GETTING BACK TO THE OLD NORMAL
Despite a volatile start to the year for investors, the outlook for the economy and stocks remains positive. In fact, things are beginning to look a bit more like the “old normal.” After a great deal of restructuring and adjustment in the wake of the financial crisis, and years of “new normal” sub-par growth, the economy appears to at last be on firmer footing with none of the dangerous imbalances that can presage economic trouble. The key drivers for sustainable growth are also gaining traction. Indeed, as the crisis mentality that has dominated headlines continues to fade into the background, and policy is beginning to normalize, we see economic growth and interest rates starting to return to longer-term averages.
The latest data certainly echoes the theme of expanding economic activity and renewed momentum. By some measures, Americans are expressing the highest level of confidence in years, while other reports point to steady expansion in the manufacturing sector, a pickup in business investment, and continued recovery in the housing market. Even the disappointing employment figures in December appear to be mostly related to the unseasonably cold weather, rather than a genuine slowdown, as more forward-looking indicators continue to suggest that the labor market is strengthening. Indeed, there are few signs of any impediments to building consumer demand, with the three-month annualized growth rate of core retail sales reaching its highest rate in nearly two years.
In the public sector, we believe fiscal drag is moving toward neutral while the federal deficit is set to shrink to its smallest level since 2008. Last year’s political brinkmanship seems to be behind us as well, as evidenced by the recently agreed-upon budget deal for 2014. The agreement should remove quite a bit of uncertainty over critical factors like tax rates and spending levels, which influence expectations for economic growth and in turn the investment and spending plans of businesses and consumers alike. While negotiations regarding the debt ceiling continue, another political stalemate seems far less likely.
With economic indicators pointing in the direction of stronger, more self-sustaining growth, and inflation expectations subdued, we expect the Fed to stay the course on its tapering of asset purchases. After nearly quadrupling the size of its balance sheet over the last several years to support the economy and stave off financial collapse, the Fed’s actions to stimulate borrowing activity have now passed the point of diminishing returns. And we believe authorities have appropriately begun down the path of policy normalization and a return of market forces.
For investors, this means market returns are likely to be driven more by economic fundamentals than by the Fed’s policy manipulation going forward. While in some quarters this has raised questions about the sustainability of the bull market and the impact of tapering on emerging market economies, we continue to remain optimistic and overweight equities. The outlook for global growth overall, driven by faster growth in advanced economies, continues to improve and should support a healthy increase in corporate earnings. Along with reasonable valuations, reduced uncertainty, and low interest rates, we believe the ingredients are in place for stocks to continue to do well. Of course, as recent volatility demonstrates, investor sentiment can be fickle and there remains a risk of a correction in the near-term. However, we would view a modest pullback as a healthy pause in an ongoing secular bull market and believe that with patience, equity investors should continue to be rewarded in the year ahead.
THE FED On February 1st, Janet Yellen will make history when she becomes the first woman to run the 100-year-old Federal Reserve Bank. After serving for the past three years as Vice Chairman of the Fed, she takes over the position from Ben Bernanke, who is retiring. In previous positions, she served as a member of the Board of Governors of the Fed and Chief Executive Officer of the San Francisco branch of the Fed. She will be joined by the eminent economist Stanley Fischer as her Vice Chairman. For the past eight years he ran Israel’s Central Bank, and prior to that, he served as Chief Economist at the World Bank. Interestingly, while he was a professor at MIT, he was the Ph.D. thesis advisor for both Bernanke and the European Central Bank’s Mario Draghi.
Yellen and Fischer will serve as part of the twelve-member Federal Open Market Committee (FOMC), the group that determines monetary policy. They will soon be joined by five newcomers to this committee, including one recently nominated new member from the Board of Governors, and four presidents of regional Fed banks that rotate in and out each year. Despite this change in leadership, the Fed is expected to continue with the active Keynesian economic policies that have been in place since the economic downturn. That said, there are many new personalities that need to be understood by the markets, so we predict some increased uncertainty from Fed watchers as they try to understand statements made by both the FOMC and each individual member.
EMPLOYMENT The December employment report resounded a disappointing thud as gains in payrolls increased by just 74,000. This was well below the 205,000 average of the previous three months and the smallest increase in three years. The inclement weather in December appears to have been a factor in the report, as the number of workers employed but not at work due to bad weather was 273,000. That is the highest December reading since 1977, and construction is one sector that is highly affected by the weather. It should be remembered that the monthly change in payrolls can be volatile at times and this particular report may very well be one of those anomalies. The number will be revised when the January employment report is released on February 7th. At that time, the Bureau of Labor Statistics, the government agency that calculates the employment data, has their annual benchmark revisions. At that point we will be able to get a better read on the labor markets, which had been improving prior to the December report.
The unemployment rate fell to 6.7%. This drop was driven by a 347,000 decrease in the labor pool. In the past, the Fed has stated that an unemployment rate of 6.5% is a threshold for considering interest rate hikes. But with the drop in the unemployment rate being driven more by a decrease in the labor pool rather than overheating economic growth, the Fed has backed down from that statement. The press release from the December 18th FOMC meeting noted “it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” As such, with the Fed’s preferred inflation metric (core PCE) at just 1.2%, we can probably expect the short-term interest rates to remain low for some time.
INFLATION The consumer price index ended the year at 1.5%, the lowest year-end rate in three years. Wholesale prices (PPI) rose 1.2% for the year, landing at their lowest year-end level in five years, thus showing that there is very little pipeline pressure for higher prices. Prices of imported products ended the year by falling 1.3%, showing a dearth of price pressure from abroad. Together, all of these numbers are below the Fed’s target inflation levels of 2.0%. The good news is that low inflation allows the Fed to continue their highly accommodative monetary policy: keeping short-term interest rates low. Disinflation, a slowdown in the rate at which prices increase, still remains a concern of some Fed officials but has been relegated to the “back burner” for now. However, in Europe, there is concern that their level of disinflation could lead to a bout of deflation, a decrease in asset prices. There, the CPI has been falling since 2011, when it was 3.0%, and now stands at just 0.8% for the past year. This trend may force the European Central Bank to take more action to stimulate their economy.
US TRADE BALANCE In recent months, the trade deficit has been narrowing and now stands at a level we have not seen since the Great Recession. But unlike 2009 that saw the improvement due to a dramatic decline in consumption, which brought on a 35% decrease in imports, this improvement is due to an increase in exports that is now at a record high. The sharp improvement in the domestic energy sector, driven by technological improvements in drilling and fracking, has decreased the amount of petroleum imported and increased the amount exported. The monthly petroleum trade deficit has fallen $15 billion, whereas prior to the recession, it had been as wide as $42 billion. Other exports, such as aircraft and chemicals, are also helping with the improvement of trade, and exports to China have hit a new record high due to the rise in diesel exports.
The improvement in the energy sector is a big 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.
CHARTS OF THE MONTH
INFLATION RATES Although the Federal Reserve Bank has a target inflation rate of 2.0%, they do not indicate what inflation metric they are looking at. The most ubiquitous measurement of the inflation measurements is the Consumer Price Index (CPI). Another measurement, which is often reported as the Fed’s favorite, is Core Personal Consumption Expenditures (Core-PCE). This is so because it does not include the volatile food and energy prices (core) or the housing component, which is not as pronounced as those found in the CPI. Whatever the measurement is that is used for inflation by economists, and there are many, they all are currently below the target rate of 2.0%.
There is fear by some, but not us, that the massive amount of quantitative easing in the past few years has been sowing the seed of future inflation. Banks, with record levels of excess reserves, are able to make an unlimited amount of loans that will increase the money supply and spending (at a pace faster than the economy can expand), causing inflation to ensue. But, to the frustration of the Fed, those reserves are just sitting unused at banks and are not being loaned out.
This lack of lending can be seen in the velocity of money (the measurement of the speed at which money moves through the economy), and each time it changes hands, it has a multiplying effect. The higher the rate of velocity, the higher the simulative impact on the economy. This in turn puts upward pressure on inflation, but velocity remains at record low levels, thereby not providing that multiplying effect.
Overall, velocity is hampered by lending standards at banks. Since the end of the Great Recession, the number of lending institutions has fallen, and long gone are the rouge lenders. With less competition, while still smarting from massive loan losses, lending standards remain significantly more stringent than in the past. This is keeping lending levels low and aggregate demand low. Combine that with falling commodity prices, and inflation is low.
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