U.S. ECONOMIC OUTLOOK: GAINING ALTITUDE
After starting the year on a slow note, the U.S. economy appears to be ending 2013 with some renewed momentum. Despite the partial Federal government shutdown earlier in the quarter, in many respects, recent economic data has not only held up, it has shown improvement. Thanks to record-high equity markets and strengthening job creation, consumer confidence is rebounding and translating into more household spending. Businesses too are shaping up in order to support the increase in the pace of hiring. Industrial production has finally risen above its prerecession level, and the manufacturing ISM (Institute for Supply Management) sits at its highest level in more than two and a half years. Even the housing market has picked up following a pause this past summer when mortgage rates jumped, with housing starts now at their highest rate since 2008.
In the public sector, the aftermath of the government shutdown has brought a compromise that is expected to reduce fiscal drag further in 2014 and — importantly — to help remove much of the uncertainty that has weighed on economic growth for much of 2013. Helping offset cuts at the federal level even further, state and local governments have organized their finances to such an extent that they are now raising spending and, consequently, boosting both GDP and job growth. All told, the ingredients are in place for stronger growth in 2014, and we have become much more upbeat about prospects in the quarters ahead.
The Fed’s recent unexpected tapering announcement comes on the heels of the strengthening momentum in the economy. Citing progress in the labor market and more balanced risks to the outlook, the Federal Open Market Committee (FOMC) has decided to scale back the pace of its monthly asset purchases beginning in January. For some time, we have been of the opinion that asset purchases were never meant to go on forever, and that 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. Of course, the economy is far from hitting on all cylinders, and with the unemployment rate still elevated and inflation well below its target rate, the Fed has not put its foot on the brake, but only slightly lifted its foot off the gas pedal.
Since early this summer, the markets have been uneasy over when the Fed would slow the pace of its asset purchases, but the reaction so far has been positive. Tapering will be more gradual than expected, and short-term interest rates will most likely not be raised from near-zero until later than previously thought. Given these circumstances, it is no wonder that markets have taken the news in stride, with stock prices rallying, Treasury yields rising minimally, and market interest rate expectations falling. It seems investors have gradually realized that tapering is very different than tightening and that policy will remain accommodative for a long time.
As economic fundamentals continue to rebalance toward a slightly stronger pace of economic growth, our recommendation is to stay overweight risk. After years of avoiding stocks, retail investors reversed course in 2013 and have been rewarded with a great year, seeing most equity markets up over 20%. While these outsized gains have left some investors skeptical as to whether or not the current rally will have more room to run, we believe that with an improving economy and corporate profit growth, stock prices should continue to advance.
Equity valuations may not be as attractive as they were a year ago, but they are not overly stretched and still represent reasonable value, especially relative to current historically low-yielding bonds. Indeed, in the coming months we see potential for greater investor flows into stocks with mid- to longer-term interest rates poised to rise, while shorter-term rates remain anchored near zero. Although the impressive gains in stocks thus far are unlikely to continue, and a pullback is likely at some point, we believe patient equity investors should continue to be rewarded in the year ahead.
THE FED Five years after reducing the federal funds rate to near zero, and following three separate programs of quantitative easing, the Federal Reserve Bank is satisfied enough with its assessment of the economy and the pace of the labor market recovery to initiate a reduction in the massive amount of stimulus that it provides. Beginning in January, the Fed will lower its monthly pace of asset purchases by $10 billion per month, to $75 billion per month. In its communiqué, the Fed indicated that it will continue to reduce the amount of asset purchases at future meetings based upon the strength of the incoming economic data. In the press conference that followed, Chairman Bernanke indicated that, in his view, the most likely path would be to taper $10 billion per meeting.
Additionally, the Fed also made an important comment in which it emphasized that the federal funds target rate will remain exceptionally low, even past the time that the unemployment rate falls below 6.5% (currently at 7.0%), especially if the projected inflation rate continues to be below the Fed’s 2.0% long-run goal (currently at 1.1%). At the end of each quarter, the Fed publishes a range of economic projections. For 2014, the midpoint of its ranges are as follows: GDP growth 3.0%, Unemployment rate 6.45%, and Inflation 1.5%.
EMPLOYMENT The labor markets were a little brighter in the first two months of the fourth-quarter with nonfarm payrolls above 200,000 for two consecutive months. In the past three years, we have seen a trend develop in which nonfarm payrolls have had stronger growth in the fourth and first quarters and weaker growth in the middle two quarters. The variance in the average monthly gain is around 50,000 jobs, and is thought to be linked to seasonal adjustments. The unemployment rate is down to 7.0%, the lowest level since just prior to the economic downturn. Since the Fed began its latest round of quantitative easing (QE3) in September 2012, the unemployment rate has fallen from 8.1% to 7.0%, and during that same period 2.8 million jobs were created. Average hourly earnings have been increasing at a 2.0% rate, practically unchanged for the past three years and at the lower end of the range for the past 30 years. Normally in the business cycle, as the unemployment rate falls, which it has for the past three years, workers’ earnings will accelerate. However, that is not happening this time, due in part to productivity gains and the soft labor market. If history is any guide, wages will most likely not increase until the unemployment rate pierces the 6.0% level.
INFLATION Price pressure continues to weaken, a trend that has been in place for about two years. It has been driven by lower commodity prices, weak wage growth, and banks with restrictive lending policies. The core Personal Consumption Index, the Fed’s preferred metric for measuring inflation, has been growing at 1.1% in the past year, near its all-time record low and well below the Fed’s target interest rate of 2.0%. The Fed has stated its discomfort in the low level of current inflation, and there are no meaningful signs of acceleration. However, the Fed’s longer-term view is much closer to its target rate. So the risk of deflation (falling asset prices) does not look imminent here.
CONSUMPTION There has been some good news in the past month showing some strengthening of demand for goods and services. First, the consumption component of second-quarter GDP was revised from a paltry 1.4% to 2.0%. This jump puts the pace of demand back on track to the average pace that has occurred since the end of the recession. Second, the monthly retail sales reports, which gives us a more current view of demand, has increased substantially in the past few months and the most recent report for November was unambiguously strong. This improving trend has economist increasing their estimates for a stronger consumption component in GDP for the third and fourth quarter. Finally, consumer confidence has begun to rebound after the partial federal government shutdown. Since consumption accounts for more than 2/3rds of GDP, the recent increase can play an important role in helping to elevate overall growth.
CHARTS OF THE MONTH
HOUSING AND MORTGAGE RATES Although the housing market has suffered some volatility of late, we believe the recovery will continue well into the new year. Strong fundamentals of a gradually improving economy, and the combination of historically low mortgage rates coupled with an improvement in home prices makes for an environment of increased demand.
The housing recovery, which began in 2010 and accelerated in 2012 and the first half of 2013, has begun to taper its rate of growth.
The recent slower rate of housing growth is due in part to a run up in interest rates this past summer, which was linked to Fed Chairman Ben Bernanke’s comments that the central bank might reduce its bond buying program. But in September, the FOMC chose not to initiate the taper of QE3, and fixed-rate mortgage rates moved down somewhat. Then, tapering discussions began again and on December 18, the decision to taper was made. Thus, mortgage rates have moved up a bit. Hybrid mortgage rates (fixed for five years, then floating rate, for example) continue to be near historically low levels.
The latest S&P Case-Shiller 20-City Home Price Index, which measures constant-quality home prices, shows prices rising 13.8% over the past year. This remarkable increase is the largest since February 2006 and marks the 20th consecutive monthly increase. Helping to keep this number elevated are two important issues. First, the supply of homes is low compared to the past few years. Second, there are significantly fewer distressed properties for sale. The large number of distressed properties had bogged down the price of homes the past few years.
The higher mortgages rates, combined with higher home prices, have reduced the housing affordability index. Yet, on a historical basis, the index is relatively high, indicating the relative “cheapness” in affordability of buying a home.
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