The activity that's been catching many investors' attention recently has been in the markets, which have been manic to say the least. The S&P 500 Index fell more than 5% in June, only to rally more than 7% in July. This level of volatility and changing direction has left many investors dizzy, and certainly is deserving of analysis and review, as we have done in several of our recent Market Notes. But many of you have been asking the deeper questions about overall economic health and the potential for action by either Congress or the Federal Reserve. These are key questions and get to the heart of where our focus has been.

Certainly the recent data coming out about the U.S. economy has been one of the trend line slowing. We have seen this in the U.S. GDP announcement of 2.4% growth in the second quarter, with consumer spending coming in at a 1.6% increase. That was slower for both than their 3.7% and 1.9% first quarter showings, respectively, and below economists' expectations. We think this will continue to fuel the debate about the need for more stimulus and the cost of such a move.

How To Spur On Economic Growth?

There are two decidedly different ways the U.S. economy can be stimulated: through direct spending and through central bank activities. We have already seen the former, in the 2009 stimulus package, of which $400 billion is yet to be spent. And we have seen the latter in the form of quantitative easing and securities purchases by the Federal Reserve. Today, most economists are divided between the need for Congress to enact more stimulus, at a cost of increasing an already unsustainable deficit, or of austerity and tax increases at a cost of continued protracted unemployment and potential GDP contraction. We are also seeing a Federal Reserve which is acting with a wait and see approach as outlined by Chairman Bernanke in his address to Congress, and the president of the Federal Reserve Bank of St. Louis who went on record yesterday stating the need for the Fed to buy government debt now. We think the eventual answer will tend to be somewhere in between in both cases; stimulus that can be shown to be revenue neutral or close to it, and Fed actions that are moderate and directed by specific economic measures.

The current tax law places a large portion of the revenue burden on the wealthiest of Americans. As the Obama Administration considers the Bush?era tax cuts and their sunset provisions, there is a desire to maintain a tax advantage for those with income below $250,000 annually, which requires an increase on those making more than this amount. At issue, though, is that as annual income increases, the elasticity of taxation also changes. In other words, as wealth increases, so does one's ability to decide if he or she is going to recognize income and pay a tax. California has seen this very issue over the last few years, and we think the Federal government may be reminded of it again. Decreasing the deficit by tax increases is a very hard thing to do, and using tax increases to also fund stimulus makes it even harder.

We think stimulus, if used, will need to take the form of projects that have higher multiples of impact than what was seen in the last round. That is to say, a dollar of stimulus should be spent in a way that creates two or three dollars of increase in the overall economy. That tends to be less favored by individuals in the short run, since a tax refund check can be used to immediately reduce a credit card debt or make a house payment. But that dollar tends to stop there. A dollar used to construct infrastructure, for example, allows it to make its way through contractors, suppliers, and others, increasing its impact.

What Will The Fed Do?
The Fed also has its hands full. The chairman has said he stands ready to act if the economy warrants it, and most believe that action would be in the form of increasing liquidity by buying for the Fed's balance sheet government debt. We expect that action would tend to lower longer?term interest rates, based upon where along the maturity range the Fed makes its purchases, as well as weaken the dollar. The lowering of rates would be the primary objective, as the Fed would be trying to get private sector credit moving again. As we outline in our Third Quarter Chart Package, there has been considerable contraction in personal and business debt, which supports less spending and production. Such a purchase of securities by the Fed could also have positive impacts on stocks, at least in the near term, as the stock market sees some of that increased liquidity.

Our Forward?Looking View
So what do we see happening? In a word, plenty, though it will take time to play out:
We continue to think that we will see positive GDP growth for the rest of 2010, though at rates materially slower than the first half of the year.
Because of the sluggishness of the economy and the continued levels of unemployment, the Fed will keep rates at their current levels into 2011 and may be forced to begin securities purchases, should growth slow even more.
We do not see any appetite for additional government spending, beyond the current programs, to stimulate the economy and Congress will not consider it until after the November elections, if at all, in 2010.
We also do not believe Congress will address the income tax issues of the 2010 sunset provisions until after the elections, leaving a lame duck session to make some of the most important economic decisions of the next several years. In the end, we expect increases in taxes for the highest income earners, either in 2011 or perhaps a few years out, if Congress has the desire to punt the ball during the current economic environment to, say, 2012 or 2013.
Finally, the current levels of both debt and almost non?existent credit growth will mute overall demand and might even lead to price contraction. While the Fed is watchful for signs of ©2010 Wilmington Trust Corporation deflation, or dis?inflation as we like to think of it (since in modern fiat monetary systems, the central bank has the ability to create whatever level of near?term price action it wants), we do think the continued waning of growth has the potential to slip price changes from slightly positive to negative, much as they have been in Japan for years. Japan's position of near zero interest rates and slight deflation is considered to be a more stable economic environment than a U.S. stated target inflation rate of 2% while rates are near zero. Some growth is necessary in order to support a higher interest rate and thereby the targeted inflation rate. At these levels, dis?inflation becomes a real possibility.

Given all these moving parts, we will continue to support a widely?diversified allocation. We believe this really is the best defense for portfolios today. This much uncertainty should continue to stir markets, causing higher volatility and more periods like those we have seen over just the last two months. Our slightly defensive position places our clients in position to weather aspects of this storm.

R. Samuel Fraundorf, CFA, CPA, is president of Wilmington Trust Investment Management. This commentary originally appeared in Wilmington Trust's Market Notes newsletter.