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Equity Markets Hit New Highs; Will the Economy Follow?

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US equity markets are robust with the Dow Jones Industrial Average hitting new highs and other major market indices surging near historic peaks; however, economic data remain mixed and most economic forecasters expect 2013 US GDP growth of around 2%.  What accounts for this divergence of performance and are financial markets indicating a brighter future than economists expect?

Since 2008, first in response to the global financial crisis, and more recently in efforts to stimulate a weak economic recovery, major central banks have flooded markets with liquidity.  Through aggressive open market operations and an accommodative bank reserve policy, the Federal Reserve System has grown its balance sheet by 243% since the end of 2007.  Artificially low interest rates have driven investors out of cash and short term maturities to the riskier environs of longer bond maturities, speculative grade debt, and equities in search of higher returns.

Equities and riskier fixed income investments have performed well on the strength of this flow of funds, but without a corresponding improvement in general economic fundamentals, these returns are unlikely to be sustained, at least at the current pace.

Although the housing sector has improved and more jobs are being created, economic growth in the US and other OECD (Organization for Economic Co-operation and Development) countries will remain constrained by high debt levels in the public and household sectors, costly social welfare programs, and aging populations.

Despite these obstacles, strong financial market performance enhances economic morale and builds wealth.  Improved psychology and new wealth will flow into the general economy and will, perhaps, result in higher growth than the data would suggest.  This is the central bankers' bet and while the risks in exiting this bet are substantial, real benefit may be realized in the months ahead.  We are beginning to see some evidence of this benefit in our banking business with a stronger loan pipeline than we have seen for 2 or 3 years.  In any event, it is good to feel optimistic again and time will tell if the central bankers' bet pays off.

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Douglas L. Williams, President & CEO
March 22, 2013