Life in the Slow Lane Economic Update & Outlook

1. Life in the Slow LaneEconomic Update & Outlook Robert Frentzel Executive Vice President| Specialized Industries

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3. Agenda Potholes on the Road to Recovery Financial Market Outlook

4. The Output Gap: Why it doesn’t feel like a recovery… Source: SG Cross Asset Research/Economics

5. Manufacturing is losing steam… • After leading the recovery for the past three years, the U.S. factory sector has contracted for three consecutive months as foreign demand and business investment spending have waned. ISM Manufacturing Index Industrial Production (m/m %)

6. Labor market remains a “grave concern” Participation rate at 30 year lows… Unemployment above 8% for 43 months…

7. Deleveraging process is winding down

8. The housing market is on the mend Prices are beginning to rebound… Median price for new and existing home (NSA) Sales volumes are still light… Existing Home Sales in Millions (SAAR)

9. Record affordability and shrinking inventorysupport housing prices Housing affordability near record highs… NAR Housing Affordability Index Inventory of properties for sale has normalized… Months Supply of Existing Homes on Market

10. Demographic trends support housing market Housing supply vs. Demographics Source: SG Cross Asset Research/Economics

11. Banks are more willing to lend, but borrowers remain cautious

12. The Fed’s Case for Action • The Federal Reserve is currently falling short on both prongs of its dual mandate. Unemployment well above target… Inflation running below 2% objective…

13. The Fed’s Ballooning Balance Sheet Assets Liabilities

14. Sizing up the impact of the Fed’s actions 65 bp 26 bp 38 bp 8 bp 88 bp 67 bp 46% 7% 18% • * Initially, $600 billion but expanded by an additional $1.15 trillion on Mar 18, 2009 • ** Initially, $400 billion but expanded by an additional $267 billion on Jun 20, 2012

15. The High Cost of Low Interest Rates • While the Fed’s zero interest rate policy has been a boon for borrowers and indebted governments, “financial repression” poses a dilemma for investors and has other negative side effects for the economy. • Returns on bank deposits and money market instruments are not keeping pace with inflation. • Faced with negative real returns, savers are forced to cut back spending, eat their “seed corn,” or move out the risk spectrum to longer maturity instruments or riskier asset classes. • Retirements are postponed to allow future retirees to build a bigger nest egg due to lower expected returns. • Financial institutions and money market funds face compression in margins due narrow gap between deposit and lending rates. • Falling interest rates increase the present value of fixed pension contracts, further straining the finances of state and local governments. • Central bank intervention may obfuscate market signals and distort behavior of underlying market, delaying constructive reforms.

16. Potholes on the road to recovery • Political factors pose some of the greatest risks to the global economic outlook for 2013. • U.S. Fiscal Consolidation • Can Congress and White House reach a compromise to avert year-end “fiscal cliff” and avoid a repeat of last year’s debt ceiling debacle? • Europe’s Debt Crisis • Can European leaders agree on a roadmap for tighter political and fiscal union and achieve balance between growth and austerity to keep single currency intact? • China’s slowdown • Can Beijing manage a soft-landing for the world’s second-largest economy? • Will property market avoid a U.S.-style implosion?

17. déjà vu: Is this 2008 all over again? While the symptoms of the current market turbulence are similar to 2008, the root causes are completely different, meaning that the weapons used to combat the last crisis may not be effective in the current environment. • 2008 • A bottom-up crisis which began with overextended homebuyers and rippled through to financial institutions • Consumers and businesses heavily leveraged • Crisis due to lack of liquidity • Epicenter of crisis was U.S. investment banks • Government is the solution • 2012 • A top-down crisis as governments around the world have demonstrated an inability to stimulate their economies and get the fiscal houses in order • Consumers and businesses stockpiling cash and unwilling to spend or borrow, resulting in anemic consumption and investment growth • Crisis due to a chronic lack of confidence • Epicenter of current crisis is European sovereigns • Government is the problem

18. The U.S. runs the largest peace-time deficit in its history… U.S. Annual Deficits Since 1791

19. The budget deficit is both a spending and revenue problem • Over the past thirty years, the federal deficit has averaged 3.2% of GDP, but the budget gap has widened dramatically in the wake of the Great Recession as spending soared and revenues plummeted. U.S. Federal Outlays (yellow) & Revenues (red) as % of GDP

20. Putting the U.S. fiscal situation in perspective • If the federal government were a household, here is a snapshot of what its finances might look like: • 2012 Income (Taxes) $24,700 • 2012 Expenses $35,900 • 2012 Deficit -$11,200 • Credit card debt (debt held by public) $112,540 • Borrowing from family (debt held by govt trust funds) $47,617 • Total debt $160,157 • Off-balance sheet liabilities (Medicare, Soc Sec) $1,206,631 • Planned income increase/spending cuts for 2013 (fiscal cliff) $6,060

21. Staring over the fiscal cliff • The U.S. economy faces over $606 billion of tax increases and spending cuts beginning on January 1, 2013 unless Congress intervenes. These cuts could trim 3% from 2013 GDP, pushing the U.S. economy back into recession. • Potential Scenarios • Punt. (65% chance). Temporary extension of tax cuts and delay spending cuts agreed during lame duck session with permanent deal worked out in first half of 2013. • Retroactive deal (25% chance). No deal during lame-duck session. Fiscal cliff goes into effect on Jan 1st but partial reversal legislated retroactively by incoming Congress. • Over the cliff (5% chance). The entire cliff goes into effect on Jan 1st with no retroactive fixes. • Grand bargain (5% chance). A grand compromise reached that gradually phases in fiscal restraint and stabilizes debt within 10 year timeframe.

22. Bumping up against the debt ceiling again… • Under current projections, we will reach the debt ceiling just after the elections in November.

23. U.S. interest rates are at multi-century lows… Ten Year U.S. Treasury Yields Since 1790

24. Financial Market Outlook For 2013 • With Fed on hold, short-term rates are likely to remain stable in near-term. • Low yields offer very poor risk-return profile for investors but once-in-a-lifetime opportunity for borrowers. • Fed’s open-ended QE3 increases longer-term inflation risks, putting upward pressure on long-term interest rates resulting in a steepening yield curve • Open-ended QE3 undermines U.S. dollar. • Stronger U.S. growth vis-à-vis Europe could exacerbate trade deficit. • USD is undervalued on purchasing power basis against major trading partners • QE3 and weaker USD is generally supportive of raw materials prices. • Upside risk for oil prices due to risk of supply disruptions. • Chinese demand is key for industrial metals. • Investors are underweight equities, and sentiment lowest since 1980s. • Valuations are attractive from historical and relative perspective. • High equity risk premium may signal above-average future returns for stocks • Corporate earnings growth decelerating amid slower GDP growth Interest Rates Foreign Exchange Commodity Prices Equities

25. Shifting into the fast lane • Despite near-term challenges, the foundation is building for a more robust recovery. • Companies have become more productive and competitive. • Borrowing costs are near record lows. • Corporate and individuals’ balance sheets have dramatically improved (lower leverage & greater liquidity). • Rising stock market and stabilizing housing prices boost consumer confidence. • Consumers have pent-up demand after enduring the longest and deepest recession in the post-war period. • Housing affordability remains near record lows. • Excess industrial capacity and labor force slack allows for prolonged period of above-trend growth without triggering inflation.