Weekly Economic and Financial Commentary

*Moderate Economic Recovery Remains Under Way*
* Economic indicators released during the week continue to suggest a
moderate recovery is underway. The nominal trade deficit narrowed
slightly from a revised $38.4 billion in October to $38.3 billion
in November. The upside risk to the forecast from international
trade, however, will likely by tapered by less inventory building.

* The Fed's Beige Book also noted moderate economic conditions in
most districts. Districts' with higher concentrations of
manufacturing, retail and nonfinancial services sectors saw better
activity.

*Fourth-Quarter Real GDP Brings Brighter Days*
Economic indicators released during the week continue to suggest a
moderate recovery is underway. The nominal trade deficit narrowed
slightly from a revised $38.4 billion in October to $38.3 billion in
November. Exports and imports both nudged higher on the month. Exports
have now risen for the third consecutive month with increases being
driven by solid growth in the rest of the world. While the real trade
deficit widened to $45.2 billion, October's sharp narrowing will help
contribute around 1.5 percentage points to fourth-quarter real GDP.

The upside risk to the forecast, however, will likely by tapered by
less inventory building. Business inventories rose 0.2 percent in
November, which means part of the outsized contribution from
international trade could be offset by less of a contribution from
inventories. Consequently, our estimate for fourth-quarter real GDP
remains unchanged at an increase of a 3.4 percent annual pace. The
Fed's Beige Book also noted moderate economic conditions in most
districts. Districts with higher concentrations of manufacturing,
retail and nonfinancial services sectors saw better activity. As
expected, residential real estate markets remained weak across all
districts and commercial construction remained slow. Labor markets in
most districts appear to be firming somewhat, but with virtually no
upward pressure on wages. Districts also mentioned increasing cost
pressures but only modest pass-through into final prices because of
competitive pressures. This week's producer price index and consumer
price index both corroborate this story. Wholesale prices rose a
morethan- expected 1.1 percent in December with prices further back in
the pipeline continuing to build momentum. The consumer price index,
however rose only 0.5 percent, which suggests very little pass-through
to the consumer.

One of the more disappointing reports released this week was the Small
Business Optimism Survey conducted by the National Federation of
Independent Business. Small businesses play a critical role in the
economy and make up around 45 percent of private-sector employment.

The survey fell 0.6 points in December and showed little to no
improvement in most of its key components. Small businesses remain
pessimistic about the nearterm economic outlook and credit conditions
were tighter on the month. While hiring plans picked up to their
highest level since September 2008, the level remains at historic
lows.

Speaking of jobs, labor market indicators for the week were also less
than encouraging. Initial jobless claims rose by 35,000 to 445,000,
dashing hopes of a quicker-than-expected labor market recovery. On a
trend basis, the four-week moving average rose by 5,000, to 416,500.

While the increase was disappointing, it remains below the average of
around 460,000 since January. The Job Openings and Labor Turnover
Survey also illustrated a sluggish labor market. The hires rate, which
is the rate of hires as a percentage of total nonfarm payrolls fell to
3.2 percent, while the separations rate rose to 3.2 percent in
November from 3.1 percent.

!! Housing Starts • Wednesday !!
November housing starts rose 3.9 percent to a 555,000-unit pace.
Single-family starts in November rose a modest 6.9 percent, while the
more volatile multifamily starts declined 9.1 percent. The slight
increase in housing starts is welcomed news, but the positive reading
was likely due to seasonal adjustment factors as opposed to signaling
a rebound in starts. Single-family housing permits in November were
running below the level of housing starts, which suggests continued
weakness in the housing starts numbers. Our expectation is that
housing starts fell in December to 546,000 units. With a large number
of homes in foreclosure combined with the oversupply of existing
homes, we anticipate continued weakness in housing starts. Our
forecast for 2011 continues to indicate that starts will improve
slightly this year by approximately 680,000 units; however the pace of
starts will likely be agonizingly slow over the next few quarters.
Previous: 555K Wells Fargo: 546K Consensus: 550K

!! Initial Jobless Claims • Thursday !!
Initial jobless claims, a leading indicator of the labor market, have
continued to signal gradual improvement in the unemployment situation.
This week, initial claims rose to 445,000, an 8.5 percent increase
from the previous week. The slight increase is likely due to noise
from temporary holiday workers. Although week-to-week changes may show
some slight increases, the trend as measured by the four-week moving
average continues to indicate a gradual decline in the number of
initial jobless claims. Based on historical trends, the fact that
claims are trending towards the 400,000 level signals that slightly
stronger labor market is on the horizon. Continuing claims have also
shown signs of gradual improvement declining by 248,000 or 6.0 percent
this week. We anticipate continual improvement in the labor market
over the next year with a monthly average of approximately 160,000
jobs created.
Previous: 445K Consensus: 425K

!! Leading Economic Index • Thursday !!
The leading indicator index, which increased 1.1 percent in November,
continues to provide further evidence of modest economic growth. Many
of the leading indicators that make up the LEI have improved.
Specifically, interest rate spreads and the pace of supplier
deliveries helped to boost the index slightly higher in November. The
only component that detracted from the index was building permits,
which have continued to show the weakness in the housing market. As of
the November reading, the LEI has increased for the fifth consecutive
month. Additionally, the six-month trend continues to improve, up 4.4
percent on an annual basis. We anticipate that the positive trend in
the LEI continued in December, increasing 0.7 percent. The overall
improvement should be led by continued positive contributions from all
major categories with the exception of supplier deliveries which were
slightly lower in the previous ISM reading.
Previous: 1.1% Wells Fargo: 0.7% Consensus: 0.6%

*Strong Growth in Latin American Exports*
* The last months of 2010 saw a large increase in exports from Latin
American countries to the rest of the world. Although some of this
increase may be reflecting an increase in commodity prices the
sheer strength and size of the move in export numbers from the
region cannot be explained solely by this increase in prices.

* Growth numbers for the last quarter of the year for the world
economy, but especially for emerging markets, may surprise on the
upside as the export sector in Latin America is not showing any
signs of slowing down, just the opposite.

*Strong Growth in Latin American Exports*
The last months of 2010 saw a large increase in exports from Latin
American countries to the rest of the world. While some of this
increase may be reflecting an increase in commodity prices, the sheer
strength and size of the move in export numbers from the region cannot
be explained solely by this increase in prices.

Although this contention is very difficult to prove, there are some
countries in the region that provide the segmentation regarding
whether exports increase due to price effects and/or quantity effects.
Argentina is such a country and the one we will use for this
explanation. In the case of Argentina, exports increased by 23.3
percent in November 2010 compared to the same month a year earlier.
Out of this increase in the value of exports, the quantity of goods
exported increased by 12 percent while the price of those goods
increased by 10 percent.

Meanwhile, imports of goods, which, of course, are exports of other
countries to Argentina, increased by 53 percent in November,
year-over-year. Of this increase in imports to Argentina the quantity
of goods imported increased by a whopping 39 percent while prices of
these imports rose by only by 9 percent.

For Brazil, exports during December 2010 surged by 52.5 percent
compared to December 2009. Although we don't have the numbers
regarding the composition of this increase in imports, we can deduce
from Argentina's numbers that the increase in the value of exports was
due, fundamentally, to an increase in the quantity of goods exported
by Brazil rather than by only an increase in price effect. By looking
at the breakout in Brazilian exports during December 2010 it is clear
that raw materials were leading the way with metals and petroleum in
the vanguard of the charge. In fact, petroleum exports increased by
192 percent in December 2010 compared to December 2009. However,
petroleum prices increased by only 20 percent during the same period
of time. Meanwhile, iron ore exports surged by 208 percent during this
period with the largest buyers of iron ore being China, Japan and
Germany.

Mexican exports were also strong at the end of 2010, increasing by
25.9 percent in November compared to the same month a year earlier.
Although Mexican exports may have been helped more by the increase in
commodity prices than Argentina and Brazil, Mexican exports were
already growing strongly a year ago and thus they are also benefiting
from an increase in the quantity of goods rather than this being just
a price issue.

The bottom line here is that growth numbers for the last quarter of
the year for the world economy, but especially for emerging markets,
may surprise on the upside as the export sector in Latin America is
not showing any signs of slowing down, just the opposite. And since a
large share of Latin American exports to the rest of the world
comprise raw materials for the production of other goods then it is
clear that even growth for developed countries may also surprise on
the upside once these numbers are released.

!! U.K. CPI • Tuesday !!
Consumer prices in the United Kingdom increased 0.4 percent in
November, lifting the year-over-year inflation rate to 3.3 percent - a
six-month high. The inflation rate has remained at or above the Bank
of England's (BoE) ceiling of 3 percent in each of the first 11 months
of 2010. December consumer prices are due out on Tuesday of next week,
and we expect to see a twelfth month where inflation is above 3
percent. This will increase pressure on the BoE to reign in prices
without snuffing out the recovery.

Prices could be pushed even higher in January by an increase in the
value-added tax - a national sales tax. Prices are not the only
measure influenced by the tax hike. Retail sales for December are due
out on Friday of next week and we may find that U.K. consumers
increased spending in December to get major purchases in ahead of the
higher tax rate in January.
Previous: 3.2% Wells Fargo: 2.9% Consensus: 3.3% (Year-over-Year)

!! German Zew Index • Tuesday !!
The December reading of the ZEW economic sentiment survey suggested an
improving outlook for the largest economy in the euro-zone, despite
indications of an intensifying sovereign debt crisis. This view was
confirmed by the Ifo business climate survey which surged to a record
high in November before slipping by a tenth of a point in December.

Subsequent German economic data have been mixed. November retail sales
figures were a disappointment, but factory orders jumped 5.2 percent
in November. The German PMIs both remain firmly in expansion
territory. Will sentiment deteriorate as a result of the escalation of
the sovereign debt situation? We will find out next week when the
December reading of the ZEW survey hits the wire on Tuesday and the
Ifo survey comes out on Friday.
Previous: 4.3 Consensus: 5.8

!! Chinese GDP • Thursday !!
The Chinese economy expanded 9.6 percent on a year-over-year basis
through the third quarter of 2010. While the outturn was slightly
stronger than the consensus estimate, it marked a slowing in the pace
of Chinese economic growth. Growth was held back by measures
implemented earlier in the year to reign in Chinese lending.

Fourth-quarter GDP data are due out on Thursday of next week and we
expect to see the world's second-largest economy grew at about the
same rate for the full year 2010.

Also due out next week are the latest readings for both retail sales
and industrial production. Both measures are expected to show
double-digit percentage growth on a year-over-year basis.
Previous: 9.6% Wells Fargo: 9.4% Consensus: 9.4% (Year-over-Year)

!! Interest Rate Watch !!
_Recovery Takes Shape: Rising Rates_
While our outlook for sustained economic growth has been in place for
a while, the recent rise in food and energy prices suggest another
force building the case for rising intermediate and long-term interest
rates post-QE2. Disappointing harvests around the world have led to
sharply higher farm prices. Oil prices have also risen due to rising
demand and limited supplies. Increases in food and energy prices are
expected to drive the headline CPI up 2.0 percent in 2011.

Growth at three percent and rising inflation means we have seen the
lows for interest rates in this cycle. Of course, there may be a
temporary dip in rates as expectations adjust, but over the course of
the year longterm Treasury rates are expected to rise.

Yet, we also recognize that this pattern of rising rates during an
economic expansion is actually the typical business cycle pattern. The
challenge is that the rise in rates should be met by an increase in
the expected rate of return on invested capital. Therefore, a rise in
rates that reflects better growth expectations and the end to
deflation concerns would be consistent with continued economic growth
- not a double dip.

Why are interest rate rises key for our view on the economy? Concerns
about U.S. fiscal deficits or the dollar or a rapid rise for inflation
would send a very different signal to the markets and would be met by
a turn to the dark side of economic growth.

We expect U.S. fiscal deficits to decline modestly, but if this turns
out to be too optimistic then the excess demand for credit by the
Treasury will outstrip supply and rates would rise faster than the
expected rate of return on capital; thereby weakening investment
spending and growth.

Similarly, concerns about the dollar or an outsized rise of inflation
would produce a rise in rates not associated with a better economy and
therefore would exert downward pressure on the economy. Credit markets
and interest rates are always a balancing act - for now in our favor.

!! Consumer Credit Insights !!
_Mixed Signals from Small Businesses_
The Small Business Optimism Index dipped slightly to 92.6 in December
from 93.2 in November, which was the highest since the recession
began. On the positive side, capital spending plans increased, while
sales expectations and hiring plans were the highest in over two
years. Dragging down the index were a drop in plans to increase
inventories, a decline in the earnings outlook, a near halving of the
share expecting a better economy and a slight worsening of credit
conditions. The share experiencing an easing of credit conditions was
-11 percent. This says that more small businesses are experiencing
tighter credit conditions on net. While this may not sound good for
the lending outlook, the truth is that this indicator has never been
positive since records began in 1999. In addition, it is off the lows
of -16 percent reached several times in the last couple of years.

Although hiring plans, spending plans and sales expectations rose,
this does not necessarily mean more small businesses will come seeking
a loan. Bank loans on the balance sheets of non-farm, non-corporate
businesses have dropped for seven consecutive quarters through the
third quarter and are down nearly a third from the peak. And although
small business cash reserves are down 15 percent from the peak, they
are still nearly triple levels seen seven years ago. It will likely be
some time before sales are strong enough and cash reserves are low
enough for small business loan demand to rebound.

Are Price Pressures Starting to Emerge?
This week's release of several inflation indicators may raise some
concerns about the onset of a longer-term inflationary spiral. In
short, we do not think this sort of inflation spiral is likely to
occur. The recent increases in the consumer price, import price and
producer price indices reflect upward pressure from two main sources:
energy and commodity prices have been rising steadily over the past
couple of months. While the increase in prices from these two sources
may be putting some strain on household budgets, there is little
evidence to suggest that the food and energy price pressures will
spill over to other goods and services.

We can see from the graph to the right that in the 1970s, core
inflation was highly correlated with headline CPI numbers. The reason
for the tight relationship can be attributed to wage contracts during
this time period. Most of these contracts required wage increases to
keep pace with headline inflation. The result was a spill-over effect
that allowed higher volatility in food and oil prices to spill over
into wages, thus affecting both core and headline inflation readings
by nearly the same amount. The higher costs of food and energy today
are not likely to produce the same effects that were observed in the
1970s. We now see greater separation between the core CPI and the
headline numbers as a result of the reduction in the number of
inflation-adjusted wage contracts. Evidence of this change can be seen
in 2008 when oil prices led to higher headline CPI numbers while the
core values remained relatively stable. The large volatility of food
and gasoline prices underscores the reason for measuring core
inflation. Another key factor that will likely prevent more widespread
inflationary pressure is the high unemployment rate. Today's
employment situation makes spill-over effects on wages unlikely due to
the scarcity of jobs and the willingness of employees to accept lower
wages. Therefore, unless we begin to see the core inflation measure
begin to rise, our outlook for inflation will remain subdued.