Markets & the Economy / This Week & Focus

March 14, 2011

THIS WEEK Outside forces may dominate the markets attention, following Europes new measures to deal with its debt crisis, Saudi Arabias uneventful protests, and Japans tragic earthquake. The Federal Open Market Committee meets amid a more cautious outlook for the near-term. The decision is unlikely to bring surprises, because the public remarks of a number of policy makers recently have reiterated a patient message from the central bank. Headline February price reports are expected to repeat a theme seen in the previous reports. If these reports were about inflation and not supply-side developments (relative prices), they would be meaningful for market participants. But with the economy severely underemployed, the true inflation story remains tame. February housing starts are expected to pull back, because the number of new multi-family projects doubled in January and that seemed an aberration.

THE US ECONOMY
Annualized qtrly. % change, unless noted otherwise 2010 Q4 Real GDP 2.8 Final sales, US-made 6.7 Final sales, all items 3.1 Consumers 4.1 Inv. change ($b ar) +$7.1 Real GDI 3.3 Aggregate hours worked 1.9 Nonfarm payrolls 0.8 Ave. mnth. ch. (000) 139 Unemployment (% qtr end) 9.4 Chain PCE prices (% oya) Food (% oya) Energy (% oya) Core (% oya) CPI (% oya) Core (% oya) WTI petroleum ($ / barrel)
___________________________________________________________________________

2011 Q1 3.0 2.2 3.8 2.6 +$33 3.5 1.2 1.2 135 9.1 1.1 4.0 4.4 0.6 1.7 0.8 90

Q2 3.0 3.8 4.0 3.3 +$7 3.5 2.2 1.1 99 9.3 1.3 7.4 4.5 0.5 2.0 0.8 85

1.2 1.2 7.4 0.8 1.4 0.8 89

FOCUS: WHAT YOU DONT SEE MATTERS TOO The turmoil in the oil producing region together with widespread crop damage last year has driven prices of a wide range of commodities sky high. It is widely believed that these disruptions will slow global economic activity. Such conclusions are overly pessimistic, however, because they focus only on one side of their economic impact, the threat to consumers. Often, the second and third round responses, what are not usually visible, are as important as the drag on consumers.

Change from 12 months earlier at quarters-end Note: bold figures are estimates or forecasts Sources: US Deps. of Commerce and Labor; API

THE FED AND THE MARKETS

Percent

Now Mar 15 Apr 27 Federal funds rate target 0-% 0-% 0-% Federal funds futures contracts n.a. 0.14 0.14 3-month Libor 0.31 0.31 0.30 Spread over 3-month OIS 0.17 0.14 0.13 3-month OIS 0.14 0.17 0.17 2-year Treasury yield 0.64 0.60 0.50 10-year Treasury yield 3.40 3.35 3.35
___________________________________________________________________________

Last day of the FOMC policy meeting Sources: Federal Reserve Board, Bloomberg

JPMorgan Chase Bank, New York, NY James E. Glassman, 1-212-270-0778 jglassman@jpmorgan.com

Markets & the Economy / This Week & Focus

March 14, 2011

FOCUS: WHAT YOU DONT SEE MATTERS TOO

Abstract The turmoil in the oil producing region together with widespread crop damage last year has driven prices of a wide range of commodity sky high. It is widely believed that these disruptions will slow global economic activity. Such conclusions are overly pessimistic, however, because they focus only on one side of their economic impact, the threat to consumers. Often, the second and third round responses, what are not usually visible, are as important as the drag on consumers.

There they go again By now, observers should be a little more surefooted about the sustainability of the economic recovery. Financial market signals imply that investors are. After all, the US (indeed the global) economic tide has been rolling in steadily for almost two years, despite a fiscal crisis in Europe that took equity markets down a peg last summer, despite ongoing belt tightening in the state and local government sector that has shed almost 300,000 jobs since the end of 2009, despite a doubling of oil prices in 2009 and 2010, despite negligible job growth and slow return of the consumer, and despite a new home building industry that has no noticeable pulse. So, it is a little surprising that new anxieties about the outlook are creeping back, this time triggered by the jump in oil prices following Libyas unrest. The worries are compounded by confusion about the role of outside forces that are disrupting oil and commodity markets, including an unjustified fear that what is taking place in Libya could inflame unrest in Saudi Arabia, a much more important player in global petroleum markets, and an under-appreciation of the momentum behind the cyclical recovery, and the power of the Federal Reserves stimulative policy stance.
2

Markets & the Economy / This Week & Focus

March 14, 2011

Conventional views echo partial equilibrium thinking Pundits are preoccupied with oil prices and the impact they have on our economy. Its fairly obvious why: gas prices are in our face every day. Few of us know the price of a dozen eggs but most of us can recall to the penny the price of regular-grade gasoline (thats the number featured prominently at the top of every sign posted at the service station) at two or three different locations. And its not hard to figure out that a rise in the pump price means that consumers have to cut back somewhere, whether its driving habits or spending for non-transportation items, to stay within budget. However, like many economic issues, and the argument about the massive federal government deficit and dangers of rising debt burdens that dominates the soap box arena comes to mind, what is true for the individual almost never carries over to the economy as a whole. Economics students learn this lesson early on, when they first hear about the Fallacy of Composition. An event that affects individuals can affect the broad economy very differently and what you see is rarely what you get, when it comes to the macro economy. This should be obvious when it comes to the deficit and debt debate. Although the budget deficit is massive, interest rates are at rock-bottom levels, indicating that whatever is causing deficits to balloon also affects other things that depress the private demand for credit. Bond market participants know, if many pundits dont, that deficits soar when economies fall into recession and deficits fall when economies recover. This describes everyone, including Europe, Japan, the US, and state and local entities. Yes, it is true that the Federal Reserves $1.5 trillion net increase in securities holdings, above and beyond what is needed to support the statutory reserve requirements backing transactions deposits, is holding long-term interest rates down, everything else the same. But in a sense, the Feds securities purchases merely replace the credit that would have been provided by now-defunct investment houses. So, as financial conditions eventually normalize, new investors likely will step in even as the Federal Reserve backs away from its asset purchase program and winds down its unusually large securities holdings.
3

Markets & the Economy / This Week & Focus

March 14, 2011

The role of oil prices in the economy is similarly overstated, because the negative impact of higher energy prices on consumers is only half the story. The net economic impact of rising oil prices depends on what happens on the other side of the gasoline pump, how consumers alter their driving habits, and how new oil revenues are recycled, at first into financial markets and eventually into global spending. Farm developments, a recent repercussion of last years widespread crop damage, hurt the consumer, for obvious reasons, but because the US is a net exporter of agricultural commodities, rising farm prices are a net benefit for the US economy. Mortgage refinancing is yet another example of an event that gets confused by a focus only on one side of the equation. Borrowers benefit, of course, when a decline in interest rates allows them to refinance into lower mortgage rates. Nonetheless, savers whose investment income then falls with the drop in interest rates are on the other end of that transaction. The net benefit of mortgage refinancing activity depends on the balance between increased spending by borrowers who benefit versus the reduced spending by creditors who are hurt. Oil attracts so much attention, because its so visible Back to oil Petroleum prices have spiked about $20 per barrel since the threat of civil war in Libya. It remains to be seen whether the recent run-up in oil prices holds or falls back. For one thing, the rise in prices is a reflection of fear and not a deliberate attempt by producers to push the price of oil up. In fact, OPEC members with spare capacity apparently already have boosted production. For another, a change in prices elicits responses and oil producers are well aware of that. For example, if oil prices are sustained at current levels, that would do more to revive the publics interest in alternative energy sources, a fad that rises and falls in the publics consciousness as gasoline prices rise and fall. And with global gas shale discoveries opening up a vast new source of energy, credible petroleum alternatives are gaining ground. The idea that a rise in oil prices might be a tax on oil
4

Markets & the Economy / This Week & Focus

March 14, 2011

consumers might seem like common sense. If we have to pay more at the pump, those who have to stay within their budgets (call them human beings) have two choices. Either we must cut our use of gasoline to offset the rise in the pump price, and there are many ways to do that despite the common assumption that energy demand is inelastic, for example, locked in by the choices we have made about where we live. Or, if we dont change our driving habits and have to pay more for gasoline, then we will have to cut back our spending for something else. If the prices of something else dont fall, then real consumer spending and, therefore, real GDP will decline. If retailers who sell something else

The recent runup in oil prices, if sustained

Prices of selected crude grades of oil (dollars per barrel)

150

150

125

125

100

100

75

75

50

OPEC reference price West Texas Intermediate

50

25 2007

Updated through March 9, 2011

25 2009 2010 2011

2008

Sources US Department of Labor; Bloomberg

Markets & the Economy / This Week & Focus

March 14, 2011

cut their prices to keep their customers, then the burden of higher energy prices will fall on them and curb their revenues, profits, and business activity. Either way, the adjustments to higher energy prices will be reflected in lower consumer spending, lower final business spending, or both. Conventional wisdom about the oil tax, coded in most econometric models, assumes that a $20 rise in the price of a barrel of petroleum reduces the level of real GDP by about percentage point within a year, and so slows growth in the first year by that amount. The impact, taken at face value, is common sense. The US imports $250 billion of oil annually, according to the US Commerce Department, at prices that are around $85 per barrel, where they were until the turmoil in Libya erupted. So, if US consumers dont adjust their driving habits and energy use, a $20 per barrel rise in oil prices will raise the US oil bill by $59 billion annually at current prices. That represents about 0.40 percentage point of nominal GDP. So, for a given level of nominal GDP, the increase in the nations petroleum bill would lower real GDP by that amount. Higher energy prices may discourage energy intensive capital spending as well and that is how the 0.40 percentage point drag can expand to 0.50 percentage point. This analysis may provide a useful first impression, and it describes the conclusion of most market analysis, but it is overly simplistic and may overstate the drag from higher oil prices for several reasons. For one thing, the visible impact of oil on the economy is shaped by the backdrop, partly psychological, that often is difficult to sort out from the oil impact. The drag from higher oil prices was more visible back in 2007 and 2008, when the economy faced stiff headwinds. Now, with the wind, including the Feds stimulative policy, at our backsand, oh by the way, the recently-passed payroll tax providing a cushion equal in magnitude to the rise in households energy billsthe impact of a rise in oil prices is likely to be less disruptive.

(1) Consumer choices have a say in the matter More important, how a rise in oil actually affects the economy
6

Markets & the Economy / This Week & Focus

March 14, 2011

will boost the US oil bill and why higher oil prices look like a tax on US consumption
US net petroleum imports (billions of dollars annually)

400 350 300 250 200 150 100 50 0

Updated through February 2011

400 350 300 250 200 150 100 50 0

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Source: US Department of Energy

depends on the response of the consumer and the the business community. Three scenarios highlight the possibilities. Consider one scenario in which consumers respond by cutting back on their use of energy in response to a rise in energy prices. For example, the rise in gasoline prices resulting from a $20 increase in oil prices following the outbreak of violence in Libya would be completely offset if a typical driver curbed the amount the drive by a modest amount, shifted to a lower grade of gasoline, or drove a little slower. In that case, energy consumption would decline, but so would petroleum imports, implying little net impact on the
7

Markets & the Economy / This Week & Focus

March 14, 2011

level of US GDP. Only modest changes in driving habits would be needed. For example, the typical person drives about 12,000 miles annually. If their vehicles get 20 miles per gallon, and it is higher for many, they will use about 600 gallons of gasoline annually. At $3.00 per gallon for regular grade, prior to the Libyan events (State of New Jersey), their annual gasoline bill would be $1,800. At $3.50 per gallon, what would be expected if the full $20 spike in the price of a barrel of oil passed through to the pump price, and it has not done that yet, that typical drivers annual gasoline bill would be $2,100. At the higher $3.50 per gallon price, the typical driver could hold his annual fuel cost in check, where it was, by consuming 515 gallons of fuel rather than 600 gallons. That would require driving 1,700 fewer miles every year or 5 miles less each day, by planning ahead and economizing on trips that are needed to run errands, a trivial sacrifice, or by carpooling. Alternatively, where it is technically possible, drivers might be able to economize on their fuel bills by shifting to a lower grade of gasoline, which reduces the per gallon cost of gasoline by 10-20 cents, half the expected increase related to the $20 rise in oil prices. Thirdly, modest reductions in the average speed usually result in substantial fuel savings. For example, fuel consumption drops noticeably, at lower speeds. A modest drop in average speed traveled, say from 74 miles per hour to 69 miles per hour would be expected to boost the fuel efficiency of a vehicle yielding 20 miles per gallon to 23 miles per gallon. Spread out over the 12,000 miles traveled each year, such a modest adjustment in travel speed would virtually offset the cost of $3.50 per gallon versus $3.00. What if consumers choose not to cut back on the volume of energy use and instead cut back on spending for nonenergy goods and services in order to stay within their budgets. Retailers would see a drop in sales. If businesses did not respond by offering discounts and instead were resigned to a drop in consumer activity, the impact of higher oil prices would show up as a reduction in consumer spending and, therefore, real GDP. If instead, businesses responded by discounting
8

Markets & the Economy / This Week & Focus

March 14, 2011

merchandise, consumer spending might be unaffected but business sales, profits, and activity likely would be curtailed. In this case, the rise in energy prices would curb real GDP through reduced business spending. (2) Recycling of oil revenues mitigates then reverses the oil tax This analysis focus on only one variable in the oil equation, how consumers are affected. Nonetheless, oil producers, whether they are in Saudi Arabia, Norway, Kuwait, Texas, or Oklahoma, for example, benefit as well. Initially, they immediately invest oil revenues in financial

Rising food prices

Prices received by farmers for all farm products (1990 92 = 100)

180

Updated through February 2011

180

170

170

160

160

150

150

140

140

130

130

120 2008
Source US Department of Agriculture

120 2009 2010 2011

Markets & the Economy / This Week & Focus

March 14, 2011

would be expected to be a boost to the farm sector and the US economy

US net agricultural exports (billions of dollars annualized)

125

Updated through February 2011

125

100

100

75

75

50

50

25

25

0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Source: US Department of Agriculture

markets and that cushions any pullback by consumers by lowering interest rates. Eventually, spending by oil producers, or their shareholders, if oil businesses choose to boost payouts from elevated earnings, would be expected to rise. In that case, and this would be expected within a couple of years, increased spending by oil producers would be expected to replace any reduction in spending by consumers.

Farm events work the other way The rising cost of farm products, even if it proves to be
10

Markets & the Economy / This Week & Focus

March 14, 2011

temporary and reverses once farmers recover from last years natural disasters, is squeezing consumers. The typical household spends 50 percent more of their budget on food than energy and prices of food are likely to climb this year by as much if not more than for retail energy. Nonetheless, the impact of rising price of agricultural commodities for the US economy is the opposite as that of oil, because the US exports more agricultural products than it imports. So, although US consumers face higher food bills, farmers are benefiting. There are many telltale signs of this at work, including the rising price of farmland. Global integration mutes supply shocks Conclusions that outside forces act as a tax on our economy are becoming less convincing as global economies become more integrated and as manufacturing becomes more globally diverse. In this case, a supply disruption that would appear to be a tax on one country and a windfall for another will at the end of the day prove to benefit both trading partners. With monetary policy winds at the backs of recovering economies, most excesses addressed, public entities addressing their structural budget imbalances, there are many good reasons to expect that the US recovery will gradually accelerate to about a 4% annual pace heading into 2012. This, not surprisingly, is the expectation of the Federal Reserves policy makers. And the Fed will not stand down until this pace is firmly in place.

The material contained herein is intended as a general market commentary. Opinions expressed herein are those of James Glassman and may differ from those of other J.P. Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. Further, the views expressed herein may differ from that contained in J.P. Morgan research reports. The above summary/prices/quotes/statistics have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness. Past performance is not a guarantee of future results. Not all investment ideas referenced are suitable for all investors. These recommendations may not be suitable for all investors. Speak with your J.P. Morgan representative concerning your personal situation. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument.

11