The U.S. economy is snapping back with the latest government estimate showing GDP rising 4.0% in the second quarter. In addition, the decline of first quarter GDP was trimmed to 2.1%, from 2.9%, while other revisions show the economy growing at an even faster pace than previously thought in the second half of 2013. These new numbers help to make sense of recent conflicting economic data such as the strong pace of job creation, which has stood at odds with the contraction in overall economic growth in the first quarter.
Although the recent volatility in quarterly GDP can be frustrating, the important takeaway in our minds is that the economy remains resilient and that improving underlying fundamentals continue to set the stage for an upcoming pickup in economic activity. A stark difference between the current cycle and previous ones is that five years into the expansionary phase, the U.S. economy has not yet been able to make the transition from recovery to a stronger, more sustainable rate of growth. By historical standards, the U.S. economy should have already exceeded its full capacity and the Federal Reserve would have started to raise rates to prevent an overheated economy. However, we are confident that there is reason not to give up hope for faster growth ahead.
We believe the case for stronger output going forward is compelling. Employment growth has accelerated to its best six-month pace since 2006. Consumer and business confidence is slowly, but steadily, rising to more normal levels, and household balance sheets have recovered. At the same time, financing costs are low, firms have plenty of cash on hand, and banks are starting to make more loans. As demand grows, these factors should help enable corporations to boost investment, leading to much needed labor productivity gains, and eventually higher income growth.
Worries of secular stagnation have arisen as the deep downturn and slow recovery have meant that the U.S. economic growth rate in the last decade has fallen to 1.8%, well below the historical average of 3.0%+. While job gains have been a recent bright spot, the 200,000 average pace over the last two years would be more promising if labor productivity had not slowed to a crawl. Even a rebound in growth rate of output per worker to 1.5%, last experienced in 2012, would be enough to lift GDP growth to 3.0%+.
So far, capital spending, a key driver of labor productivity, has been unable to maintain the gains needed to ensure a satisfactory recovery in labor productivity and overall economic growth. We believe corporate caution that resulted from the scars of the 2007 downturn and uncertainty regarding government policy has been the main contributor to this slower pace of capital spending growth. However, the recent rebound in business investment in the second quarter is encouraging and rising capacity constraints signal stronger gains over the next year or two. Along with diminished fiscal drag and better consumer spending, this should help lift domestic demand growth above the recent trend for the remainder of 2014 and into 2015.
As the pieces for improvement in economic activity fall into place, the successful transition to self-sustaining growth will remove one layer of uncertainty and should if recent history is any guide, the road ahead is bound to be bumpy. Slow global growth remains a headwind, while unpredictable geopolitical crises such as the unrest in Ukraine or the recent flare up in the Mideast have the potential to damage international trade, disrupt energy supplies, and roil financial markets. Despite all of these factors, the U.S. economy appears resilient, capable of dealing with risks should they materialize, and poised for better days ahead.
THE FED Despite the economy entering its sixth year of expansion and having significant improvements in the labor market recently, Chairwoman Janet Yellen, testified to Congress on July 16th that “the recovery is not yet complete” and that “a high degree of monetary policy accommodation remains appropriate.”
With the asset purchase program, often referred to as quantitative easing (QE), the Fed has purchased more than $3.5 trillion in securities over the past several years. Those securities, combined with the near $1 trillion in securities they had before QE started, gives the Fed about $4.5 trillion in assets. This enormous holding of securities outside the market has kept downward pressure on intermediate and longer-term interest rates. This in turn has kept financing costs down for businesses and has helped subsidize markets that are reliant on low financing costs, such as the housing and auto sectors.
The Fed has stated that it expects to terminate the acquisition of any additions to its balance sheet this October. Based upon Yellen’s statement regarding the need to keep a high degree of monetary policy accommodation, it is believed that the Fed plans to hold the roughly $4.5 trillion level steady by reinvesting all future coupons and principal payments, which will continue to maintain that same downward pressure on interest rates.
EMPLOYMENT The July employment report marks the sixth consecutive month of 200,000-plus workers being added to the payroll, helping to keep the unemployment rate at 6.2% – down 1.1 percentage points from last year.
Job gains have been widespread across the industries, reinforcing the belief that the consistency of these robust job gains will continue. Over the past six months, payroll gains have averaged 244,000 per month – nearly double the average of all the other months since the end of the recession. A frustrating and somewhat disappointing aspect of this report is that increased demand for workers has not done much to budge wage gains. Average hourly earnings, which are up just 2.0% in the past year, have been at this level for almost three years. Normally at this stage of economic expansion, wage gains are in the range of 3.0% to 4.0% due to labor shortages. This low level of wage gains is a metric the Fed uses to gauge the slack in the labor market, helping to determine if it can defer the raising of interest rates.
INFLATION Price increases are gradually moving back to the Fed’s 2.0% target rate. The Consumer Price Index (CPI) currently stands at 2.1% for the past year, while the Core Personal Consumption Expenditures Price Index (PCE), the Fed’s preferred inflation gauge, is at a less pronounced 1.5% for the same period of time.
While the sudden increase in the inflation rate has contributed to a more heated debate on Fed policy, it is not expected to prompt the Fed to tighten policy any faster. Many Fed offi cials have stated that they are tolerant of higher prices during this period of ultra-low interest rates, all in an effort to strengthen the labor market. Despite this statement, the situation is still a difficult balancing act for the Fed. Very low interest rates increase the risk of higher prices, which we are starting to see. At the same time, the labor market will need to strengthen enough so that wages increase faster than inflation in order to allow workers to have more purchasing power. Currently, though, all we have are higher prices, mostly from food and energy components.
HOUSING The housing market continues to remain in recovery mode. Since the recession ended five years ago, existing home sales have been on an erratic, but slight, upward trend characterized by mini increases in monthly sales followed by sudden decreases in those sales. During those five years, sales have been averaging 4.6 million homes per year, down sharply from the 6.2 million annual rate in the five years prior to the onset of the recession. Since hitting a cycle peak last summer, more recent existing home sales have come under significant pressure, due in part to higher mortgage rates (which increased more than 1.0%) and an extremely frigid winter. The spring thaw brought out more interested buyers looking for homes and, combined with a recent pullback in mortgage rates and relatively easier access to credit, have helped give a boost to home buying. Prices, while still moving up, are increasing at a slower rate, making it easier for prospective buyers to afford a home.
CHARTS OF THE MONTH
MANUFACTURING Manufacturing employment is growing at a stronger pace than in the previous expansion. In part, it is benefiting from the “on-shoring” of jobs, due to factors such as the rising cost of foreign labor and lower domestic energy costs.
For those whom are working in manufacturing, the average work week is now at 42.0 hours. The extended work week tends to be a good leading indicator for continued employment growth.
In the past few decades, as the American economy has been transforming to a service-oriented economy, manufacturing payrolls, as a percentage of the labor force, have been decreasing while the amount of manufacturing output has been increasing.
The outlook for manufacturing continues to look good as the Purchasing Managers Index (PMI) has been in the expansion phase for most of this recovery.
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