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LPL F INANCIAL RESEARCH

Weekly Economic CommentaryJuly 23, 2012

John Canally, CFAEconomist LPL Financial

Beige Book Window on Main StreetMore Uncertainty, but Economy Still Growing

Highlights

Beige Book Barometer suggests modest growth, but still not back to “normal” on Main Street.

Uncertainty returns and is accompanied by concerns over Europe.

Both China and the looming fiscal cliff were mentioned in the latest Beige Book, but Main Street is not as concerned as the media is about these issues.

The Federal Reserve (Fed) released its Beige Book — one of our favorite economic reports — last Wednesday, July 18, 2012. The report provides market participants with valuable insights into the economy and the future of the Fed’s monetary policy actions. On balance, the latest Beige Book suggests that while economic and policy uncertainty is on the rise, the economy continues to plod along at a modest pace. Our view is that the current pace of growth is below what the Fed finds acceptable, and that another round of bond purchases — quantitative easing (QE3) — is likely from the Fed later this year.

The LPL Financial Research “Beige Book Barometer” is a diffusion index that measures the number of times the word “strong” or its variations (stronger, strength, strengthen, etc.) appear in the Beige Book less the number of times the word “weak” or its variations (weaken, weaker, etc.) appear [Figure 1]. At +61, the Beige Book Barometer is down from a recent high of +101 in the April 2012 Beige Book, and also below the +89 recorded in the June 6, 2012 Beige Book. However, it remains above where it was last summer (+30 to +50 range), suggesting that the economic backdrop is a bit more favorable this summer than last summer. Still, at +89, the Beige Book Barometer remains below the range seen in 2005 and 2006, the years just prior to the Great Recession. In short, the Beige Book Barometer is consistent with other more quantitative metrics on the U.S. economy that suggest that the economy is in recovery, but is still not back to “normal,” where normal is defined as the pre-Great Recession years of 2005 – 2006.

Beige Book BreakdownThe word clouds on pages 2 – 3 are dominated by words describing the tone of the economy at the time the Beige Books were published. Below are some observations on the current Beige Book relative to other recent editions of the Beige Book.

� The economy is still expanding at a modest pace.

� Themes that dominated the Beige Books last summer and fall — weak confidence, European concerns, and high uncertainty — which had nearly disappeared from the Beige Books released in early 2012, are starting to reappear amid the renewed turmoil in Europe. Importantly, the word “uncertain” and its variations appeared 30 times in the July 2012 Beige Book (up from 15 in the June 2012 Beige Book and a recent low of just

Please see the LPL Financial Research Weekly Calendar on page 3.

See page 4 for "Some Color on the Beige Book."

1 Beige Book Barometer Suggests Modest Economic Recovery, but Still not Back to Normal

Source: Federal Reserve Board, LPL Financial 07/23/12

2005 2006 2007 2008 2009 20122010 2011

150

50

-50

-150

Number of Times “Strong” (and Variations of This Word) Is Mentioned Minus Number of Times “Weak” (and Variations) Is Mentioned

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WEEKLY ECONOMIC COMMENTARY

nine in February 2012). The word “uncertain” appeared in the Beige Book 26 times as recently as the October 2011 Beige Book, after hitting a post- Great Recession peak of 38 mentions in the September 2011 Beige Book.

� The word “confidence,” which was used 11 times in the September 2011 Beige Book amid the worst of the situation in Europe, appeared just twice in the latest Beige Book. During last summer and early fall, the word confidence appeared an average of eight times in each Beige Book. Increased uncertainty, rather than lack of economic confidence, seems to best describe the current economic environment on Main Street.

� Warm weather, which almost certainly made an impact on economic activity in the late winter of 2011 and early spring of 2012, appears to have faded as an issue in the summer months. Although there was likely some “payback” as weather patterns returned to normal in the spring of 2012, we do not think the recent deceleration in the economy is weather related.

� The lack of rain and concerns over the drought in the midsection of the United States did show up in the latest Beige Book. The word “drought” was mentioned 13 times in July (up from just five in June 2012) and the word “crop” was mentioned 27 times. A look back to the Beige Book of a year ago (July 2011) finds that drought was also a concern (mentioned 12 times, just one fewer than in the July 2012 Beige Book). Looking ahead, we would expect drought and the damage to crops due to the lack of rain this summer in the Midwest to make a return appearance in the next Beige Book, due out in early September.

2 Uncertainty Makes a Comeback

Source: Federal Reserve Board, LPL Financial 07/23/12

Number of Times “Strong” (and Variations of This Word) Is Mentioned Minus Number of Times “Weak” (and Variations) Is Mentioned

Jul 2012

Jun 2012

Apr 2012

0

2010

Uncertainty

Gasoline

Gasoline

Gasoline

Weather

Weather

Europe

Drought

Uncertainty

Drought

JapanUncertainty

Uncertainty

Jul 2011

Trending Words in Various Beige Books

Source: The Federal Reserve Beige Book, LPL Financial 07/23/12

3 Beige Book Word Cloud: July 2012


4 Beige Book Word Cloud: June 2012

How the Barometer WorksThe Beige Book Barometer is a diffusion index that measures the number of times the word “strong” or its variations appear in the Beige Book less the number of times the word “weak“ or its variations appear. When the Beige Book Barometer is declining, it suggests that the economy is deteriorating. When the Beige Book Barometer is rising, it suggests that the economy is improving.



Fed Global Notables

LPL Financial Research Weekly Calendar

U.S. Data

2012

23 Jul � Markit PMI (Jul) � China: HSBC PMI (Jul)

24 Jul � Richmond Fed (Jul) � Netherlands: Bond Auction � Eurozone: Markit PMI (Jul)

25 Jul � New Home Sales (Jun) � UK: GDP (Q2) � Germany: IFO (Jun) � Germany: Bond Auction � New Zealand: Central Bank Meeting � Thailand: Central Bank Meeting � Philippines: Central Bank Meeting

26 Jul � Durable Goods Orders (Jun) � Initial Claims (7/21) � Pending Home Sales (Jul) � Kansas City Fed Mfg. Index (Jul)

� China: Leading Index (Jun)

27 Jul � GDP (Q2 and revisions) � Consumer Confidence (Jul)

� Olympic Games open in London

Unofficial Pre-FOMC

Quiet Period

� The financial media is chock full of stories on the looming fiscal cliff in the United States (please see the 2012 Mid-Year Outlook for more details) and on the likelihood of a hard landing in China. The Beige Book tells a slightly different story, but does suggest that concerns over fiscal issues and China are having some impact on economic activity on Main Street. There were six mentions of the word “fiscal” in the latest Beige Book, up from just two in June 2012, and either one or two mentions over the past nine months or so. We expect more mentions of the fiscal cliff in the coming months. China was mentioned just three times in the Beige Book, up from two in June 2012. The recent peak for mentions of China was six in the January 2011 Beige Book. We continue to expect a soft landing, not a hard landing, in China. Even so, we expect China to continue to be a heavy topic of conversation in the media in the months ahead, but thus far, bankers and business owners on Main Street seem less concerned than the media about China. �


5 Beige Book Word Cloud: April 2012



LPL Financial Research 2012 Forecasts � GDP 2%*

� Federal Funds Rate 0%^

� Private Payrolls +200K/mo.†

Please see our 2012 Outlook for more details on LPL Financial Research forecasts.

Some Color on the Beige BookAs we noted in the June 4, 2012 Weekly Economic Commentary, the Beige Book compiles qualitative observations made by community bankers and business owners about economic (labor market, prices, wages, housing, nonresidential construction, tourism, manufacturing) and banking (loan demand, loan quality, lending conditions) conditions in each of the 12 Fed districts (Boston, New York, Philadelphia, Kansas City, etc.). This local color that makes up each Beige Book is compiled by one of the 12 regional Federal Reserve districts on a rotating basis — the report is much more “Main Street” than “Wall Street” focused. It provides an excellent window into economic activity around the nation using plain, everyday language. The report is prepared eight times a year ahead of each of the eight Federal Open Market Committee (FOMC) meetings. The next FOMC meeting is July 31 – August 1, 2012.

The previous “word clouds” or “text clouds,” which are a visual format useful for quickly perceiving the most important words in a speech, text, report, or other transcript, are culled from the Fed’s Beige Books published in July, June, and April 2012. In general, the more often a word appears in a speech, text, report or other transcript, the larger that word appears in the word cloud. The word clouds show the top 50 words for the Beige Books mentioned above. Similar words are grouped together and common words like “the,” “and,” “a,” and “is” are excluded, as are words that appear frequently in all Beige Books (Federal, district, loan, level, activity, sales, conditions, firms, etc.).


Member FINRA/SIPC of 5

RES 3782 0712Tracking #1-086023 (Exp. 07/13)

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

* Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

^ Federal Funds Rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

† Private Sector – the total nonfarm payroll accounts for approximately 80% of the workers who produce the entire gross domestic product of the United States. The nonfarm payroll statistic is reported monthly, on the first Friday of the month, and is used to assist government policy makers and economists determine the current state of the economy and predict future levels of economic activity. It doesn’t include: - general government employees - private household employees - employees of nonprofit organizations that provide assistance to individuals - farm employees

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.

The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System, is charged under the United States law with overseeing the nation’s open market operations (i.e., the Fed’s buying and selling of United States Treasure securities).

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

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Jeffrey Kleintop, CFAChief Market Strategist LPL Financial

LPL F INANCIAL RESEARCH

Weekly Market CommentaryJuly 23, 2012

Will Economic Surprises Bring a Market Surprise?

HighlightsIn the past few weeks, market and economic performance have decoupled.

This may be explained by the weak economic data increasing the odds of a new Federal Reserve (Fed) stimulus program that may be holding Treasury yields down even as it boosts the stock market.

A gap in market and economic performance similar to the current one appeared in July of 2011, only to close with a sharp drop in the S&P 500.

Economic data continues to disappoint. The economic surprise index, which measures whether data reports come in better or worse than economists’ estimates, has continued to fall for the world’s largest 10 economies.

The performance of the stock versus the bond market over the prior three months has tended to track the economic surprise index closely in recent years. But in the past few weeks, market and economic performance have decoupled, as you can see in Figure 1.

Consistent with this pessimistic tone of the economic data, the yield on the 10-year Treasury note has fallen to near all-time lows as investors bid up prices for Treasuries by 4% over the past few months as they seek a safe haven from risk. Yet stocks proved resilient to the data in recent weeks as the S&P 500 recouped some of the earlier losses and are now about flat over the past three months. This relative performance is a far cry from the 20% gap suggested by the economic surprise index.

1 Markets Have Decoupled From Economic Performance

Source: LPL Financial, Bloomberg Data 07/20/12

The S&P 500 is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data.

2007 2008 2009 2010 2011 2012

100

50

0

-50

-100

-150

40%

20%

0%

-20%

-40%

-60%

Citigroup Economic Surprise Index G10 (Left Scale)3-Month Return of S&P 500 Less Total Return of Barclays 10-Year Treasury (Right Scale)

WEEKLY MARKET COMMENTARY

LPL Financial Member FINRA/SIPC Page 2 of 3

Stocks have either priced in an expectation for a sharp turnaround in economic performance or investor behavior is being driven by factors other than the economy. However, earnings, Europe, and the election are not likely to be the drivers.

� While stocks have tended to rise during the earnings season, as we pointed out a few weeks ago, the earnings reports thus far in the second quarter 2012 reporting season are not particularly strong on an absolute or on a relative to expectations basis.

� The situation in Europe has not improved as demonstrated by yields on Spanish debt rising over 7% on Friday.

� And election polls on the presidential race in the United States remain close with no clear breakout for either candidate for the markets to react to.

Instead, the reason for the markets’ behavior may be the Federal Reserve (Fed). Last week’s semi-annual testimony by Ben Bernanke in front of Congress was the catalyst for the gains as stocks turned around on the Fed chairman’s comments on Tuesday, July 17 and headed higher for the next couple of days. His downbeat comments on the economy suggested the Fed may announce another stimulus program before the year is over.

The stock market would welcome a third round of stimulus as an inoculation shot against the economic drag of tax increases and spending cuts on tap for next year. The potential for Treasury purchases by the Fed that would likely be part of the stimulus program may also be holding Treasury yields down even as it boosts the stock market.

For the gap between market and economic performance depicted in Figure 1 to close, either upcoming economic data must surprise to the upside or stocks need to drop sharply. It is notable that a gap similar to the current one appeared in July of 2011. Ominously, that gap closed with a sharp drop in the S&P 500, as you can see in Figure 2. n

2 Will the S&P 500 Follow Last Year’s Pattern in August?

Source: LPL Financial, Bloomberg Data 07/20/12

The S&P 500 is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

Jan Feb Mar Apr NovOctSepAugJulJunMay Dec

1450

1350

1250

1150

1050

20112012

WEEKLY MARKET COMMENTARY

Member FINRA/SIPCPage 3 of 3

RES 3781 0712Tracking #1-085867 (Exp. 07/13)

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Treasuries: A marketable, fixed-interest U.S. government debt security. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level.

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