prices since NAFTA, benefiting primarily low-income New markets were created (cars to Mexico, agriculture/aerospace/cars to China) Outsourcing increased US productivity of high skilled labor

27 Who loses from free trade? State of the US free trade agreements Acute image problem for trade Costs are concentrated American manufacturers Low-skill labor with little education Rising premium for education Inability of displaced workers to find jobs Reliance on government Trade-adjustment assistance program

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29 Steven Chenenko Lead, Investment Risk Management, Nationwide Insurance Chief Risk Officer, Nationwide Bank

30 Disclaimer The views and opinions expressed in this presentation are my own and do not necessarily reflect the views or positions of my company Copyright 2016 FactSet Research Systems Inc. All rights reserved. Confidential: Do not forward. 30

31 Financial Crisis...

32 ... Led to Greater Regulation Dodd-Frank Enacted July 2010 SIFIs and FSOC Nonbank regulation Break-up, concentration and growth limits Orderly liquidation Living wills Volcker rule Derivatives rulemaking Executive compensation CFPB As of July 19, 2016 Source: DavisPolk

33 Financial Crisis Led to Greater Regulation DF Required Rulemaking Dodd-Frank enacted July 2010 Required 390 rules Finalized, 274, 71% Proposed, 32, 8% Not yet proposed, 80, 21% As of July 19, 2016 Source: DavisPolk Of the 80 rules not yet proposed, 32 have passed the statutory deadline for finalization.

34 Which was not a cure all

35 And may have had unintended consequences in conjunction with low rates and slow economic growth Source: FDIC New bank charters totaled 2,448 (122 a year) between 1990 and 2009 Only 7 new charters between 2010 and New Bank Charters

36 And big banks have gotten bigger 70% Bank and Credit Union Market Share 60% 50% 40% 30% 20% 10% 0% Small Medium Large Very Large Source: FDIC, NCUA, ILSR Market share is defined as % of assets Small = $1b or less (2010 dollars) Medium = $1-10b Large = $10-100b

37 Banks are substantial providers of credit especially to consumers Banks provided 34% of system wide credit (excluding financial sector and government debt) in 2007 and 35% at the end of % 80% 70% 60% 50% 40% 30% 20% 10% 0% Commercial Bank Credit Market Share Q4'15 Commcl Real Estate Residential Mortgage Credit Cards Auto Loans Other Consumer

38 While banking share of the credit market has not changed substantially loan growth has been slower this recovery Source: Citigroup, Federal Reserve

39 Deposit growth has been more robust Deposits have grown at a 5% CAGR since Non-interest deposits market share up 7% Banks have recovered 6 points of market share from money market funds Low interest rates likely account for these trends Source: Citigroup, Federal Reserve

40 Result is shrinking net interest margin Slow loan growth and a low rate environment combine to shrink net interest margin at banks However, this trend dates back to the 1990 s reflective of increased disintermediation and technology advances

41 Current trends may threaten remaining profit sources Source: SNL, JP Morgan, Citigroup

42 Fintechs and alternative payment systems Payments Blockchain P2P lending Credit underwriting B2B lending Treasury management Investing PWC estimates more than 20% of existing financial services business is at risk by 2020

43 Lending Standards Loan Demand Is slow loan growth demand or supply driven? Lending standards and loan demand commercial Source: Federal Reserve

44 Lending Standards Loan Demand Lending standards and loan demand consumer Source: Federal Reserve

45 Market Liquidity Impacts Derivatives Higher cost Wider bid/ask spreads Daily counterparty limits Increased margin requirements Bond trading Pervasive reports of reduced liquidity Lack of evidence in dealer positions and transactions, issuance, trade size and liquidity premiums

46 Conclusions and What s Next Post election markets anticipate faster growth Infrastructure spending More favorable regulatory environment Bank stocks reflect expectation of, at a minimum, favorable changes to Dodd- Frank And effects of faster growth Rates have risen and this is expected to continue Yield curve slope matters just as much to banks Slowdown in lending, investment and capital formation appears to be more demand than supply driven

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