Sit Investment 33rdAnnual Client Conference (Laguna Niguel, California; February 15, 2015) Sidney L. Jones

ECONOMIC PROSPECTS and POLICIES

The U.S. economy finally gained real traction with robust GDP growth, moderate inflation, and impressive employment gains – the “sweet spot” in the business cycle – during the last nine months of 2014. More of the same is projected for 2015 despite intense uncertainty created by familiar geopolitical and geoeconomic risks. Accelerating growth and net new job creation are based on the solid revival of a “consumer economy” with surging sales of new cars and trucks, consumer electronics, household appliances and furnishings, eating out, entertainment, recreation, travel, health care, and government transfer payments and services supported by improving real disposable personal income, modest personal saving, and private and public debt with unusually low interest rates. A repetitive “virtuous circle” of more consumption/investment/ jobs -- which enhances the ability and willingness of households, businesses, and governments to spend – has created optimism about near-term prospects despite frustrating real and statistical surprises. Dysfunctional fiscal policies have evolved into acceptable “pragmatic normalcy” allowing governments to simply postpone difficult taxation and spending decisions despite potential risks of the growing $18 trillion gross national debt, which will have to be financed with much higher interest rates. Monetary policy officials have completed their unconventional quantitative easing program used to create new money to reflate the economy – specifically financial asset and real estate prices – and will rely instead on forward guidance to signal accommodative policies. The traditional “go-and-stop” domestic economy will sustain its “go” phase throughout 2015.

The “slow, long, and erratic” recovery from the severe Great Recession, which officially ended in June 2009, generated a moderate real GDP annual growth rate of only 2.4% during the last 66 months despite very aggressive monetary and fiscal stimulus. But the U.S. economy shifted gears last year, while inflation remained below the 2% target, and the unemployment rate continued to decline from a cyclical peak of 10.1% in October 2009 to near the full employment level of 5.6% by December 2014. My baseline forecast projects real GDP growth of 3% during 2015 (measured 4th to 4th quarters) – well above the current 2 1/4 % trend target -- a 70% probability. Faster growth is a 20% probability if low energy, food, and commodity prices ignite even more household and business spending. Slower growth is a 10% probability if external shocks disrupt economic activity. Headline CPI inflation is extremely uncertain – 1 1/4 % estimate – depending on future energy, food, and commodity prices and core CPI inflation (energy and food prices deleted) should edge up to 2% as shelter costs rise and labor cost pressures develop. The unemployment rate probably will decline slowly to an average of 5 ? % for the entire year (likely lower by yearend) depending on the worker participation rate. Strong domestic demand for imports will maintain the current account deficit of 2 ? %. Pragmatic fiscal policies will create a FY 2015 federal budget deficit in the $500 billion zone after additional contingent military operations and disaster relief payments are added to the original estimate. The Federal Reserve will use forward guidance to signal a moderate and gradual increase in its fed funds interest rate target after mid-2015. Household spending will continue to be the driving force; business investment will gain traction; residential construction will remain above the 1-million start level to match pent-up demand; and net exports will be the only negative sector, as moderate global growth and appreciation of the value of the U.S. dollar restrain exports while domestic demand increases imports. Major risks are: the slowdown of global growth; recurring private and public debt crises; volatile financial markets; energy, food, and commodity price and supply shocks as the “super cycle” ends; chronic current account imbalances; disinflation/deflation pressures; monetary and fiscal policy errors; and political, social, and economic stress caused by pervasive hot and cold wars, insidious terrorism, civil unrest, and unstable, incompetent, and corrupt governments. My baseline forecast will be vulnerable to all of these disruptive exogenous factors.

Despite this positive forecast for 2015 there are medium-term risks. The Great Expansion, with robust growth and moderate inflation and unemployment, which prevailed from December 1982 until December 2007, has ended. This new era will have lower average and more volatile GDP growth, higher inflation and unemployment rates, lower current account deficits, budget stress at every level of government, and an accommodative monetary policy tilt. The dominating “demographic twist” will require payment of retirement income and health care benefits to the unique “baby boom” generation for a very long time period. Geopolitical disputes will continue. Geoeconomic competition for trade and investment markets and transition of economic power from the West to the East will intensify. Technology is portable enabling competing nations to become more productive and competitive. Concerns about access to production resources and the physical environment will escalate. Disparate income and wealth results will disrupt social and political stability. The future integrated and realigned global economy will require policies that encourage investments in human capital, technology, real resources, and the infrastructure.

CRITIQUE OF THE 2014 FORECAST

My baseline forecast was that the disappointing “slow, long, and erratic” recovery of the U.S. economy finally would accelerate to a robust 3% growth rate, with moderate inflation and gradually declining unemployment and underemployment rates, stabilization of dysfunctional fiscal policies and easing of federal budget restraint, and sustained monetary accommodation using forward guidance about the future policy interest rate as the quantitative easing program gradually phased out – creating a “sweet spot” in the business cycle when output and job growth improve before new inflation pressures develop and the next familiar boom/bust sequence begins. After six years of severe recession and a tepid recovery, the U.S. economy entered 2014 with positive momentum, prospects, and policies despite serious geopolitical and geoeconomic risks.

My baseline forecast projects real GDP growth of 3% during 2014 (measured 4th to 4th quarters) slightly above the medium-term target of 2 ?% -- a 65% probability. Faster growth is a 25% probability if business investment and inventory spending exceed current expectations. Slower growth is a 10% probability if consumers become more cautious or external shocks disrupt economic activity. Moderate energy, food, and commodity prices should keep the headline and core inflation figures close to 2% targets. The unemployment rate probably will continue to decline slowly and average 6 ? % for the entire year depending upon changes in the participation rate. Strong domestic demand for imports will likely delay further improvement in the persistent current account deficit. Continued revenue gains and mandated spending restraint should reduce the FY

2014 federal budget deficit to about $600 billion. The Fed will complete the gradual phasing out of quantitative easing purchases of bonds and use forward guidance to continue its pledge to continue the existing “zero boundary” policy interest rate target until at least mid-2015. (Economic Prospects and Policies, February 16, 2014, pp.1-2)

My baseline forecast of robust 3% growth was quickly distorted by a sharp negative swing in inventory spending, net exports balance, personal consumption, residential construction, business investment, and pessimism about global economic prospects. However, when the harsh weather conditions improved, and the pace of payroll jobs creation finally accelerated after five years of modest gains, consumer spending for durable goods and services revived (particularly surging new car and truck sales) and business spending responded. Government spending, both federal and state and local, swung from a negative to positive force and residential construction outlays stabilized. The slowdown of economic activity in Europe, Japan, and Emerging Market economies, and the rapid appreciation of the dollar’s forex value, did not erode exports as much as expected.

Advance GDP estimates now indicate that during 2014 the real output of goods and services

increased 2.5% (4th to 4th quarters). CPI measures of inflation were below 2% (December to December). The average unemployment rate steadily declined to 6.2%, as job creation accelerated and the participation rate (civilian labor force as a percent of the civilian noninstitutional population) fell to the lowest level since 1977. The Fed validated its accommodative policy interest rate target and quantitative easing gradually was phased out. Federal budget “fiscal drag” declined as current spending and tax policies stabilized. After a surprising negative first quarter, partially due to severe weather, private consumption and investment regained momentum and government spending at all levels contributed to GDP growth as improving tax revenues steadily reduced cyclical budget stress.

Comparison of Baseline 2014 Forecast Summary and Advance GDP Estimates

(Percent Change; Fourth to Fourth Quarters; Real Chained [2009] Dollar Basis)

Sector 2014 Forecast 2014 Results*

Gross Domestic Product 3 2.5

Personal Consumption Expenditures 2 1/2 2.8

Business Fixed Investment 7 1/2 5.5

Residential Construction Investment 12 1/2 2.6

Federal Government Outlays - 1 0.2

State & Local Government Outlays 2 1.1

Inventories (contribution to GDP; pp) - 0.1 0.26

Net Exports (contribution to GDP; pp) 0.0 - 0.56

Unemployment Rate (average) 6 1/2 6.2

Headline CPI (December/December) 2 0.8

Core CPI (December/December) 2 1.6

FY 2012 Federal Budget Deficit $600 billion $483 billion

Federal Funds Rate Target Zero Boundary & QE3 Zero Boundary & QE3

? First estimate of GDP figures released January 30, 2015; figures will be revised in February, March, and July.

Personal consumption expenditures increased 2.8% and contributed 1.92 percentage point to GDP growth. Consumer durable goods spending increased 8.4% as sales of new cars and light trucks surged to 16.5 million vehicles (easy credit and falling gasoline prices) compared with only 10.4 million units in 2009. Nondurable goods consumption rose 2.3% and services 2.1% as consumer confidence rose to the highest level since 2007 after employment and income prospects improved. The ability to spend increased as disposable personal income rose 4.2% and inflation remained moderate because of declining energy, food, and commodity prices. Employee compensation, proprietors’ income, rental income, personal financial asset income, and personal government transfer payments all reported gains. Positive “wealth effects” created by rising stock market and real estate values supported more consumer spending. The willingness to spend also increased as income and job prospects improved, the personal saving rate declined from 4.9% in 2013 to 4.8%, and consumer debt rose to a new record of $3.298 trillion by November: nonrevolving credit (automobiles, mobile homes, education, boats, trailers, and vacations) totaled $2.416 trillion and credit card debt was $882 billion. As economic activity rebounded, following the harsh winter weather, consumers reversed six yeas of recession and slow cyclical recovery by replacing their old cars and increasing nondurable goods and services spending. Consumers also appear to have ignored disruptive geopolitical events around the world. Personal consumption is again the driving force in the accelerating pace of domestic economic activity. A significant part of this turnaround is the very rapid drop in gasoline prices (down 37% from $3.64 in June to $2.30 per gallon by the end of December), which has bolstered consumer spending and created new confidence about sustaining growth.

Business capital investment increased 5.5% and contributed 0.68 percentage point to the total GDP. Business equipment spending increased 4.7%, intellectual property products 6.5%, and investment in structures (plants, office buildings, shopping centers, and utilities) 5.6%. Confidence rapidly improved after the cautious first quarter based on solid sales and profits; cash reserves; access to credit at low interest rates; competitive pressures to add new technologies; explosive growth of investment to develop domestic energy resources; and the steady erosion of unused production assets. The capacity utilization rate for production facilities increased to 79.2% by December, compared with a 2009 recession low of 66.9%, and a 1972-2013 average of 80.1%.

Fluctuating quarterly inventory spending contributed a solid 0.26 percentage point to the GDP growth rate. Inventory spending is a small part of the GDP but it often has a very large marginal impact on quarterly growth rates. New durable goods orders, shipments, and other measures of activity reported positive momentum after the first quarter. The Purchasing Managers’ Indexes (PMIs) for manufacturing and services recorded solid improvement reflecting the cyclical gains.

Residential construction investment increased only 2.6% and contributed 0.08 percentage point to GDP growth. New housing starts rose to 1,005,800 units, from a low of 554,000 units in 2009, but were far below the previous cyclical peak of 2,068,300 units in 2005. Single-unit starts rose 4.9% and multi-unit starts were up 17.1%. The continued slow pace of new starts, sales of new and existing houses, and steady deceleration of house price gains were caused by continued employment and income concerns and a previous surge of prices (S&P/Case-Shiller Home Price Index, 20-city composite, rose 13.4% in 2013) , which discouraged buyers burdened by uncertain job prospects and heavy personal debt (particularly student loans). Severe weather also limited activity during the first quarter. Positive factors finally pushed new starts above the benchmark one-million annual rate during the last six months: employment and income prospects improved; the “affordability index” (ratio of median house prices to median family income) was still relatively favorable (4.3% rise in the S&P/Case-Shiller index from November/November); historically low mortgage interest rates; sustained builder optimism; the inventory of new and existing houses for sale remained historically low; progress was made in reducing mortgage foreclosures and distressed sales (houses with “negative equity” values declined from 25% of outstanding mortgages at the end of 2011 to 18.8%); many governments and private financial institutions provided buyer assistance programs; and the Fed maintained its accommodative “zero boundary” policy interest rate target to stimulate residential construction, sales of new and existing houses, and related household durable goods spending.

Net exports of goods and services subtracted 0.56 percentage point from GDP growth. Real exports increased 2.0% to $2.118 trillion and imports rose 5.3% to $2.590 trillion (4th/4th quarters). Exports reported solid growth despite the global economic slowdown – particularly among U.S. trading partners – based on enhanced competitiveness from low energy costs and stable unit labor costs. However, stronger U.S. economic growth increased imports and rapid forex appreciation of the U.S. dollar to its highest level in nine years restrained exports. Development of domestic oil and gas resources and falling world energy prices increased U.S. petroleum product exports and reduced its petroleum imports. The basic current account deficit declined to 2.3% of GDP slightly below the 2 1/2 % estimate in my 2014 baseline forecast and down from 6.2% in 2005.