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Excess Supply/ Past Credit Sweet SpotApril 2016

! Steven Ricchiuto, U.S. Economist, 212-209-9432

2

Conclusions

• 

! Domestic Economy

!  Disappointing first half with real growth

!  No acceleration into the second half

!  Growth expected to stay comfortably in 1.75% to 2.25%% range through December

!  2016’s growth critically dependent on how quickly the Fed raises short-term rates and begins normalizing its portfolio.

!  Currency market dynamics also key to 2016 outlook as it becomes clear Japan and Europe stuck in deflation

!  Importance of the Balance Sheet

!  Economies are able to withstand unforeseen developments or external shocks when all of their balance sheets are healthy

!  Recent financial crisis shows what happens when balance sheets become compromised

!  After several years of restructuring, both the household and banking industry balance sheet restructuring are complete

! Excess Supply a Problem for the Fed

!  Lack of pricing power very evident in second quarter earnings reports as companies face an excess supply of both tradable

goods and commodities

!  Dollar exchange rate is sensitive to an even marginal expected change in monetary policy

!  Productivity decline over stated in terms of effect on potential growth

!  Global economy also mired in below-trend growth trajectory, as China downshifts, and Japan and Europe face deflation

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Model Based Real GDP Forecast

Mizuho U.S. Macro Forecast

Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 2015 2016 2017

Real GDP (Q/Q%): 2.00% 1.4 1.75 2 2.1 2.25 2.4 1.8 2.1

PCE Deflator (Y-O-Y%): 1.3 1.3 1.5 1.4 1.3 1.3 1.5 1.4 1.6

Fed Funds Rate (Q4,%) 0-0.25% 0.25-0.5% 0.25-0.5% 0.5-0.75% 0.5-0.75% 0.5-0.75% 0.25-0.5% 0.5-0.75% 0.75-1.0%

10-year Treasury Note (%): 2.22% 2.19% 1.91% 2.15% 2.00% 2.05% 2.14% 2.06% 2.25

Inflation no longer determines the business cycle

4

5

Credit flows determine business cycle

6

Credit cycles evolve differently than inflation cycles

7

Monetary Policy

8

Dual mandate trade-off ?

9

Financial system health is no longer a key policy concern

10

Monetary policy remains accommodative

11

End of QE already evident in reserve market

12

Demand and liquidity risk showing up in spreads

Commercial Paper Spread

13

Credit Considerations

14

Banks seem to be sensing increased risk in lending (C&I loans)

15

Banks a lot less aggressive in lending (Consumer)

16

A lack of demand shows banks have been more conservative than suggested

Banking System Balance Sheet

18

Banking system nearing completion of its restructuring

Corporate Balance Sheet

20

Corporate sector leveraging its balance sheet

21

Credit markets no longer constraining the economy

Non-financial corporate leverage has increased to drive up stocks

22

Duration extension has run its course

23

24

Corporate debt burden is healthy

Household Balance Sheet

26

Household savings should continue to rise

27

Household deleveraging still underway

NET HOUSEHOLD LIABILITIES = TOTAL HOUSEHOLD LIABILITIES MINUS CASH, CHECKING ACCOUNTS, TIME DEPOSITS, AND MONEY FUND BALANCES

28

Consumer balance duration extension has run its course

29

Household debt burden is a positive

30

Asset side of household balance sheet recovery has lost momentum

Corporate share of national income: Inflection or turning point ?

31

Valuation Considerations

33

Low long-term rates has boosted P/E but is the bloom off the rose

34

Some models suggest stocks are no longer cheap

* = Non-Financial corporate profits are profits from domestic operations only and include privately held companies, LLCs and sub chapter “s” corporates while S&P EBITDA includes financial companies as well as profits of overseas subsidiaries not just those repatriated.

35

Earnings are not driving valuations

36

Deflation risk is rising

37

TIPS inflation breakeven back to Fed PCE target

38

Liquidity premium remains evident in the market

Consumers shift purchases to avoid price increases

39

Auto Appendix

41

Auto sales dominating retail activity

42

Auto assemblies out of step with the rest of manufacturing

43

Auto dealer inventory inflated

Housing market appendix

45

Housing market correction has run out of steam

Vacant single-family homes weighing less on the market

46

Rents seems to be keeping pace with home prices

47

Banks are less accommodative

48

Recovery in new starts is shallow

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