November 2011invisible

Laufenberg Economic Quarterly

Daniel E. Laufenberg, Ph.D.

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

Executive Summary

  • The economic news since the last Quarterly was published has been dominated by the debt “crisis” in Europe and the fear of it causing another global recession. Even a better-than-expected growth rate for the U.S. economy in the third quarter was dismissed as a one-off event and did very little to erase the pessimism. In fact, the consensus forecast for the rest of this year and early next year is still very disappointing. Although my forecast for real growth has been revised slightly lower than it was in August, it remains far more optimistic than the consensus.

  • The first half of 2011 was much weaker than expected thanks to a sharp drop in government spending owing to local government budget pressures, parts shortages due to a major earthquake in Japan, and to a sluggish consumer sector owing to higher prices. As expected, these factors proved temporary. In the third quarter, real government spending was unchanged, while both factory output and real consumer spending rebounded from the preceding quarter.

  • The outlook for real growth in the fourth quarter is at least equally favorable, despite all the noise around debt issues here and abroad, as well as the flooding in Thailand. In particular, based on the October employment report alone, total hours worked have already increased dramatically in the fourth quarter, favoring a solid gain in real GDP. Indeed, the historical relationship between hours worked and real GDP, even though far from perfect, suggests that real GDP growth in the fourth quarter could very easily exceed the better-than-expected pace in the previous quarter.

  • In 2012, the outlook remains favorable, with real GDP expected to grow in excess of 3.0 percent and inflation to remain relatively benign. This too is considerably better than the consensus outlook for next year.

  • My outlook for interest rates has changed. I now expect the Fed to wait until late 2012r before it starts to remove its accommodative policy stance. This is earlier than the Fed said it would act, but I doubt that the Fed can wait until the middle of 2013. That being said, given that the Fed has provided a specific date, any reversal in policy sooner than that will be politically difficult even if fundamentally warranted.

  • Despite ongoing volatility, equities and high-yield bonds are still preferred over high-grade bonds for now.

Forecast at a glance

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Forecast details

Forecast Details

Still cautiously optimistic

Concern of a recession in Europe due to defaults on sovereign debt and the perceived negative implications for the European and U.S. economies have weighed on financial markets for the last seven months or so. From all indications, this concern will continue to haunt financial markets for some time. The big problem is that a quick and easy solution to the European debt debacle is not available, even though financial markets intermittingly hope for one. And of course, if Europe’s problems would pull the U.S. economy into a recession, an already large federal budget deficit and the extremely accommodative monetary policy currently in place would complicate any policy responses considerably. The Fed says it has additional policy tools at its disposal but monetary policy looks to be pushing on a string now. All of these concerns are legitimate, but I contend that the likelihood of such an outcome, albeit higher than it was a year ago, is still quite low.

It seems very likely that Greece will default on some of its debt obligations, forcing creditors to renegotiate the interest rate, length of the loan, or the principal payments. This is typically how sovereign defaults are handled. The result in most cases is that local interest rates rise, the foreign exchange value of the local currency plunges, inflation surges, and the economy drops into recession. The Greek situation is complicated because it shares a common currency with the rest of Europe but shares very little of anything else. In other words, there is no political process in place to deal expeditiously with a default by a European Union member country.

Of course, another aspect of the problem is that the debt overload problem spreads to other European Union members. At the moment, Italy is in the spotlight as the next debt crisis candidate. Global stock markets plunged recently because the yield on the 10-year Italian note spiked above 7 percent. I contend that such a move is a good thing if it imposes budget discipline on Italy. That is, higher yields make it more difficult for Italy to borrow, forcing Italy to reduce its borrowing needs either by spending less or taxing more. Under such circumstances, the rest of Europe should not provide debt relief because it only encourages more bad behavior, including speculators betting more heavily against Italy. If Italy does default, it exacerbates the financial fallout. Instead, Europe should provide some form of temporary economic relief to the Italians (a form of automatic stabilizer) while the economy gets back on track. The bottom line is that if Europe wants to be united, it needs to be united in more than just currency. Member states must give up some of its political power to the European Union.

Despite all the ongoing headwinds coming from Europe, the outlook for real economic growth in the U.S. over the remainder of this year and for all of 2012 has changed very little from the August 2011 issue of the Laufenberg Economic Quarterly. I continue to expect real gross domestic product (GDP) to grow about 3.2 percent through 2012. This should be sufficiently robust to boost employment and push the unemployment rate to about 7.5 percent by the end of 2012. In the meantime, inflation should be relatively well behaved on average over the same period, although very volatile energy prices will continue to influence short-term inflation results.

That being said, the outlook for interest rates has changed once again. In particular, the Federal Reserve is expected to keep its federal funds rate target at its current low level until late next year. In their statement following the October policy meeting, the Committee repeated that it would keep its federal funds rate target at a low level "at least through mid-2013." In the press conference, Bernanke seem to suggest that the Fed may wait even longer before it raises rates. I continue to believe that the Fed has already waited too long but will not realize it until late next year. Unfortunately, Chairman Bernanke will learn the hard way that being too specific about the timing of monetary policy makes it even more difficult politically to act sooner than advertised, even if the fundamentals warrant it.

By the way, uncertainty never goes away, it simply changes its face. Today the uncertainty is about Europe. When the situation there is resolved, uncertainty will surface in another form—Iran, China, U.S., Eastern Europe, Russia, or Northern Africa to mention a few. And I am fairly confident that the financial media will label it a “crisis” wherever and whatever it might be.

A solid third quarter

As I expected in my August forecast, U.S. real growth accelerated in the third quarter following the sluggish pace in the first half of the year. Real GDP grew at a 2.5 percent annual rate according to the Bureau of Economic Analysis’ advance estimate, about double the pace in the second quarter and nearly six times the pace in the first quarter. Although third-quarter real GDP growth was not as robust as the 3.4 percent pace shown in my August forecast, I had expected real final sales (a measure of final demand for goods and services produced in the U.S.) to increase 3.3 percent. The implication was that the third-quarter change in business inventories would be close to neutral. As it turns out, real final sales grew a slightly better-than-expected 3.6 percent but the change in inventories was far from neutral. In fact, inventories detracted a whopping 1.1 percentage points from real growth in the third quarter, which is clearly unsustainable given the strength in final sales. In other words, real final demand was much stronger in the third quarter than the overall real GDP growth rate suggests.

The surge in real final sales was lead by consumer spending and business fixed investment. Real personal consumption expenditures, which increased 2.4 percent at an annual rate in the third quarter, contributed 1.7 percentage points to final sales, reflecting in large part the largest quarterly percent gain in service spending since early 2005. Recall that I have argued in the past that job growth will improve once consumers start spending on services, since slightly more than 80 percent of all private nonfarm payroll jobs are service jobs. Hence, the recent improvement in service spending should bode well for service employment over the remainder of this year.

The 16.4 percent annual rate of gain in real business fixed investment in the third quarter contributed 1.5 percentage points to real final sales, better than I expected in August. Business spending on equipment and software jumped 17.4 percent, which was not that surprising. The surprise came from spending on nonresidential structures, which increased a solid 13.3 percent in the third quarter, following an advance of 22.6 percent in the preceding quarter. Clearly there was no evidence in the third quarter of fixed business investment slowing down in the wake of the European debt debacle.

The growth rates of the remaining segments of real final sales differed somewhat from my previous forecast, but on balance contributed about as expected. Both residential investment and government spending fell short of expectations but net exports exceeded them. The end result was that real final sales, which represents final demand for goods and services produced in the U.S., was even better than the above-consensus estimate of 3.3 percent in my previous forecast.

The surprise was that the change in business inventories detracted as much as it did from overall real GDP growth last quarter. Indeed, inventories increased a scant $5 billion in the third quarter, which was down considerably from the $39 billion increase in the previous quarter. What made this third-quarter slowdown in inventory accumulation even more interesting is that it occurred in a quarter when final sales surged $117 billion. As a result, the inventories-to-final sales ratio for the overall economy slipped to a very low level in the third quarter by historical standards. Hence, if final sales increase in the fourth quarter anywhere near as much as I expect, the change in business inventories must contribute to fourth-quarter real GDP growth just to keep pace.

The 1994-95 parallel revisited

As I noted in my last Quarterly, there seems to be an interesting parallel between real GDP growth this year and real GDP growth the last time the federal government engaged in a bitterly partisan debate over deficits and debt in 1995. Recall that in 1995 Bill Clinton (a democrat) was in the White House and Newt Gingrich (a republican) was Speaker of the House, and that many of the same issues were debated then as now. In fact, the federal government was partially shut down for a few days in November 1995 and again for a few days at the end of December into January 1996. The federal government did not lose its AAA rating but there was plenty of talk about it.

So what happened to the pattern of U.S. economic growth during the previous major budget debate? As shown by the solid line in Chart 1, real GDP grew 4.1 percent over the four quarters of 1994, slowed to less than 1.0 percent in the first half of 1995 and then reaccelerated to 3.0 percent over the second half of 1995. Over the four quarters of 1996, real GDP grew nearly 4.5 percent. This time we have Barack Obama (a democrat) in the White House and John Boehner (a republican) as Speaker of the House. If we superimpose the pattern of real GDP growth over the four quarters of 2010 and the first three quarters of 2011 on the same chart (the dashed line), it seems to follow a very similar pattern. The difference is that real GDP grew 3.1 percent over the four quarters of 2010 but also slowed to an average pace of less than 1.0 percent for the first half of 2011 before accelerating to 2.5 percent in the third quarter.

My expectation is that real GDP growth remains solid in the fourth quarter of 2011, providing an average growth rate for the second half of this year that is not too different from the average pace in the second half of 1995. I also expect real growth to exceed 3.0 percent for all of 2012. It seems that some of the same type of uncertainty that restrained growth in the first half of 1995 may have been in play in the first half of 2011. Beyond that, there are very few similarities between now and then. But the differences do not always preclude economic fundamentals from repeating itself. And while the trajectory going forward may not match the 1995-96 experience precisely, the general direction seems like a good bet to me.

Although early, the fourth quarter also looks solid

Over the last few weeks, the better-than-expected economic data has helped ease the concern that the U.S. economy is heading into a double-dip recession, but the ongoing European debt debacle has prevented this concern from abating entirely. Many policymakers still consider the U.S. economy vulnerable to a shock of some sort and a recession in Europe may provide just such a shock. My response to this concern is twofold. First, I do not think that the U.S. economy is as vulnerable as policymakers seem to think. The U.S. economy hit a soft patch in the first half of the year due to a variety of temporary factors. Many of those headwinds have waned, as evident by the solid gain in real output in the third quarter. More importantly, it looks as if real GDP growth could be even stronger in the fourth quarter.

Recent economic data point to an economy that finished the third quarter strong and has maintained that momentum into the fourth quarter. For example, in September (the most recent data available), the level of real consumer spending, which represents about 70 percent of GDP, was already up 1.2 percent at an annual rate above the third quarter. This suggests that real consumer spending had substantial upward momentum at the end of the third quarter and only needs to show slight improvement over the last three months of the year to register a very solid fourth-quarter increase at an annual rate. In this regard, light-vehicle sales in October totaled 13.3 million units at a seasonally adjusted annual rate, up a bit from the 13.1 million units sold in previous month.

On the supply side of the economy, total hours worked in October were already at a level that was 2.7 percent at an annual rate above the third quarter level. Based on historical data, such a gain in hours worked suggests that based on only one month of employment data, real GDP already is up 1.4 percent in the fourth quarter. This relationship is demonstrated in Chart 2, which is a scatter diagram of percent changes in total hours worked and percent changes in real GDP. The data points are annualized growth rates of quarterly data from 1970 through the third quarter of 2011. The trend line in Chart 2 represents an ordinary least squares regression of real GDP growth on total hours worked growth. Although the data points are clustered along the trend line, they do not fit perfectly along the line. This implies that any estimate based on the trend line is subject to a sizable error. It is also worth noting that the bulk of the data points are in the upper right hand quadrant in which both hours worked and real GDP are increasing. On the other hand, there still are a dozen or so data points in the lower right hand quadrant where hours worked increased but real GDP did not.

To the extent that total hours worked continue to increase in the November and December employment reports, the trend line in Chart 2 suggests that real GDP most likely will increase further as well. My best estimate at the moment is that total hours worked will be up close to 5.0 percent at an annual rate and that real GDP will be up close to 3.5 percent, a combination that would most certainly be on or near the historical trend line.

In addition, the Institute of Supply Management (ISM) index for manufacturing (also known as the Purchasing Managers Index or PMI) came in at 50.8 percent in October, which was lower than the consensus estimate of 52.0 percent and down from 51.6 percent in September. Several analysts contend that this lower reading confirmed that the economy was still soft and slowing. I disagree with their analysis. After all, a PMI reading above 50 percent suggests that output in the manufacturing sector is expanding and 50.8 percent is still above 50 percent. More importantly, according to the ISM, if the PMI reading of 50.8 percent for October is annualized, it corresponds to a 2.0 percent increase in real GDP annually. The average PMI for January through October is 55.7 percent, which corresponds to a 4.6 percent increase in real GDP. For the next year, I would expect the PMI to average about 51 percent and for real GDP to grow roughly at 3.2 percent.

Finally, as noted earlier, the increase in real business inventories slowed to a scant $5 billion at an annual rate in the third quarter. If real final sales increase as much as I expect in the fourth quarter, then real business inventories need to increase about $30 billion for the inventories-to-sales ratio to remain at a historically low level. As a result, the change in real inventories alone could easily add 0.5 percentage point to real GDP growth this quarter. At the moment, I expect the change in inventories to add only 0.2 percentage point to real growth in the fourth quarter, but this may be too conservative.

Interest rate forecast revised

Fed Chairman Ben Bernanke noted during his press conference following the recent Federal Open Market Committee (FOMC) meeting that the central tendencies of economic forecasts provided by the committee members were “inherently uncertain and therefore subject to revision.” This is Fed speak for “we could be wrong.”

I happen to think the Fed will be wrong and that the economy will grow even faster than the high end of its range of estimates for 2012. That being said, my forecast is subject to the same inherent uncertainty facing the small army of Fed economists who advise the FOMC members and help develop their forecasts. In fact, if there is one aspect of my forecast that has consistently been wrong, it has been my interest rate forecast. For two years, I have argued that interest rates would move higher. They have not, and there is no indication from the Fed that short-term interest rates will be higher anytime soon.

According to the statement and press conference following its last policy meeting, the FOMC made no new policy decisions at the meeting. The November statement noted that "economic growth strengthened" compared to "remains slow" in September. However, the language repeated that there are "significant downside risks to the economic outlook." The Fed lowered its real GDP projections and increased its unemployment rate numbers for each year from 2011 through 2013. The projections across the forecast horizon are lower than the previous ones released in June. I would contend that the Fed went too far in its downward revision to growth for 2012 but it is now closer to my forecast than it was.

The new information released by the FOMC was that it provided its first forecast for 2014. The Fed sees unemployment in a range of 6.8 percent to 7.7 percent at the end of that year and inflation at or below its implicit target of 2 percent. Many contend that such a forecast provides support for the Fed keeping rates low for an extended period. There was no change in the inflation language. "Inflation appears to have moderated" and the Committee "anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate." The Fed's projections for headline and core PCE are slightly higher for 2011 to reflect recent data but are little changed for the rest of the forecast horizon.

My inflation forecast for 2012 is not that different from the FOMC’s forecast. The problem is that in order for the Fed to achieve its inflation forecast for 2013 and 2014, I believe it must implement a less accommodative policy stance much sooner than currently being advertised. I am confident that the Fed knows how to fight inflation. The problem I have is whether the Fed will engage in that fight soon enough to avoid triggering another recession in the process. If they follow their timetable, I believe they will be too late.

With regard to current policy, the FOMC decided to continue its so-called “operation twist” program by extending the average maturity of its securities holdings and is maintaining its reinvestment of principal payments in agency mortgage backed securities. As far as the federal funds rate, the FOMC repeated that it would keep it at low levels "at least through mid-2013." In the press conference, Bernanke emphasized this point, suggesting that the FOMC could keep the federal funds rate target at an exceptionally low level even longer than that. But as he also noted very diplomatically during his press conference, the Fed could be wrong.

European Union survival kit

The budget debacle in Greece and Italy, and concern that other European Union (EU) member countries will soon face similar problems, have weighed heavily on global financial markets. Indeed, some are concerned that the U.S. is heading toward a similar crisis, which may explain why U.S. financial markets react so aggressively to renewed concerns about Europe. With that backdrop, what does the EU need to do to survive? Do not misunderstand the issue. Europe will survive, although sometimes financial commentators make it sound like Europe will disappear. Instead, it is a question of whether the politically precarious EU will survive. Unfortunately, it is a very complicated problem because the union essentially is in currency only.

In my view, Greece is a more serious threat to the EU than Italy. In particular, analysts suggest that for Greece's debt to be widely seen as sustainable it needs to be cut by about a half. Given the nature of the Greek economy, the only way to achieve this outcome is for Greece to default. Greece's credit rating would be affected adversely only for a short time, if it initiated the necessary reforms to keep debt levels low. The alternatives being proposed, including swaps, buy backs, or concessions, do not get the job done. For example, one proposal under discussion is for the European Financial Stability Facility, the euro zone's bailout fund, to help Greece go into the market and buy back bonds now trading at a discount. This might not trigger any default calls from ratings agencies—but it might not do much good for Greece. In the barely traded market for Greek debt, the entrance of a big buyer would instantly drive up prices, and significantly limit the scope for debt reduction.

From most reports, there seems to be an overwhelming urge on the part of European policymakers to rescue banks from a sovereign default. I think such a goal is a huge mistake. Instead of saving banks, the other member countries should be focused on providing some assurance to depositors and providing sufficient liquidity to the financial system in the event of a default.

Opponents of default are concerned about the unintended consequences of such a step, including the payout to holders of insurance bought in the credit-default-swap market. They often compare the situation to the previous financial crisis, suggesting that it could lead to the collapse of financial institutions and chaos in financial markets. Indeed, they point to the recent demise of MF Global as the tip of the iceberg. 1 They seem to ignore the fact that MF Global violated the rules of prudent investing and as such probably deserved to fail. I could argue that MF Global’s overly-speculative behavior was a result of financial regulators not being tough enough on bad actors during the last financial crisis. I strongly believe that when firms make poor decisions, especially financial firms, they should be allowed to fail. It is my opinion that no firm is ever too big to fail.

Euro-zone governments do not have many options in front of them that could return Greece to debt sustainability. They could, as their record suggests is more likely, take a more cautious approach toward Greece and prolong the questions about whether the country's debt will be repaid in full and on time.

What about contagion? After all, it looks as if the problem has already spread to Italy, with the prospect of more to follow. In my view, the difference between Italy and Greece is that Italy actually has a private sector to soften the blow of an austerity program put in place. Italy has done it before. Germany did it when East and West reunified. I believe that the other EU members will do the same. It will not be painless, but it is doable without the entire EU falling into a recession at this time. That being said, Greece is in a recession, has been in a recession for several years, and likely will remain there for some time. That does not mean that all of the EU will suffer the same fate. After all, not all state economies participate when the U.S. economy expands or when the overall economy contracts.

This brings us to a study released recently by the Federal Reserve Bank of San Francisco that highlights the European debt crisis as significantly increasing the risk of a U.S. recession.2 If concerns about Europe continue, this study could garner considerable attention in the financial media. According to the study, the probability of a recession sometime late this year or early 2012 is greater than 50 percent, driven largely by foreign risks. The probability of a recession based on domestic indicators is currently still very low but increases gradually through the second half of 2012 to about 30 percent before it starts to retreat again. Hence, it is the sharp climb in the risk of recession associated with indicators from other major developed economies, especially Europe, that greatly enhances the risk of recession next year.

There will be another recession but I doubt it will be in 2012. My guess at the moment is that it will be closer to 2014. My skepticism of the results from the San Francisco Fed study rests on two key factors. First, one of the more powerful indicators of recession in the U.S. is the yield curve—it always inverts prior to a recession although a recession does not always occur when the curve inverts. Yet the authors of the Fed study decided to drop the yield curve from their analysis because they argued its signal was misleading. It seems to me that for a recession-probability model to maintain its integrity over time, model users should not modify the model to fit their preferences. It may be that the yield curve is providing a very important positive offset to some of the other less favorable signals from the other indicators. After all, a positive sloped yield curve is an important channel of the impact of monetary policy on the economy. One would think that Fed economists would appreciate that channel more than most.

Second, the authors note that the signal from the foreign indicators is lower quality than the signal from the domestic indicators in normal times. I am not sure exactly what that means, but they seem to put more faith into the signal from the foreign indicators because they consider the current situation to be abnormal. This sounds like another the authors injected another judgment call in their analysis.

On the other hand, as the authors note in their study, the more imminent danger to the U.S. economy suggested by the foreign indicators does not directly reflect the health of the European financial system. The implication is that a financial crisis in European sovereign debt could be even more threatening to the U.S. economy than the San Francisco Fed study suggests. I still believe that much of the problem in Europe is political and that voters will realize it before the situation becomes a widespread economic problem.

Investment implications

I continue to believe that the economic and financial fundamentals in the U.S. are positive and, more importantly, improving. For that reason, my investment implications are little changed once again. I still think equities will be the best performing financial asset for all of 2011 and most likely for all of 2012 as well. The economy should continue to expand at a reasonable pace, which I define as 3.0 percent or more, and inflation should be subdued, although not as subdued as the Fed seems to expect. For this reason, I maintain my view that longer-term Treasury yields will head higher, even substantially higher by the end of next year regardless of whether the Fed raises its target on short-term interest rates. Indeed, I expect that market participants will put pressure on the Fed to raise short rates sooner than the Fed has advertised.

Europe, and to a lesser extent China, will continue to create noise in financial markets, including U.S. markets. After all, a quick and easy solution to the European debt problem does not exist. It will take time and it will involve some pain. However, I am confident that the situation will be more favorable for the U.S. economy than most economists now contend, including many Fed economists.

I believe my boast early this year that 2011 “will prove to be very challenging for investors” has played out very much as expected but for the wrong reasons. In 2012, the challenges to investors will not disappear but they may be less pronounced or less frequent. Indeed, higher interest rates in 2012 will actually be considered a good thing for the economy primarily because they will reflect higher inflation expectations more so than unusually high credit risk. If the Fed looks to be ahead of the inflation curve, financial markets will react favorably. It is when the Fed is viewed as behind the curve that investors get jittery.

In this regard, I continue to dislike long bonds of any kind but especially Treasury longer-term notes and bonds with exceptionally low coupons. As I noted before, investors who feel safe from interest-rate risk because they think the Federal Reserve will provide advance warning of higher rates may be sadly disappointed. The Fed may warn them but by then it will be too late. Indeed, because corporate earnings should remain solid and economic fundamentals should continue to improve, high-yield corporate bonds and many municipal bonds seem more attractive than U.S. Treasuries—for now.


1. Many people are very uncomfortable about what governments did during the last financial crisis but are having a difficult time explaining why. I believe the issue is that regulators and policymakers treated economic units differently. Under what seemed to be similar circumstances, some firms were allowed to fail, while others were not. For example, several large firms, both financial and nonfinancial, were provided taxpayer relief without any consequences, while others were allowed to fail. I think people are upset with this idea that firms can be too big to fail and are therefore subject to a different set of rules. Governments should either let them fail or prevent them from getting “too big” in the first place (enforcing anti-trust laws). In fact, this issue may explain why so many people can sympathize with the “Occupy Wall Street” protests but are unclear exactly why.

2. See Travis J. Berge, Early Elias, and Òscar Jordà, “Future Recession Risks: An Update,” Federal Reserve Bank of Dallas, Economic Letter, November 14, 2011.



The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

Mid-term updates to the Quarterly Reports - Surprise! (Aug 16)


November 2009 - LEQ (PDF)
February 2010 - LEQ
May 2010 - LEQ

August 2010 -LEQ
November 2010 - LEQ
February 2011 - LEQ
May 2011 - LEQ
August 2011 - LEQ


Executive Summary

Forecast at a Glance

Downgrading the U.S. Political Economy

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Executive Summary

Forecast at a Glance

Downgrading the U.S. Political Economy

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Executive Summary

Forecast at a Glance

Downgrading the U.S. Political Economy

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