UMB Investment and Wealth Management Economic and Market Outlook

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1 Ecnmic and Market Outlk Return t the Lng, Hard Slg Part One V r W r July 19, 2010 William B. Greiner, CFA President and Chief Investment Officer Scut Investment Advisrs william.greiner@scut-ia.cm Outlk and Summary In January f 2008, we pstulated that the U.S. ecnmy was n the verge f recessin, and excesses had been built in ur system. These excesses included: UMB 2010 Ecnmic Outlk GDP GROWTH: 2.8% UNEMPLOYMENT: 9.2% T much leverage (debt) in the system T much liquidity that was chasing t few gd ideas, which led t bad decisins (i.e. subprime mrtgages) An asset valuatin bubble which was becming unsustainable in the U.S. husing market Other levered financial excesses INFLATION: 1.0% FED FUNDS RATE: 0.5% Lack f savings Let s revisit these excesses t examine if ur ecnmy is still shuldering many f these cncerns. What Shape is the Recvery? The natin s ecnmic and market pundits have been speculating what shape the ecnmic recvery is we are experiencing. Des the recvery resemble a V? A W, r smething else? A V shaped recvery (rapid decline fllwed by a rapid and sustained rebund) gained much ppularity and became the expectatin frm the majrity f ecnmists late last year and earlier this year. Recently, GDP grwth rates have been revised t the dwnside, emplyment gains appear nn-sustainable and financial market gains are evaprating. Cnsequently, the V shaped expected recvery has lst ppularity and credence. A W shaped recvery (rapid decline fllwed by a shallw recvery and then anther rapid decline) has recently gained ppularity. Revisins in grwth, and emplyment fit well with this utlk. Hwever, it appears t us that the prbability f the W wrking ut is nt t high. Mnetary plicies wrldwide are very easy. Additinally, the six-mnth rate f change f the Leading Ecnmic Indicatrs suggests we are far frm a renewed actual cntractin in ecnmic grwth. There is a big difference

2 Ecnmic and Market Outlk between an utright ecnmic cntractin (recessin) and a slwdwn in grwth. S, if we are nt frecasting a V shaped recvery r a W shaped recvery, what type f recvery, ver the lng-term, d we expect? We believe the ecnmic grwth rate ging frward is ging t be extremely slw, but still psitive in its reading. We believe the ecnmic grwth rate has been and will cntinue t be mre reflective f a in nature. This being a square rt sign, where we experienced a rapid decline in ecnmic activity fllwed by a rebund and ending with a sideways mve. As ur readers are aware, we believe ecnmic grwth rates will be very slw ging frward, n a sustained basis. This weaker-than-nrmal ecnmic grwth envirnment may be secular in nature, rather than cyclical in its duratin. What is the Difference Between 2.0 Percent and 3.0 Percent? If we believe GDP grwth ging frward is ging t systemically be slwer-than-nrmal, we need t understand the meaning f nrmal. Since the end f Wrld War II, the U.S. ecnmy has grwn by an average f 3.3 percent per year, n a real basis (after inflatin), which is the measure mst peple agree upn is a brad-based measure f ecnmic grwth. Over that same perid f time, inflatin (as measured by the Cnsumer Price Index) has risen by 3.7 percent per year (since 1948). Cnsequently, the nminal, r rate f ecnmic grwth plus inflatin within the U.S. has been 7.0 percent per year. The 7.0 percent nminal grwth in ecnmic activity ver the last number f decades is highly imprtant, due t the fact that business tp line grwth is crrelated with this data. This number includes nt nly unit-vlume grwth rates and prductivity gains, but als pricing. A business manager needs t see revenue generatin, r the prspect f revenue generatin prir t making investments, either in peple r in prcesses. Cnsequently, when cnsidering cyclical and secular ecnmic grwth variables, it is imprtant t understand the difference between real and nminal grwth rates. Grwth is imprtant fr many reasns, amng them prviding ecnmic gds and services t expanding ppulatin bases. The wrld s ppulatin grwth rate is 1.13 percent annually. The U.S. ppulatin base is currently grwing at 0.89 percent annually. Our ecnmy has grwn by 3.3 percent n average since the end f Wrld War II (after inflatin). If ur ppulatin is grwing by 0.9 percent, and ecnmic grwth is increasing at 3.3 percent, than the real ecnmic grwth rate (incme grwth rate) has been rughly 2.4 percent per year. At this rate, the after-inflatin standard f living dubles every 29 years. This is imprtant data t understand when cnsidering the natin s incme grwth rate, which fuels capital frmatin, research and develpment, ecnmic pprtunities and lngevity itself. If the lng-term ecnmic grwth rate declines frm 3.3 percent t 2.0 percent, and assuming inflatin ver the lng-term remains at 3.7 percent per year, the real standard f living within the U.S. wuld duble every 64 years. This dramatically lwers capital frmatin rates, research and develpment cmmitments and general prsperity levels f the cuntry verall. S, as peple talk f lwer-than-nrmal ecnmic grwth rates, we need t remember hw imprtant this discussin truly is, ver lng perids f time. The current ecnmic envirnment is far frm nrmal. Nt nly is GDP grwing slwer than nrmal, nminal GDP is grwing significantly slwer than has been the histrical average. We expect real GDP t grw by less than 3.0 percent ver the immediate future. Additinally, we expect nminal GDP t grw n mre than 4.0 percent fr the remainder f this year (as cmpared, nce again, t a nrmal 7.0% nminal grwth rate) and int Putting these numbers int histrical cntext gives us a very gd feel as t hw slw ecnmic grwth, jb creatin and incme increases truly are. The questin t ask regarding the sustainability f this slwer-than-nrmal grwth is, Why is this happening? What are the factrs which are leading t this less-than-nrmal ecnmic grwth rate? 2 / 5

3 Ecnmic and Market Outlk There are many factrs driving ur thughts that the ecnmy is experiencing, and will cntinue t experience slwer-than-nrmal grwth rates, bth real and nminal. These factrs include: Demgraphics. The cuntry is aging. This is undeniable. It is als undeniable that a 65 year-ld persn is less active and perhaps less prductive than smene in their 30 s. Additinally, as mre peple age, the demands n the ecnmic system fr cnsumptin relative t prductin tend t rise. The use f health care systems is an example. Cnsequently, as the cuntry cntinues t age, the wrkfrce will tend t becme less prductive. Debt. Mre ecnmic resurces are being utilized n a cntinuus basis t finance yesterday s cnsumptin. This is capital that is nt available fr either future investment r current cnsumptin. By ur calculatins, freign investrs have a net $2.7 trillin mre invested in the U.S. than we have in freign investments. Assigning 5.0 percent simple interest cst t this deficit balance indicates that we pay $136 billin net per year mre t freign investrs than we receive frm freign investments. GDP. Assuming ur GDP is rughly $14.5 trillin, this shws that 0.93 percent f GDP annually flws utside f the U.S. (net f inflws) t pay fr freign investments within the U.S. The net $2.7 trillin which we we is significantly higher than has been the case, histrically. As a matter f fact, prir t 1986, we were a net creditr t the wrld. As recently as 1999, the net debt we we t the rest f the wrld was less than $1 trillin. As f the end f 2009, that figure has ballned t $2.74 trillin (accrding t Ned Davis Research). Cnsequently, simply lking at the massive amunts f investments which have been purchased by freign investrs ver the last few years and assigning a mdest 5.0 percent interest rate (lnger term) t that flw leads us t the cnclusin that grwth ging frward well may be slwer than histrical trends have indicated. Returning t the There is t much debt that has been created. Perhaps we can all nw understand why there is t much debt, and why this is weighing s heavily n the U.S. ecnmic system. It is easy t understand why we stand by ur view, that the shape f the ecnmic recvery and grwth trajectry ging frward is smewhat flat-line in nature. S, we return t. What is the slutin t this prblem? There is n real painless slutin t debt repayment. It needs t happen, if we as a sciety want t return t a mre nrmal 3.0 percent+ grwth trajectry, at least n a sustained basis. In a piece we wrte this March, we frmulated three pssible slutins t the debt prblem. In abbreviated frm, the slutins put frward were: The Ugly (highest prbability): Business cycles shrten as grwth becmes shallwer. Interest rate shift has mre impact than nrmal. Cnsumptin is replaced with higher savings rates, due t emplyment uncertainties. Value f the dllar cmes under lngterm pressure and wrldwide inflatin starts t accelerate. This prcess ends with debtr natins paying back creditr natins with depreciated currencies. The pain f this prcess is real, but it passes withut the wrld s ecnmies cllapsing. The Bad (lwer prbability): The wrld s financial system cmes t the impressin that the U.S. will nt, r wn t get its fiscal act tgether, as we cntinue t brrw and spend well abve ur means. The U.S. is cnsistently frced t raise interest rates t cntinue 3 / 5

4 Ecnmic and Market Outlk t attract needed capital. The currency (and freign investrs) pays the price, as the dllar cllapses against ther currencies. Freign investrs stp lending mney and the financial system, as we knw it, is in serius jepardy. This scenari, while pssible, is nt prbable. The Gd (lwer prbability): The grwth rate f debt is what matters ging frward. If ur ecnmy grws faster than debt creatin, eventually we wrk ur way ut f the prblem, similar t what happened in the U.K. fllwing the Naplenic wars and the U.S. fllwing Wrld War II. On balance, the prbability f this ccurring within the U.S. is fairly lw. Final Wrd Please lk frward t ur next installment f The Return t the Lng, Hard Slg, as ur expected implicatins n the financial markets and expected returns will be included, plus cmments regarding the ecnmic rle f gvernment activity. At the end f the day, it appears that grwth in the U.S., n average, will prbably be lwer fr sme time ging frward than has been the case in the past. Hw much lwer, and fr hw lng? It is very difficult t answer these questins, but we believe the average annual grwth rate in the U.S. may be systemically 1.0 percent lwer than has been the case since the end f Wrld War II. A gd grwth year may be when GDP grws in excess f 2.5 percent, instead f the histrical nrm f 3.3 percent. S, returning back t the Lng, Hard Slg questin, Where are we in relatin t the recessin, and recvery? Our ecnmy has a lng way t g. The rebund is unlike any seen in ur lifetimes. Ptentially, the ecnmic implicatins as t slw grwth are mnumental. It is hard t verstate this issue. William B Greiner, CFA President and Chief Investment Officer Scut Investment Advisrs DISCLOSURE AND IMPORTANT CONSIDERATIONS UMB Asset Management is a divisin within UMB Bank, n.a. that manages active prtflis fr emplyee benefit plans, endwments and fundatins, fiduciary accunts and individuals. UMB Bank, n.a., is an affiliate within the UMB Financial Crpratin. This reprt is prvided fr infrmatinal purpses nly and cntains n investment advice r recmmendatins t buy r sell any specific securities. Statements in this reprt are based n the pinins f UMB Asset Management and the infrmatin available at the time this reprt was published. All pinins represent ur judgments as f the date f this reprt and are subject t change at any time withut ntice. Yu shuld nt use this reprt as a substitute fr yur wn judgment, and yu shuld 4 / 5

5 Ecnmic and Market Outlk cnsult prfessinal advisrs befre making any tax, legal, financial planning r investment decisins. This reprt cntains n investment recmmendatins and yu shuld nt interpret the statements in this reprt as investment, tax, legal, r financial planning advice. UMB Asset Management btained infrmatin used in this reprt frm third-party surces it believes t be reliable, but this infrmatin is nt necessarily cmprehensive and UMB Asset Management des nt guarantee that it is accurate. All investments invlve risk, including the pssible lss f principal. Past perfrmance is n guarantee f future results. Neither UMB Asset Management nr its affiliates, directrs, fficers, emplyees r agents accepts any liability fr any lss r damage arising ut f yur use f all r any part f this reprt. UMB Reg. U.S. Pat. & Tm. Off. Cpyright UMB Financial Crpratin. All Rights Reserved. NOT FDIC INSURED/ NO BANK GUARANTEE/ MAY LOSE VALUE 5 / 5