Since the government reopened, investors have evaluated a host of U.S. economic data that provide a clearer picture of the economy, labor market prospects, and inflation—all factors in the Federal Reserve’s upcoming policy deliberation. While the data itself is mixed, signs of forward economic momentum and resilience continue with the shutdown having caused minimal damage. Helped by the likelihood that slower economic growth in the near-term means the Fed is expected to postpone tapering its bond purchases until early next year, investors have taken a decidedly optimistic stance sending stock markets to all-time highs.
The biggest cost from the recent budget standoff is the hit to consumer and business confidence. Unfortunately, the ongoing gridlock in Washington, and the uncertainty it creates, will continue to weigh on spending, hiring, and purchasing plans for some time to come. The short-term nature of the recent agreement means that lawmakers must pass a new budget resolution by mid-January or the government could shut down again. Compared to the 2011 debt ceiling standoff, the drop in sentiment measures this time around was milder, an encouraging sign that the U.S. economy is in better shape to weather troubles. With political drama receding from the headlines, gasoline prices and mortgage rates falling, and equity prices rallying, confidence will likely strengthen again over the coming months. In fact, retail sales climbed in October by the most in three months, indicating the federal budget battle was not enough to stop Americans from spending before the holiday-shopping season.
Looking into 2014, we expect U.S. economic growth to resume a modest upward trajectory. The consumer is at the heart of a self-reinforcing expansion and prospects for stronger spending growth continue to be supported by improving jobs and income, stronger household balance sheets, better borrowing and bank lending conditions, and low interest rates. Despite the recent rise in long-term rates, the housing recovery remains in place, providing indirect support to consumption. The fading of the fiscal drag should boost domestic demand while manufacturers are expected to benefit from a steady recovery in the global economy and fall in the dollar.
The implication of an improving macro outlook is that the Fed will soon begin scaling back its monthly security purchases. Asset purchases were never meant to go on forever, and a gradual return toward more normal levels should be viewed as a healthy development, indicating that economic growth is more self-sustaining and in less need of support. While we continue to believe a more likely start to tapering is sometime in the first quarter, the release of minutes from the October Federal Open Market Committee (FOMC) meeting has raised investor concerns that the Fed may begin as early as December, especially if the November employment report is surprisingly strong. Still, even if early tapering were to lead to near-term disruption, the much more important consideration for us is that policy will remain accommodative over the long-term. The Fed’s bias to err on the side of being too easy is well-entrenched, and neither tapering nor the changing of the guard is expected to alter its fundamental course, preserving the environment for risk assets to continue to perform.
Given our forecast for improving growth, subdued inflation, low interest rates, and ongoing easy monetary policy, the continued overweighting of equities is appropriate. Corporate earnings look set to modestly accelerate in 2014 and, despite the recent rally, equity valuations remain attractive relative to fixed income. Although we do not expect the same impressive gains seen in stocks this year to continue, and volatility is certainly possible especially as we approach another budget debate early next year, patient investors who can ignore the daily headlines should continue to be rewarded in the quarters ahead.
THE FED The FOMC is starting to look at different ways to help propel the economy into a faster growth trajectory. They are beginning to lay the groundwork to rely less on their asset purchase program (the Fed’s balance sheet is about $4 trillion in size) and rely more on forward guidance, a pledge to keep interest rates very low until certain economic targets are met. By doing so, it should convince households that interest rates should remain low and they can borrow and spend to help improve economic growth. The Fed is becoming less convinced of the effectiveness of increasing the amount of quantitative easing and is somewhat fearful of the effects on other markets. How and when the Fed will approach the tapering of their asset purchases is still unclear. They do not want to relive the attempt earlier this year when the markets mistook the possible reduction in stimulus as a signal that rates could rise. Interest rates rose more than 100 basis points and the economy slowed. The Fed was forced to withdraw its plans to taper.
The FOMC views economic activity continuing to rise at a moderate pace; however, they are concerned that businesses remain unusually cautious about investing and hiring due to “uncertainty about future fiscal policy and the regulatory environment, including changes in healthcare.”1 With the federal budget and debt ceiling debates reemerging, this outlook will probably not change.
EMPLOYMENT The recent employment report reignited optimism in the labor market. Nonfarm payrolls grew at an above-trend level of 204,000 in October and the previous two months were revised upward. The three-month moving average is now at 202,000, well ahead of the three-month average from last month, which was just 140,000. Clearly, the labor market appears to have weathered the federal government partial shutdown. Growth in average hourly earnings improved to 2.2% over the past year. This matches the recent high in August and stands at the highest level since mid-2011. Although this represents a low level at this stage of the business cycle, with inflation falling (due in part to lower gasoline prices) real incomes should continue to increase and may help improve the level of consumption. The unemployment rate ticked up to 7.3%, from 7.2%, the first increase since May. This was due to an unusually large drop in the labor force that also pushed the labor force participation rate down to 62.8, the lowest level since March 1978.
INFLATION Consumer prices slipped in October, the first decline in six months, due mainly to a 2.9% drop in gasoline prices. The year-over-year change in CPI currently stands at 1.0%, just half of the Fed’s target rate, and is at the lowest level since October 2009. During the past four years, we have seen the yearly change in CPI move in a range from 1.0% to 4.0% (September 2011). These moves have been heavily influenced by the shift in demand and commodity prices as many of the world’s economies have not been strong enough to consistently support higher prices. In the past year, the commodity-based portion of CPI, which includes energy, fell by 1.2%, compared to the service portion, which increased by 2.4%.
MANUFACTURING The ISM Manufacturing index, along with the employment and GDP releases, is considered one of the three most important releases in terms of having an impact on the financial markets. It is useful because it has a long history of tracking GDP well, but does not have the long lag time for its release that the GDP report has. The October release of this index rose to a 30-month high of 56.4. After hitting a recent low this past May, each monthly release of this index during the past five months has come in above market expectations. The average for the past five months has been 54.9, a significant increase over the previous five-month average of 51.7, based upon historical standards.
The manufacturing sector was one of the prime drivers that moved the U.S. economy out of the Great Recession. The federal government’s bailout of the auto industry and the “cash-for-clunkers” program together served as the primary catalysts for bringing auto manufacturing back to levels not seen since before the economic downturn. Since 2011, however, overall growth in the manufacturing sector has been relatively stagnant. This recent pick-up is welcome news as it is broad-based and expected to continue, representing an offset to the recent slower growth rate in the housing sector.
CHARTS OF THE MONTH
GDP There was good news with the advanced GDP report that showed a 2.8% growth rate in the third quarter, and marks the second consecutive quarter above 2.0% (second quarter growth was 2.5%). This places it above the average quarterly growth rate of 2.3%, which is what we have experienced since the end of the recession. The year-over-year (YOY) GDP growth remained unchanged at 1.6%.
All of the four major components of GDP advanced, with most of the increase coming from the Investment component, which was led by a pronounced increase in inventories.
Since the end of the Great Recession in June 2009, most of the components have been adding to growth. Only the Government component has been a net drag on the economy. The Investment component, led by strong housing, has added the most to GDP growth.
CONSUMPTION Consumer spending, which accounts for about 2/3 of GDP, increased 1.5% in the third quarter and is up 1.8% in the past year. The year-over-year change has been on a downward trend since June 2012 when it was 2.3%, but deceleration has begun to taper off in the past two quarters.
Within the Consumption component, the third quarter witnessed consumer spending of durable goods rising a solid 7.8% (driven by strong auto sales), and spending on non-durable goods increasing a respectable 2.7%. Spending on services (e.g. recreation, medical care) gained a paltry 0.1%. Spending on services, as a percent of GDP, has been falling since the end of the recession as consumers are being particular about how their limited amount of money is spent – replacing an aging fleet of vehicles is more important than many items that fall within the Service component.
INVESTMENT Investment was up a robust 9.5% in the third quarter, but it was a mixture of negatives and positives. Most notably, spending on equipment declined 3.7%.
However, within the Investment component there were two strong parts: inventories rose $86 billion (the largest increase in a year), and residential investment (housing) registered its fifth consecutive double-digit gain.
GOVERNMENT Government spending eked out a small increase, following three consecutive quarters of declines. This was due to increased spending at the state and local areas, where better tax revenue has improved finances. At the federal level, spending fell in the third quarter and continues a string of four consecutive quarters of decreases. In fact, it has only increased in two of the past twelve quarters.
TRADE There was a slowing of both imports and exports this past quarter. The deceleration in imports growth was more significant than that of export growth, so net trade was a positive for the quarter, following two quarters of being a drag.
THE BOTTOM LINE The 2.8% growth rate was an impressive number and was significantly better than the market expectation of just 2.0%, but overall growth remains moderate. The buildup in inventories is likely to contract from production in the fourth quarter. There are some key positives to the economic growth: ongoing housing recovery, continued growth in the energy sector and a marked increase in manufacturing. Furthermore, the drag from the federal government should dissipate, but until we see a meaningful increase in the consumer’s ability to increase spending, we expect it will be difficult for the overall economy to accelerate to a faster trajectory of economic growth.
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