The Central Banks Take Action - Economic and Financial Market Review & Outlook September 20, 2012

The Central Banks Take Action - Economic and Financial Market Review & Outlook September 20, 2012
Rabobank, N.A.
                     Trust & Investment Management Division

                     Economic and Financial Market Review & Outlook
                     September 20, 2012

                                       The Central Banks Take Action

In our August 6th economic and financial market review & outlook we devoted most of our comments to the
European sovereign debt crisis. At that time we lamented that European central bankers and government leaders
seemed to have the ability to “say the right things” to temporarily calm investors and spark brief market rallies,
but not the ability to take substantive action that would have long-lasting beneficial effects. We stated that we
would like to see two market-related outcomes that would demonstrate that investors believed Europe was on
the right track—Spanish 10-year government bond yields below 6% (at the time, these yields were about 7%)
and the Euro vs. U.S. dollar exchange rate above $1.27 (at the time, this exchange rate was about $1.23).
As of September 20th, Spanish 10-year government bond yields had fallen to 5.77% (Exhibit #1) and the Euro vs.
U.S. dollar exchange rate had risen to $1.2973 (Exhibit #2, next page), meaning that both rates had met our
targets with room to spare.
This dramatic turn of events was driven by a key announcement by the European Central Bank (ECB) on
September 6th. The ECB announced approval for undertaking so-called Outright Monetary Transactions (OMTs)
in secondary markets for sovereign bonds in the euro area. This tool would enable the ECB to address severe
distortions in government bond markets through bond purchases in the secondary markets. The ECB’s ability
and willingness to step in to buy government bonds in order to provide stability immediately gave investors
confidence to invest in government bonds, thus pushing prices higher and yields lower. The ECB also forcefully
reiterated its commitment to the irreversibility of the euro. This commitment contributed to the rally in the euro.

                                                Exhibit #1
                                   Spanish Government 10-Year Note Yield

              Source: Bloomberg

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The Central Banks Take Action - Economic and Financial Market Review & Outlook September 20, 2012
Exhibit #2
                               Euro/U.S. Dollar Exchange Rate (EUR/USD)

           Source: Bloomberg

You may recall from our August 6th report that we not only wrote that we wanted to see Spanish government
bond yields below 6% and EUR/USD above $1.27, but we also wanted to see them stay there for at least a
month. It has not been a full month yet. However, we feel the ECB’s recent announcement is substantive enough
that we would be surprised to see a relapse into the volatile ways of the recent past. That having been said,
Europe does have plenty of economic challenges ahead. Central bankers and government leaders will have their
hands full for the foreseeable future.
So, Europe is no longer #1 on the list of what we formally call “risk case scenarios,” and informally call
“reasons for graying hair and worsening ulcers.” However, we shall save discussion of our other risk case
scenarios for October’s report.
In the U.S., economic reports continue to be disappointing. On September 7th, the government released its
August employment situation report. This report indicated the U.S. economy added only 96,000 new jobs in
August, and the unemployment rate edged down to 8.1%. Furthermore, figures for June and July were revised
downward by a combined 41,000 (Exhibit #3, next page).
By our standards, this report earned a flunking grade. In early 2011, we set 175,000 new jobs as the basis by
which we would judge employment reports as successes or failures. We chose this figure based on prior
experience with other economic recoveries. August was the sixth consecutive month in which the economy
failed to generate 175,000 new jobs.
There are two additional points that we wish to make regarding this employment report. First, this report not
only earned a flunking grade in our books, it apparently earned a flunking grade with the Federal Reserve,
prompting important action by the Fed that we will discuss momentarily. Second, the reduction in the
unemployment rate to 8.1% was covered by the media in a decidedly negative way, and worse, in a misleading
way. Since the media’s selective use of statistics was so blatant this month, this seems like the right time to
discuss this particular pet peeve.
Following the Federal Reserve’s Open Market Committee meeting on September 13th, the Fed commented that
“the Committee is concerned that, without further policy accommodation, economic growth might not be strong
enough to generate sustained improvement in labor market conditions.” As a result, the Fed formally announced
the immediate implementation of a third round of quantitative easing (QE3, for short), in which the Fed would
purchase additional agency mortgage-backed securities at a pace of $40 billion per month. The purposes of this
policy are to “put downward pressure on longer-term interest rates, support mortgage markets, and help to make

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The Central Banks Take Action - Economic and Financial Market Review & Outlook September 20, 2012
broader financial conditions more accommodative.” Although the Fed stated it would be monitoring incoming
economic and financial developments, it specifically stated “if the outlook for the labor market does not improve
substantially” it would continue using these accommodative monetary policies. Clearly, the Fed’s eyes are on
the labor market.
                                              Exhibit #3
                   Change in Total Nonfarm Payrolls (bars) & Unemployment Rate (line)

              Source: U.S. Dept. of Labor, Bureau of Labor Statistics; Federal Reserve Bank of St. Louis

The media had a field day with this employment report, focusing on the fact that the economy added 96,000 new
jobs but that 368,000 people dropped out of the labor force. Put another way, for every one person who found a
job, nearly four people got discouraged and gave up looking. On the surface, this statistic is compelling and it
gained ample airplay.
However, two problems with this viewpoint are it relies on comparing apples with oranges and it only looks at
the most recent data point, not the longer-term trend. The 96,000 new jobs figure comes from the establishment
survey, while the loss of 368,000 people from the civilian labor force comes from the household survey. These
are two separate surveys, that produce completely different results. Making comparisons using output from both
surveys usually will not produce reliable results. If making inappropriate comparisons were the media’s worst
transgression we would not be too concerned. However, the media consistently uses such figures to spin the
news in a negative way. Specifically, the media consistently report changes in the civilian labor force only when
the number drops, never when it rises. We heard a lot about the 368,000 Americans who supposedly became so
discouraged they gave up looking for work in August. We never heard a peep about the hundreds of thousands
of Americans who reentered the workforce in previous months. Based on the way this news is covered by the
media, you might be surprised to know that the civilian labor force has actually increased by 758,000 in the first
eight months of 2012. Okay, let’s get off our soapbox, and move on to the financial markets.
The global stock market rally that began in late May received a boost in September courtesy of the actions by
the European Central Bank and the Federal Reserve. In fact, since July 25th the S&P 500 has increased in value
by about 9% through September 20th. International stock market averages made similar gains over that time
period (Exhibit #4, next page).
Although we are pleased with recent stock market performance, we are becoming more cautious. Recent
earnings shortfalls from FedEx and Norfolk Southern Railroad show the effect that weak economic conditions
are having on company financial statements. We expect more earnings shortfalls as companies begin reporting
results in October.

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Furthermore, we expect the upcoming U.S. elections and so-called fiscal cliff will begin to gain more attention
from investors, most likely leading to increased market volatility. We will discuss this issue in more detail in
                                                  Exhibit #4
                    Global Stock Market Indices – 3-Month Price Changes (6/20/12 – 9/20/12)

              Source: Yahoo! Finance

              [Blue = U.S. Stocks (S&P 500); Red = Int’l developed market stocks (MSCI EAFE); Green = Emerging market stocks]

In terms of investment strategy, we have taken some profits in stocks, taking a few chips off the table in the
process. We remain underweight in international stocks, due to prolonged economic weakness in Europe and
Japan, and in investment-grade bonds, due to low bond yields. Only recently have we lowered our U.S. stock
allocations from an overweight to a slightly underweight position. We remain overweight in high-yield bonds
and real estate-related investments (REITs). That having been said, the rally in these two asset classes is getting
long in the tooth. The mutual funds that we use to invest in these asset classes recently hit four-year highs. If we
were to make adjustments in these asset classes, it would likely be to reduce allocations.

                          Warren E. Bitters, CFA
                          SVP/Senior Portfolio Manager
                          Rabobank, N.A. – Trust & Investment Management Division
                          75 Santa Rosa St.
                          San Luis Obispo, CA 93405
                          (805) 269-7071

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For more information about the Trust & Investment Management Division, please contact:
North Central Coast, Mid-Central Coast, South Central Coast (Santa Barbara area) and Central Valley regions:

                 Cindy Wolcott
                 VP/Trust & Investment Services Officer
                 (805) 547-8500

South Central Coast (Ventura area), Imperial Valley and Coachella Valley regions:

                 Doug Wied
                 SVP/Senior Regional Trust Officer
                 (805) 477-3303

North Central Valley, North State and North Coast Wine Country regions:

                 Curt Jarboe
                 Trust & Investment Services Officer
                 (530) 532-0800 ext. 3223

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