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Bending But Not Breaking - The U.S. Economy at Mid-Point

NEW YORK, NY (KWR) June 16, 2011 - The U.S. economy is reaching the mid-point for 2011. Looking from the beginning of the year, 2011's progression has been disappointing. Indeed, there is a considerable concern as to whether the economy is going to slip into the troubled waters of another recession, pulling credit and equity markets down with it. Along these lines, the summer is going to be a hot one because risks are likely to outweigh rewards, but September holds some promise for recovery in the economy and with it the capital markets.

What happened in May?

May was not a good month for the U.S. economy. The flow of economic data was, to put it mildly, disappointing, stimulating talk of a return to recession. The most significant data points concerned housing (which appeared to already be in a double dip recession), jobs (with unemployment heading back up to 9.1% in May), and softer manufacturing numbers. Adding a degree of gloom to the picture, Federal Reserve head Benjamin Bernanke announced the U.S. economy was growing more slowly than the central bank had expected due to headwinds from Japan, adverse weather and high energy costs. Bernanke admitted the recovery is "...continuing at a moderate pace, albeit at a rate that is both uneven across sectors and frustratingly slow from the perspective of millions of unemployed and underemployed workers." Bernanke's comments reinforce our view that there are enough positive factors to keep the economy moving, but not enough to launch a broader and deeper recovery. This was dissatisfying for investors, hence the sell-off in equity markets and spread widening in the corporate bond market that marked the end of the month.

The performance of the U.S. economy remains below other recent recoveries. This is despite interest rates being near zero and the Fed buying more than a trillion dollars worth in mortgage and U.S. Treasury debt to provide liquidity. And QE2 is set to end by the end of June, something that investors are watching closely with Washington being lukewarm to the idea of QE3. The sad thing is that for all the money being spent, the U.S. economy is not on an easy road to recovery and there is a growing degree of uncertainty pertaining to second half performance. Will the "soft patch" extend into a second round of recession? Do commodity prices refuse to fall further and leave inflationary pressures on the table, holding up the dreaded prospect of stagflation?

A Tough Summer Ahead

The soft patch (or perhaps rough is a better term) in the economy will continue through the summer, but growth will increase in the fall and early winter, helped along by a modicum of business investment, manufacturing and exports. The U.S. corporate sector, in particular the largest companies, are in good shape and have a considerable amount of cash on hand, which they need to spend to create jobs. Furthermore, Emerging Market growth, which is important to exports and manufacturing, is set to expand by 6.3% in 2011-2013 according to the most recent World Bank projections. However, the U.S. debt drag will hinder any faster-paced growth in the second half of the year and into 2012.

The real challenge for the U.S. economy, to which the above points, is Washington's difficulty in dealing with the country's structural problems. These include a moribund housing sector, characterized by excess inventory, a cumbersome foreclose process, pending legal action on loan documentation, tight lending standards and a changing view about housing as good collateral. The U.S. public sector and the large fiscal deficits as well as questions over Washington's commitment to seriously deal with the problems related to reducing the red ink through tough measures like dealing with entitlements and raising taxes have led to the major rating agencies raising concern over their ability to maintain the U.S. AAA sovereign rating. Make no mistake, if the U.S. were to loose its AAA ratings there would be negative consequences for international markets and it would add considerable friction to Sino-American relations, considering that China holds more than $1 trillion in U.S. government and government-related debt.

Rounding out the picture is the challenge of dealing with high structural unemployment. Simply stated, the landscape for the U.S. job market has changed with unemployment extending further than before. Those over 55 years of age are seeing the highest unemployment rates in the post-war period, and the unemployment rate for those without a high school diploma are at 14.6% versus 4.6% for the college educated. These structural problems are not going away any time soon and represent substantial challenges for policymakers in 2011 and beyond. The top heavy nature of an economy driven by consumerism is not sustainable when the needed money to spend is borrowed. Indeed, that story is gradually coming to an end, but finding a substitute is a slow process.

Looking Ahead

Looking ahead, considerable challenges remain for the U.S. economy. While we think the economy will benefit in the second half of the year from the start of recovery in Japan, hopefully less destructive weather in the U.S. heartland, stable or perhaps lower oil prices, and ongoing demand from Emerging Markets, we do not rule out the possibilty of an extended slow down or a double dip in the economy. The set of factors influencing the economy are varied and many of them are subject to policy decisions. The exogenous factors are important, especially when seeking to gauge the impact of a Greek default on international capital markets. Most Americans discount Greek risk and other political risks and it is indeed hard to make a direct relationship or to factor in potential risk factors, such as the spread of political upheaval into oil-kingpin Saudi Arabia. Yet, if a Greek default became a point of contagion -- of which there is a real possibility -- and international capital markets seized up as they did with the Lehman shock, or if the House of Saud were toppled by pro-al-Qaeda forces, the global scenario would certainly tip into the negative, with deleterious consequences for the U.S. economy.

Although the U.S. economy is still moving, the path ahead is less clear and risk factors are mounting. For the moment it is best to be defensive.


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