• Hold your horses, we are not heading for a "Double-Dip." It is true that a number of headwinds, including a slowdown in hiring in response to weaker consumer spending, have slowed the US recovery's momentum and triggered processes that are prolonging the current "soft patch." However, the underlying recovery drivers, chief among them productive and profitable businesses with healthy balance sheets that need and are able to grow payrolls, are still there.
• Less supportive fundamentals are hitting the economy just when QEII expires, with the predictable result of increased financial market volatility.
• If you only looked at financial market trends in May you would think the US economy is already back in recession. 10-year Treasury yields fell below 3% for the first time since last December. However, slowdown fears in the second half of last year, just as QEI expired, pushed 10-year Treasury yields all the way down to 2.4% and the world didn't end then either.
• Stocks had a torrid few weeks, but the S&P 500 has lost merely 3.5% after hitting a new cycle high at the end of April. Compared to overseas markets US stocks are holding up well, beating out Europe, Japan and most emerging market (EM) regions.
• US credit markets have posted solid gains on the back of the decline in Treasury yields. YTD, the Barclays US High Yield Index is outperforming the S&P 500 by about 150 bps.
• The US dollar has regained some of its lost ground with growth currencies suffering the most, but has hardly made a dent in the damage done to its external value, which is still down 5% against its major trading partners this year.
• Finally, the retrenchment in commodity markets continues. Oil prices are down about 12% since the start of May, Silver is down almost 25% and Gold lost 1.5%. In addition, QEII and growth concerns are a lethal combination for commodity prices, which should continue to grind lower in the coming months.

Economy

Soft patch or something more serious? The US economic recovery has hit a few "bumps in the road," as the White House described them recently. The harsh winter weather depressed construction activity and restricted consumer spending, while the fiscal austerity that was forced on governments shaved about two percentage points off GDP growth in the first quarter. Put into dollar figures, the loss of spending was worth about US $300 billion on an annualized basis, or almost 40% of the 2009 stimulus package. Thus it speaks to the resilience of the US recovery that growth held up so well.

The latest problem is the negative effect of the Fed's easy money policy. The "unintended" consequence of a near record low in the external value of the US dollar is that the rise in commodity prices at the start of the year, which was fuelled by the massive Fed liquidity injections, is hitting US consumers and businesses harder compared to the rest of the world.

The loss of purchasing power among US households has extended the weakness in consumer spending into the current quarter. Meanwhile, the impact on business activity is made even worse by supply-chain disruptions following the March earthquake in Japan. As a result, the US economy is more likely to post another near-2% growth rate in the second quarter, than to accelerate back to what I believe is the underlying recovery potential of about 4%.

Policy

The Federal Reserve is very much at odds with my view of the macro world. I believe that the Fed continues to see its role as doing the job traditionally reserved for fiscal policy, stimulating growth and employment. This is especially true for Chairman Bernanke, Vice-Chair Yellen and NY Fed President Dudley. Meanwhile, the bank seems prepared to ignore inflation in the process. So far the Fed's policies have certainly helped equity markets, which told a much more bullish story than did the news headlines on the economy during much of May.

It's the weak dollar, though, that seems to pose the biggest threat to US and global economic growth. It has forced central banks around the world to deal with a bigger commodity price-fuelled inflation problem that is now threatening growth in the key emerging markets. Meanwhile, faster domestic inflation is eroding US household purchasing power and is driving up costs for US businesses. The Fed's main argument for its extremely loose monetary policy is the fear of Japan-style deflation. Yet, by leaving rates so low the bank is encouraging exactly the kind of behavior - e.g. expecting borrowing rates to fall further - it is trying to prevent.

US fiscal policy remains messy. Congress has made no progress towards a fiscal exit strategy or the federal debt limit. Rather than breaking up the problem into smaller pieces, both sides seem are seeking a grand bargain. This is not only almost impossible politically, but would also most likely be damaging to the recovery through the kind of second round effects and behavioral changes we are seeing now following the Affordable Health Care Act and Frank/Dodd.

Requiring detailed reforms from a "standing start" is much more difficult than setting a future resolution date. A legal (constitutional or not) "Debt Brake," requiring a balanced budget through the business cycle, or the idea of a "Debt Fail Safe Mechanism," which would lead to automatic spending cuts and tax increases if the budget deficit reaches a certain level, are likely the right strategies. They would set in motion processes and behavioral changes necessary to address the problem over the coming five to 10 years, which is the time frame within which politicians ought to think.

 Outlook Scenarios

In my baseline scenario, I expect growth to re-accelerate to the underlying recovery potential of 3.5% to 4%. I don't foresee a "mid-cycle slowdown," since we are nowhere near the middle of the current cycle, or a "Double Dip," which requires a new exogenous or policy shock.

The main driver of any recovery is pent-up demand. Consumer spending has a long way to go to catch-up. Some examples are auto sales, which are still below the replacement rate, and the share of business investment to GDP, which is still below the long-term average. More broadly, the ratio of GDP to employee has increased at the fastest rate EVER in the past two years, suggesting that the economy is functioning with an insufficient level of workers, pointing to pent-up demand for labor.

Given the persistent household balance sheet damages and the swing in fiscal policy from growth support to deficit cutting, stronger growth than I am forecasting seems improbable. However, the persistent recovery headwinds indicate a higher likelihood of a slower growth scenario.

 Subjectively, I believe the probabilities around the various scenarios are:

- High Conviction (65% probability): US GDP growth re-accelerates to 3% to 4%

- Alternative I (30% probability): GDP remains in weaker 1.5% to 2.5% range

- Alternative II (5% probability): GDP exceeds my forecasts

 Investment Outlook

The extent of the Treasury rally at the end of May was somewhat surprising and, in my view, represents an overreaction among investors to the more negative US macro headlines. With US inflation close to 3%, real 10-year Treasury yields at zero suggest we are already back in recession territory. However, I believe once we are through the current soft patch, investor fear should ease and bond yields could snap back quite quickly to the 3.50% to 3.75% range we saw earlier in the year. The Fed is giving us no indication that they are any closer to raising rates, hence the yield curve is likely to re-steepen again in the second half before the start of the policy rate normalization cycle brings about a bear-flattening of the Treasury curve next year.

 We remain risk neutral in our strategies, but have not succumbed to investor panic and abandoned risk assets. However, we have made the case for corporate credit to accompany equity holdings as a less volatile way to get exposure to the US corporate story That strategy has certainly taken some of the sting out of the current stock market correction. It also highlights the good call our asset allocation team made when they decided to stay risk neutral. I am still looking for a rebound in EM equities, once we have more evidence that the inflation cycle has peaked. In the meantime we maintain our preference for US asset markets, both in stocks and bonds.

Markus Schomer, Chief Economist for PineBridge Investments, is responsible for providing macro-economic forecasts, analysis and commentary for all PineBridge Investments' groups with a focus on global economic trends and their impact on financial markets. He holds degrees in Economics from the University of Bonn in Germany and the University of East Anglia, in the UK. He also studied at the London School of Economics and is a CFA chartereholder.

Certain information may be based on information received from sources PineBridge Investments considers reliable; PineBridge Investments does not represent that such information is accurate or complete. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements that do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial information. Any opinions, projections, forecasts and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. PineBridge Investments is not soliciting or recommending any action based on any information in this document.

Opinions provided are those of the author and should not be construed as advice from VALIC. VALIC represents The Variable Annuity Life Insurance Company and its subsidiaries, VALIC Financial Advisors, Inc. and VALIC Retirement Services Company.

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