ECONOMY EXPECTED TO BOUNCE BACK
It’s been a long winter, but with spring finally here, prospects for a renewed upturn in the U.S. economy are once again turning brighter. While the beginning of 2014 was marked by weaker economic growth, the recent slowdown most likely reflects the impact of temporary factors. The ongoing inventory adjustment, combined with severe winter weather, has weighed on consumer spending, manufacturing, and residential construction throughout much of the first quarter. However, as the year progresses we expect the data to continue to show strengthening economic fundamentals.
We have already seen some moderate rebound in the data, and assuming that the weather returns to seasonal norms, there is still room for economic activity in most sectors to rebound further. The better-than-expected February employment report, which showed a net gain of 175,000 jobs, likely points to a second-quarter rebound in the labor market. Consumers also appear poised to bounce back from the winter doldrums. The moderate rebound in February retail sales suggests that household spending is recovering after a tough December and January and should continue to improve in the coming months as consumers release some of their pent-up demand.
In recent quarters, consumer spending has been a strong point, and should employment start to rise at a faster rate, as we expect, then better income and consumption growth should soon follow. Businesses are starting to become more optimistic as well, with surveys indicating more business owners making plans to invest. Up until recently, there hasn’t been a need for businesses to invest in new equipment and structures because they weren’t fully utilizing their existing capital. Now, in many sectors, capacity utilization rates have returned to more normal levels and we would expect to see renewed investment growth as businesses seek to boost production to meet the pickup in demand.
On the policy front, the budget deficit has benefited from the recent significant fiscal drag, dropping from about 10% of GDP to about 3% of GDP. Sluggish economic growth during the early part of the year helped pull longterm interest rates lower, even as the Fed moved forward with its tapering. Lower interest rates are good news and strengthen our conviction that housing will continue to improve this year. Tapering will likely continue at its current measured pace and with inflation pressures benign, the Fed has ample leeway to remain accommodative. Rates are not expected to rise until mid-2015.
Markets have been in a consolidation phase this quarter, holding up despite the headwinds from political tensions in Ukraine, weakness in Chinese economic data, and last week’s Fed announcement. However, we still believe that improving growth, subdued inflation, and low interest rates create the right environment for risk assets to continue to perform well. Corporate earnings look to modestly accelerate in 2014 and equity valuations remain reasonable, particularly relative to fixed income. Although a market pullback is certainly a possibility, investors should maintain a long view and remember that trying to time the market can be an extremely difficult task.
THE FED At the most recent meeting of the Federal Open Market Committee (FOMC) — and the first one chaired by Janet Yellen — the monetary policy-making arm of the Fed announced further reductions to the stimulus that it provides the market. The FOMC will continue the tapering of its monthly bond purchases by an additional $10 billion, down to $55 billion. This marks the third consecutive reduction in accommodation from the original $85 billion per month prior to the initiation of the tapering. Even though the move was highly anticipated, it came as a surprise amid generally disappointing economic news from the past six weeks – something the Fed acknowledged but attributed solely to adverse weather conditions. The Fed also shifted away from quantitative guidance to a more qualitative approach with regard to future shifts in interest rates. In determining how long it will maintain the current low level of federal funds, it removed the target of 6.5% for the unemployment rate and replaced it with “a wide range of information,” including measures of labor market conditions, indicators of inflation pressures and expectations, and readings on financial developments. Clearly, the new guidance encompasses all three of the Fed’s mandates: employment, inflation, and financial stability.
EMPLOYMENT Following two consecutive months of weak labor reports, the February nonfarm payrolls rose by 175,000, putting them back on track with gains close to those occurring before the harsh winter weather set in throughout the country. The unemployment rate rose to 6.7% from 6.6% in January, the first increase in 14 months. This slight increase should not be taken as a sign of weakness and, furthermore, should be taken with a grain of salt. The two employment reports have been idiosyncratic lately: this most recent report does not alter the downward trend that has been occurring in the unemployment rate since hitting its peak of 10.0% in October 2009.
INFLATION While there have been some rapid increases in food inflation as of late, overall inflation continues to be relatively benign and well below the Fed’s target rate of 2.0%. For the past two years, the CPI has generally been in the 1.0 to 2.0% range. Currently, it registers at 1.1%, near the lowest point of this cycle, but up from 1.0% this past October. Although food prices were up in February, the sharpest monthly increase since September 2011, they were offset by a drop in energy prices, which was led by gasoline prices.
One of the biggest impacts on both domestic and global inflation has been the slowdown in economic growth in China, which has witnessed a year-over-year drop in GDP growth from 11.9% in 2010 to the current level of just 7.7% (it is important to note that the Chinese economy rarely falls below 7.0%). For the past few decades, China’s economy has made huge investments in infrastructure and real estate, which by their nature are highly commodityreliant. This put severe upward pressure on the prices of those related commodities. With economic growth now slowing and China’s move toward a service economy, commodity prices have fallen, pushing inflation down. Here in the U.S., commodities make up 40% of CPI, and these prices have fallen 0.8% in the past year. The remaining 60%, which comprises services, has grown 2.4% in the past year.
HOUSING There is a mixed picture on the current state of the housing sector. One complication is that during the winter months, when volume is at the lower end of its annual cycle, housing data becomes volatile, experiencing big swings in the monthly data. Adding to the confusion are the large revisions to the same data. This year’s weather, which has been one of the coldest and wettest in history, provided further complications to our ability to fully understand the trend. Generally speaking, housing has downshifted from its peak last summer. It is difficult to untangle the root cause of this trend, be it the higher level of mortgage rates, the higher cost of homes, the low levels of inventory, difficulty in obtaining credit, the reduction of institutional buyers, or, as of late, the adverse weather. The data does show that first-time home buyers accounted for just 28% of the purchases in February, which was up from an all-time low of 26% in January. The higher cost of a home and higher mortgage rates (the lower affordability index) may be part of the larger problem. But, like so many parts of the economy, housing has been on an erratic upward trajectory with mini rallies and trade-offs. Unlike other areas of the economy, which have surpassed their previous peaks, housing still has a long way to go before it can compare with historical standards.
CHARTS OF THE MONTH
While the U.S. deficit in trade and goods and services has been volatile recently, the underlying trend has been narrowing since 2006. The Great Recession made a significant improvement to the deficit, which was a result of the sharp reduction in imports.
A 35% reduction in imports during the recent economic turndown was more extreme than the previous recession, which only saw a 17% decrease in imports. Interestingly, the level of imports has not surpassed the previous peak that occurred during the recession. This is due in part to the weakened level of domestic consumption and lower energy imports.
Since the end of the recession, exports have been on a steady rise. They now stand at 16% above the previous peak that occurred during the recession.
The renaissance in the energy sector, driven by technological improvements in drilling and fracking, has decreased the amount of energy-related products imported and increased the amount exported. This deficit, currently at $19 billion, has been improving for two years.
The improvement in the energy sector is a major positive for the domestic economy because it creates good-paying jobs, reduces our dependence on foreign oil, and has the potential to be a GDP booster for many years.
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