ECONOMIC OUTLOOK Insurer Investment Forum XII Strategic Asset Alliance March 29, 2012

1. ECONOMIC OUTLOOKInsurer Investment Forum XIIStrategic Asset AllianceMarch 29, 2012 Bill Longbrake University of Maryland

2. 2012 Outlook • Optimistic View – Federal Reserve • GDP grows 2.2% to 2.7% • Unemployment falls to 8.2% to 8.5% • Core inflation (PCE) stable: 1.4% to 1.8% • Pessimistic View – B of A, Goldman, Bill • GDP grows about 2.1% to 2.3% • Unemployment remains near 8.3% (8.2% to 8.4%) • Core inflation falls to 1.3% to 1.7% • Consumer spending growth edges up slightly • Business investment growth slows

3. 2012 OUTLOOK – Topics • Households – (71% of GDP) • Employment • Income • Spending • Investment – (13% of GDP) • Residential Housing (2.4% of GDP) • Nonresidential Structures (2.5% of GDP) • Equipment and Software (8.6% of GDP) • Fiscal Policy – Massive Shock Coming in 2013 • Monetary Policy • Policy Stance • Inflation • Interest Rates

4. 2012 OUTLOOK – Significant Risks • China • Growth Strategy • Long-Term Risks • Near-Term Risks • Europe • Banks – Liquidity & Solvency • Recession • Germany’s Policy Agenda • Future of Euro Zone & European Union • U.S. Fiscal Policy • 2012 Policy Uncertainty • 2013 – potential for 4.5% negative GDP shock

5. U.S. GDP – 2011 Q4 and 2012 • 2012 Q1 • Tracking near 2.0% • Much weaker than market perception of accelerating growth • 2012 • Market optimism rising • Most expect 2012 GDP growth = 2.5% to 3.0% • Strong case for much weaker growth • Bank of America/Merrill Lynch expects growth to slow substantially in second half to < 2%

6. CHART 1 – Real GDP Growth Forecasts(percentage change over previous 12 months)

7. CHART 2 – GDP Output Gap Forecast: 1980-82 and 2007-09 Recessions Q4/82 Q3/09 Q4/11 Q1/85 Q4/15 Q1/81 Q4/07 Q1/89

8. Households • Employment (Weaker Growth Ahead) • Slower growth in payrolls coming after strong start to the year • Little or no improvement in unemployment rate during remainder of the year • Income (Weak Growth Continues) • Depends on employment growth • Growth in hourly wages stuck at 2% nominal; 0% real • Government transfer payments shrinking • Spending (Acceleration Not Likely) • In long run depends on income growth • In short run can grow faster than income, if savings reduced, but this is not sustainable for long

9. CHART 3 – Employment Growth (annual rate of change)

10. CHART 4 – Monthly Employment Growth Following 1981-82 and 2008-09 Recessions (Index = 100: January 2008 and July 1981) 12/85 7/85 7/81 1/08 7/82 1/12 6/09

11. CHART 5 – Unemployment Rate

12. CHART 6 – Nominal Disposable Income Growth(12-month rate of change) 1st stimulus

13. CHART 7 – Hourly and Weekly Wages(annual rate of change) Source: Bureau of Labor Statistics

14. CHART 8 – Hourly Wages – Nominal and Real(real wages = nominal wages deflated by the PCE price index)

15. CHART 9 – Nominal Disposable Income and Consumption Growth(12-month rate of change)

16. CHART 10 – Real Consumer Spending Growth (percentage change over previous 12 months)

17. CHART 11 – Consumer Saving Rate (quarterly average)

18. Investment – Residential Housing • Residential (Bottoming) • 1 to 2 years of excess supply • excess vacancies declining • New construction has bottomed • limited improvement in 2012 • Foreclosures will peak in 2012 and 2013 • Housing fairly valued • prices likely to fall a little more because of foreclosures • Price declines negatively affect consumer spending • Multi-family – Improving trend for apartment construction

19. CHART 12 – Number of Housing Units Above 1994-2000 Average

20. CHART 13 – Cumulative Real Housing Price Appreciation Relative to Long-Term Trend (1975-2014) Nominal prices fall 4%; inflation-adjusted prices fall 7% Nominal Housing Prices: FHFA 1975-2011 Inflation: PCE Total Index

21. 2012 OUTLOOK – Business Investment • Nonresidential Structures • 2.7% of GDP • 5.9% of GDP growth over last four quarters • Equipment & Software • 7.4% of GDP • 44.3% of GDP growth over last four quarters • Slowdown in Growth Likely in 2012 • Goldman Sachs expects growth to slow to single digits in 2012 • ISI survey indicates approximately 5% growth rate in 2012

22. 2012 OUTLOOK – Fiscal Policy • Federal and State/Local – will reduce real GDP growth by about 1% in 2012 • No Further Action on Fiscal Policy in 2012 Likely • Uncertainty will build toward end of 2012 • 4.5% Negative GDP Shock Hits January 1, 2013

23. 2012 OUTLOOK – Monetary Policy • Policy Stance – economy looks increasingly strong; but is momentum sustainable? • Policy on hold – completing Operation Twist • Communications – published forecast of fed funds rate • QE3 – second half of 2012, if economy (and inflation) slows – decision likely at June meeting • Inflation • Slowing core inflation • Trend in total inflation depends on oil prices • Limited threat of deflation • Interest Rates • No increase in short-term rates until late 2014 • Long-term rates have bottomed but will remain low during 2012

24. CHART 14 – Core PCE Inflation Forecasts(percentage change over previous 12 months)

25. CHART 15 – Federal Funds Rate Forecast

26. CHART 16 – 10-Year Treasury Rate Forecasts

27. 2012 OUTLOOK – Significant Risks – China • China’s Growth Strategy • Currency management • Exports and infrastructure investment • Aggressive credit expansion • Long-Term Risks • Unbalanced GDP – outsized dependence on trade and investment • Short-Term Risks • Property bubble bursting • Skilled labor shortage • Rapidly rising wages • Inflation • Slowing growth • European recession and slowing global growth

28. 2012 OUTLOOK – Significant Risks – Europe • Fiscal Compact • Fiscal Discipline • -0.5% annual budget deficit • -3.0% annual budget deficit • 60% Debt/GDP • Stabilization Mechanisms • EFSF – leverage • ESM - €500 billion • IMF - €150 billion ??? • Flaws • Austerity – exacerbates developing recession • Country differences in competitiveness • Banks • Capital and loan loss requirements • Credit crunch – moderated by LTRO

29. 2012 OUTLOOK – Significant Risks – Europe • Recession • ECB 2012 GDP: -0.5% to 0.3%; median -0.1% • Bank of America/Merrill Lynch GDP: -0.6% • Risks to downside • Austerity will deepen recession • Germany’s Economic Strategy Is a Problem • Intentional trade surplus creates disabling imbalances • Competitive imbalances cannot easily be resolved • Euro Zone Cannot Survive in Current Form • Nationalism vs. European integration • Economic distress will undermine European political elite

30. 2012 OUTLOOK – Significant Risks – U.S. Fiscal Policy • U.S. Budget Deficit • $1.3 trillion deficit in fiscal 2011 • $1.2 trillion deficit likely in fiscal 2012 • Public Debt/GDP = 68.2% at end of 2011 • Reinhart-Rogoff: Danger point reached between 70%-90% • Deficit Math • Debt/GDP ratio stable if deficit % = nominal GDP growth % • Fiscal 2011 GDP growth = 3.9%; deficit = 8.7%; Debt/GDP ratio increased 4.7% • To stabilize Debt/GDP ratio, assuming 4.5% nominal growth, requires deficit to be reduced $600 billion • $500 billion in taxes and/or spending • $100 billion in interest

31. 2013 Fiscal Policy Shock • Enormous Fiscal Shock ($535 billion) Hits January 1, 2013 • Expiration of Bush tax cuts = $255 billion • Budget Control Act automatic spending cuts = $109 billion • Obama Health Car Act = $21 billion in Medicare taxes • Payroll tax reduction = $112 billion • Alternative minimum taxes = $38 billion

32. CHART 17 – Total Federal Public Debt to GDP(percentage of nominal GDP) 2011 66.7%