Barnes Feb 01 06

OUTLOOK FOR THE U.S. ECONOMY AND FINANCIAL MARKETS GIC/PCBE Luncheon Philadelphia February 1, 2006

A Presentation by:

Martin H. Barnes Managing Editor The Bank Credit Analyst mbarnes@BCAresearch.com

1002 Sherbrooke St. W. Suite 1600, Montreal, Quebec, H3A 3L6 TEL 514.499.9550 FAX 514.843.1763 www.BCAresearch.com

Unusual Times Ann% Chg

Ann% Chg

REAL HOUSE PRICES*

8

8

4

4

0

0

-4

-4

% 9

AFTER-TAX CORPORATE PROFITS AS A % OF NATIONAL INCOME

% 9

8

8

7

7

6

6

5

5

$/Bbl

$/Bbl

MEAN (1955 - 2005) 2 STANDARD DEVIATIONS

REAL** WTI CRUDE OIL PRICE 80

80

60

60

40

40

20

20

%

%

PERSONAL SAVING RATE

10

10

6

6

2

2

TRADE DEFICIT ON GOODS AND SERVICES AS A % OF GDP

%

%

0

0

-2

-2

-4

-4 © BCA Research 2006

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

*SOURCE: NATIONAL ASSOCIATION OF REALTORS; SMOOTHED AND DEFLATED BY THE CONSUMER PRICE INDEX **DEFLATED BY THE CONSUMER PRICE INDEX

2 2 editors@BCAresearch.com February 2006

BCA RESEARCH

Inflation Pressures Have Peaked Ann% Chg

Ann% Chg

CORE* PPI CRUDE GOODS

20

20

10

10

0

0

-10

-10

Ann% Chg

Ann% Chg

CORE* PPI INTERMEDIATE GOODS

6

6

4

4

2

2

0

0

-2

-2 BCA PIPELINE INFLATION PRESSURE INDEX

110

110

100

Ann% Chg

CORE* PCE INFLATION

Ann% Chg

2.0

2.0

1.6

1.6

1.2

1.2

Ann% Chg 1

CORE* CPI GOODS

Ann% Chg 1

0

0

-1

-1

-2

-2

100 Ann% Chg

90

CORE* CPI SERVICES

Ann% Chg

90

%

% NFIB PLANNED PRICE HIKES**

30

3.8

3.8

3.4

3.4

3.0

3.0

2.6

30

25

25

20

20

2.6

15

15

Ann% Chg 0

Ann% Chg 4.0

EMPLOYMENT COST INDEX: WAGES & SALARIES

Ann% Chg 0

Ann% Chg 4.0

3.5

3.5

3.0

3.0

2.5

IMPORT PRICE INFLATION FROM ASIA**

-2

-2

-4

-4

2.5 © BCA Research 2006

2000

© BCA Research 2006

2002

2004

*CORE EXCLUDES FOOD AND ENERGY **SOURCE: NATIONAL FEDERATION OF INDEPENDENT BUSINESS

2000

2002

2004

*CORE EXCLUDES FOOD AND ENERGY **INCLUDES HONG KONG, SINGAPORE, SOUTH KOREA AND TAIWAN

3 BCA RESEARCH

editors@BCAresearch.com February 2006 3

Global Inflation Is Low % 2.5

% CORE* CPI

Ann% Chg

2.5

Ann% Chg

CHINA**

2

2

1

1

0

0

-1

-1

EMU 2.0

2.0

1.5

1.5

Ann% Chg

1.0

1.0 %

Ann% Chg

ASIA EX. CHINA*** CORE* CPI

4

4

% U.K.

2

1.5

2

1.5

Ann% Chg 1.0

JAPAN

Ann% Chg

1.0

.5

.5

1

1

0

0

-1 0 1998

2000

2002

-1

0

© BCA Research 2006

© BCA Research 2006

1998

2004

2000

2002

2004

*EXCLUDES FOOD AND ENERGY **NON-FOOD CPI ***KOREA, TAIWAN AND THAILAND

*EXCLUDES FOOD AND ENERGY

Inflation Rates For Selected High-Frequency Spending Items % Change in consumer prices: December 2004 to December 2005 Gas and electricity Gasoline

17.6 16.1

Tax and accounting services Vehicle repair

4.4 3.6

Delivery services Repair of household items College tuition

9.9 6.8 6.6

Movies and theatre tickets Legal services Cable and satellite

3.5 3.4 3.3

Sporting tickets

6.4

Hotels

3.3

Cigarettes Dental services Child care and nursery Intracity transport

5.9 5.7 5.5 5.4

Physician services Personal Care Services Food Laundry services

3.1 2.7 2.3 1.8

Parking Veterinary services Prescription Drugs

4.9 4.9 4.4

Newspapers and magazines Alcohol Telephone services

1.7 1.3 0.4

4 4 editors@BCAresearch.com February 2006

BCA RESEARCH

Corporate Profitability Is Excellent %

% TOTAL ADJUSTED* AFTER-TAX PROFITS AS A % OF NATIONAL INCOME

9

9

8

8

7

7

6

6

5

5

%

NON-FINANCIAL CORPORATE SECTOR PROFITS BEFORE INTEREST AND TAXES AS A % OF GDP

%

20

20

15

15

© BCA Research 2006

10

10

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

*ADJUSTMENTS INCLUDE INVENTORY VALUATION AND DEPRECIATION

A Different Kind Of Cycle 180

REAL* EBIT

180

130

130

NON-FINANCIAL CORPORATE SECTOR PRICE INDEX

120

120

110

110

100

100

160

160

140

140

120

120

CURRENT CYCLE AVERAGE OF PAST 4 CYCLES*

90 100

100 CURRENT CYCLE AVERAGE OF PAST 4 CYCLES**

REAL GDP

115

120

90

NON-FINANCIAL CORPORATE SECTOR PRODUCTIVITY

115

120

110

110

100

110

110

105

105

100

100

100 95

95

© BCA Research 2006

2000

2002

2004

2006

*ADJUSTED BY THE NON-FINANCIAL CORPORATE SECTOR DEFLATOR **SERIES ARE ALIGNED AT THE START OF EXPANSION REPRESENTED BY 5 THE VERTICAL LINE

BCA RESEARCH

© BCA Research 2006

2000

2002

2004

2006

*SERIES ARE ALIGNED AT THE START OF EXPANSION REPRESENTED

BY THE VERTICAL LINE

editors@BCAresearch.com February 2006 5

Balance Sheets Are Strong % 220

% 220

NON-FINANCIAL CORPORATE SECTOR: NET WORTH AS A % OF GDP

200

200

180

180

160

160

140

140

AS A % OF GDP: DEBT (LS) ASSETS (RS)

% 90

% 360

80 320 70 280

60 50

240

%

SHORT-TERM ASSETS AS A % OF LIABILITIES

%

60

60

40

40

20

20

%

DEBT AS A % OF EQUITY

%

100

100

80

80

60

60

40

40

%

INTEREST COSTS AS A % OF EBIT*

%

30

30

20

20

10

10 © BCA Research 2006

55

60

65

70

75

80

85

90

95

2000

05

*EARNINGS BEFORE INTEREST AND TAXES

6 6 editors@BCAresearch.com February 2006

BCA RESEARCH

Good Support For Corporate Spending %

% NON-FINANCIAL CORPORATE SECTOR: WEIGHTED AVERAGE REAL COST OF CAPITAL AVERAGE RETURN ON CAPITAL

8

8

6

6

4

4

NON-FINANCIAL CORPORATE SECTOR GAP BETWEEN RETURN AND COST OF CAPITAL* (LS) NON-RESIDENTIAL FIXED INVESTMENT* (RS)

%

Ann% Chg 20

4

10 2

0 0 -10

RATIO OF NON-RESIDENTIAL FIXED INVESTMENT TO NON-FINANCIAL CORPORATE SECTOR CASH FLOW

1.4

1.4

1.2

1.2

1.0

1.0 © BCA Research 2006

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

*SERIES ARE SHOWN AS 4-QUARTER MOVING AVERAGES

7 BCA RESEARCH

editors@BCAresearch.com February 2006 7

Consumers Set To Retrench

The Impact Of Housing And Oil Ann% % of Disp.

Income Chg 8 1.5

CONSUMER CONFIDENCE* (LS) REAL WAGES AND SALARIES** (RS) 140

6 120 4 100

% of Disp.

Income

HOME EQUITY EXTRACTION: TOTAL CASH RAISED (ANNUAL CHANGE)

1.5

1.0

1.0

.5

.5

0

0

-.5

-.5

-1.0

-1.0

2 80 0 60 CONSUMER CONFIDENCE* (LS) HOUSE PRICES*** (RS)

Ann% % of Disp.

Income Chg

140

12

120

% of Disp.

Income

CONSUMER SPENDING ON ENERGY* (ANNUAL CHANGE)

.5

.5

0

0

-.5

-.5

-1.0

-1.0

100 8 80 4

60 PAYROLL GROWTH BCA PAYROLL EMPLOYMENT MODEL****

Ann% Chg

Ann% % of Disp.

Income Chg

2

2

0

0

-2

-2

%

PERSONAL SAVING RATE (3-MONTH M.A.)

%

NET STIMULUS/DRAG: HOUSING MINUS ENERGY

% of Disp.

Income

1

1

0

0

-1

-1

%

CONSUMER SPENDING ON ENERGY* AS A % OF PERSONAL DISPOSABLE INCOME

%

4

4

6

6

5

5

2

2

0

0

4

© BCA Research 2006

1996

1998

2000

2002

2004

2006

*SOURCE: THE CONFERENCE BOARD **ADJUSTED BY THE PCE DEFLATOR ***SOURCE: NATIONAL ASSOCIATION OF REALTORS; SMOOTHED ****BASED ON HELP-WANTED ADS, NFIB HIRING PLANS AND TEMPORARY EMPLOYMENT

© BCA Research 2006

1994

1996

1998

2000

2002

2004

4

2006

*INCLUDES GASOLINE, FUEL OIL, NATURAL GAS, AND ELECTRICITY NOTE: 2005 IS BCA ESTIMATE FOR ALL SERIES

8 8 editors@BCAresearch.com February 2006

BCA RESEARCH

Consumer Finances Are O.K.

No Sign Of Debt Stress

%

% HOUSEHOLD DEBT AS A % OF PERSONAL DISPOSABLE INCOME

120

120

%

% BANK LOAN DELINQUENCY RATES:

3.2

RESIDENTIAL REAL ESTATE LOANS

2.8

100

3.2 2.8

100

80

80

60

60

2.4

2.4

2.0

2.0

1.6

1.6

%

%

% HOME MORTGAGES AS A % OF CREDIT MARKET DEBT

72

%

OTHER CONSUMER LOANS

3.2

3.2

2.8

2.8

2.4

2.4

72

68

68

© BCA Research 2006

64

64

%

%

1992

HOUSEHOLD NET WORTH AS A % OF PERSONAL DISPOSABLE INCOME

600

600

550

550

500

500

450

450

%

%

EFFECTIVE CONSUMER BORROWING RATES: HOMEOWNER RENTER COMPOSITE*

18

18

14

1994

1996

1998

2000

2002

2004

2006

“Consumer short term debt… is approaching a historical turning point. Having risen at an abnormally fast rate for ten years, it must soon adjust itself to the nation’s capacity for going into hock… which is not limitless.

Whether the rate of growth in consumer debt will slow down is no longer the question…it must slow down.”

Fortune Magazine March 1956

14

10

10

6

6

© BCA Research 2006

80

82

84

86

88

90

92

94

96

98 2000 02

04

06

*A COMPOSITE OF MORTGAGE, CREDIT CARD, AUTO, AND OTHER DEBT, WEIGHTED BY THE AMOUNTS OUTSTANDING

“Federal Reserve Chairman G. William Miller said the average American buyer is getting dangerously deep in debt, and warned that the trend could have serious consequences…

Several of the nation’s business leaders said they share Miller’s alarm over the level to which consumer debts have climbed.”

Washington Post October 1978

9 BCA RESEARCH

editors@BCAresearch.com February 2006 9

A Different Kind Of A Flat Yield Curve %

% 10-YEAR TREASURY YIELD MINUS 3-MONTH TREASURY BILL RATE

4

4

3

3

2

2

1

1

0

0

%

REAL* 3-MONTH TREASURY BILL RATE

%

6

High real rates

4

6

High real rates

4

Low real rates

2

2

0

-2

0

© BCA Research 2006

1984

1986

-2 1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

*ADJUSTED BY THE CONSUMER PRICE INDEX

Still A Large Monetary Overhang %

%

MZM AS A % OF GDP 55

55

Monetary overhang

50

50

45

45

40

40

© BCA Research 2006

35 1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

35

2006

10 10 editors@BCAresearch.com February 2006

BCA RESEARCH

U.S. Treasurys: A Return To Stability %

% 10-YEAR TREASURY YIELD

12

12

10

10

8

8

6

6

4

4 © BCA Research 2006

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Real Yields: It Is Different This Time %

% REAL U.S. 10-YEAR TREASURY YIELD* AVERAGE OF PAST 5 CYCLES (LS) CURRENT CYCLE (RS)

7

7

6

6

5

5

4

4

3

3

2

2 © BCA Research 2006

2004

2005

NOTE: PREVIOUS CYCLES ALIGNED TO FIRST RATE HIKE OF TIGHTENING CYCLE, DENOTED BY VERTICAL LINE *SHADING DENOTES RANGE OF REAL 10-YEAR YIELD DURING PREVIOUS TIGHTENING CYCLES

11 BCA RESEARCH

editors@BCAresearch.com February 2006 11

Global Real Yields: Converging At A Low Level

Excess Global Savings

%

% REAL* 10-YEAR BOND YIELDS:

4

4

EMU

3

200

200

150

150

100

100

50

50

2

U.K.

%

2.5

2.5

2.0

2.0

1.5

1.5

1.0

1.0

%

Bn US$

ASIAN* TRADE BALANCE

3

2

%

Bn US$

JAPAN

Bn US$

Bn US$

TRADE BALANCE: LATAM** PLUS EURO AREA

120

120

80

80

40

40

%

2.0

2.0

1.5

1.5

1.0

1.0

Bn US$

.5

.5

100

100

80

80

60

60

40

40

20

20

Bn US$ RUSSIAN TRADE BALANCE

%

CANADA

%

4

4

3

3

2

2

%

Bn US$

OPEC TRADE BALANCE

%

G-7 ex. U.S. U.S.

4

Bn US$

4

3

3

2

2

180

180

140

140

100

100

60

1 1998

2000

60 © BCA Research 2006

1

© BCA Research 2006

2002

2004

*ADJUSTED BY THE BCA ESTIMATE OF LONG-TERM INFLATION EXPECTATIONS

2006

1994

1996

1998

2000

2002

2004

*INCLUDES JAPAN **INCLUDES MEXICO, BRAZIL, CHILE, ARGENTINA, VENEZUELA AND COLOMBIA

12 12 editors@BCAresearch.com February 2006

BCA RESEARCH

The Bull Market In Perspective S&P 500 INDEX CURRENT CYCLE AVERAGE OF PAST 8 POST-BEAR MARKET RALLIES

180

180

4th year 3rd year 2nd year 1st year

160

160

140

140

120

120

100

100 © BCA Research 2006

2001

2002

2003

2004

2005

2006

NOTE: INDEXED TO 100 AT THE STOCK MARKET TROUGH

Tighter Money Leads To Lower Equity Multiples S&P 500 P/E RATIO BASED ON OPERATING EARNINGS

30

30

20

20

10

10

%

%

FED FUNDS RATE

18

18

14

14

10

10

6

6

2

2

© BCA Research 2006

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

NOTE: SHADING DENOTES PERIODS OF RISING FED FUNDS RATE

13 BCA RESEARCH

editors@BCAresearch.com February 2006 13

Measures Of Equity Valuation 30

30

S&P 500 P/E BASED ON OPERATING EARNINGS

25

25

20

20

15

15

10

10

S&P 500 P/E BASED ON OPERATING EARNINGS PLUS LONG-TERM GOVERNMENT BOND YIELD

36

36

32

32

28

28 MEAN 1982-1997

24

24

20

20

16

16

NON-FINANCIAL CORPORATE SECTOR EQUITIES TO REPLACEMENT COST BOOK VALUE 1.6

1.6

1.2

1.2

.8

.8

.4

.4

%

REAL* 10-YEAR TREASURY MINUS S&P 500 EARNINGS YIELD

%

0

0

-5

-5

-10

-10 © BCA Research 2006

1970

1975

1980

1985

1990

1995

2000

2005

*ADJUSTED BY THE BCA ESTIMATE OF LONG-TERM INFLATION EXPECTATIONS

14 14 editors@BCAresearch.com February 2006

BCA RESEARCH

S&P 500 Earnings Growth Set To Slow Ann% Chg

Ann% Chg S&P 500 PROFIT GROWTH BCA EARNINGS MODEL*

20

20

0

0

-20

-20

Š BCA Research 2006

1998

2000

2002

2004

2006

*BASED ON THE YIELD CURVE, DOLLAR, OIL PRICES, REAL CORPORATE BOND YIELDS AND A CORPORATE PROFIT MARGIN PROXY

Decomposing Equity Market Returns Average Annual % Change Historical Average 1950-95

Bubble Years 1996-2000

Bear Market 2000-02

Optimistic Scenario* 2005-15

MeanReversion Scenario** 2005-15

Bear Scenario*** 2005-15

Nominal GDP

7.6

5.9

3.5

5.0

5.0

5.0

Earnings

6.7

9.5

-9.0

5.0

4.5

4.0

2.3

13.3

-8.2

1.5

0.0

-2.5

9.0

22.8

-17.2

6.5

4.5

1.5

4.2

2.0

1.2

1.8

1.8

1.8

13.2

24.8

-16.0

8.3

6.3

3.3

Inflation (CPI)

4.2

2.4

2.3

2.0

2.0

2.0

Real returns

8.6

21.9

-17.9

6.2

4.2

1.3

+ Valuation change +Growth in S&P 500 + Reinvested dividends = Total equity returns

* Assumes that the forward price-earnings ratio to 18 over the period. ** Assumes that the price-earnings ratio remains at its current level near 15. *** Assumes that the price-earnings ratio falls to 12 over the period.

15 BCA RESEARCH

editors@BCAresearch.com February 2006 15

Dollar Bear Market In Perspective

Dollar Versus Regional Trade Imbalances %

100

REAL TRADE-WEIGHTED DOLLAR*

REAL TRADE-WEIGHTED DOLLAR (LS) TRADE DEFICIT/GDP (RS)

100 130

TOTAL 90

90

80

80

4

120

110 2 100 70

70 90

REAL TRADE-WEIGHTED DOLLAR: MAJOR CURRENCIES* 100

0

MAJOR TRADING PARTNERS

%

100 130 CURRENT CYCLE (LS) 1985 CYCLE (RS)

90

90

2

120 110

80

1

80 100

70

70

60

60

90 0

80

REAL TRADE-WEIGHTED DOLLAR: OTHER IMPORTANT TRADING PARTNERS*

OTHER IMPORTANT TRADING PARTNERS

%

130 105

105

100

100

95

95

90

90

85

85

80

80

120

2

110

100

1

90 © BCA Research 2006

© BCA Research 2006

YEARS FROM THE PEAK *SOURCE: THE FEDERAL RESERVE NOTE: ALL SERIES ARE REBASED TO 100 AT THE PEAK IN THE REAL TRADE-WEIGHTED DOLLAR REPRESENTED BY THE VERTICAL LINE

1975

1980

1985

1990

1995

2000

0

2005

16 16 editors@BCAresearch.com February 2006

BCA RESEARCH