Baked into the positive news for manufacturing are the resulting challenges for the labor market. Productivity growth, making companies lean and mean, implies that labor demand is weak. Job losses have moderated in recent months, but the economy has continued to shed jobs. It seems that until labor market conditions change, the consumer’s optimism about the economy is not going to improve. Indicators on consumer sentiment remain weak. In the Conference Board’s recent survey, only 6.2% of respondents described job prospects as good. After several months of leveling, housing indicators have shown weakness in recent reports.

After being propped up by tax credits in the fall, both new and existing home sales have slowed, and supply levels have risen in spite of a second round of tax credit opportunities. As a result, construction spending has fallen, down 9.3% year-over-year, and home price improvement has softened in recent months. Also, employment in construction has fallen farther. From the peak in 2006, when construction employment averaged 7.6 million workers, over 2.1 million jobs have been lost in the industry.

Inflation numbers remain tame at the core level, for the time being. Recent top level producer price numbers have indicated firming year-over-year, but consumer price index readings show no sign that any price increases are filtering through. Consumer inflation has been held down, in large part, by declining shelter costs reflecting the weak housing situation. Shelter costs make up over 30% of the Consumer Price Index. The low inflation numbers give the Fed some breathing room with respect to tightening monetary policy.

The Fed did increase the discount rate during the quarter in a move back to more normal levels relative to the fed funds rate. Not to be confused with the targeted fed funds rate, the discount rate is the rate at which banks can borrow short-term funds from the Fed, and has little bearing on broader markets. Still, this was a symbolic indication of the Fed starting to remove some stimulus. In addition, we’ll be watching mortgage rates closely next month. At the end of the month the Fed will stop buying mortgage backed securities in the open market, and we will likely see rates move higher for home buyers.

Market Developments

As we have noted in recent updates, policy maneuvers and announcements have stolen the show from the somewhat predictable economic picture. Markets had their wings clipped in January amid a number of announcements including: the Obama administration’s invocation of the Volker plan which coincided with the announcement by the Chinese that they would put stricter limits on bank lending out of fears of a financial bubble and inflation, and the potential insolvency of Greece. As the months passed, some of these concerns were forgotten, others addressed and the market has returned to positive territory year-to-date. So far this year, the S&P 500 has returned about 5.2%, lead by increases in industrial and financial sectors. Based on forward earnings estimates for the 1^st quarter of 2010, the S&P 500 is trading at a price earnings ratio of about 20.5 times. To us this seems a little rich with so much uncertainty around the economic recovery.

This past weekend, the U.S. House passed healthcare legislation which could have significant long-term implications for the industry, both positive and negative. It will be some time before everything plays out here, but, as it stands right now, some Americans will get new insurance, others will get new taxes, and it appears states will need to pony up for some new programs. We will be watching this closely as it moves through the reconciliation process.

What remains a major concern, and is only compounded by the healthcare bill, is the financial condition of the United States. We are now in debt for $12.6 trillion, and this year the federal deficit is expected to tally up to $1.2 trillion. That is debt near 100% of GDP and a deficit of about 10%. At some point something has got to give. We recently heard someone say that the wakeup call will be the failure of a Treasury auction. No doubt that would be quite a wakeup call, but what we think is more likely is a gradual demand for higher yields by investors. This week, auction demand did not meet expectations and yields have moved higher. Since the end of 2008, the ten-year bond yield has increased by almost 1.75% and is near 4.00%. In their last estimate, the Office of Management and Budget anticipated that the U.S. would spend $520 billion in interest during 2010, which implies a financing cost of about 3.75%. For every 0.10% their estimate is wrong, the debt cost increases by about $13 billion. We anticipate continued increases in Treasury rates, and we believe that the cost of debt will force marginal tax rates higher for everyone.