ECONOMY SHOULD AVOID DEEP FREEZE
While the U.S. economy is off to a somewhat chilly start in 2014, it is too early to raise alarms. It is true that a number of recent economic reports have been underwhelming, but it is likely that the severe weather experienced across much of the nation the past two months has played a key role in the apparent deterioration in housing and retail sales. By some estimates, this has been the coldest start to the year in two decades, and it will likely be quite some time before a completely clean read on the economy is available. Still, our view is that any hit to the economy would be both small and temporary, as weather is more likely to shift the timing of economic activity in the near-term rather than affect the long-term outlook.
Historically, renewed economic growth has emerged once temperatures begin to rise. This has been the case during prior periods of unseasonably cold weather, with most spending or hiring merely postponed to a later date. Moreover, not all of the recent data has been disappointing. For example, February’s flash PMI Survey data points to the fastest overall improvement in U.S. manufacturing business conditions since May 2010. The latest read from the Conference Board Leading Indexes indicates that the economy should remain resilient in the first half of 2014 with underlying economic conditions continuing to improve.
Recent employment reports were also more positive than initial headlines indicated. Although nonfarm payroll jobs disappointed, the household survey on employment is much stronger. There is evidence suggesting that the latter currently may be the better gauge of labor market strength, as it picks up a broader swath of the economy and more small business. Over the past three months, employment under the household survey increased by an average of 580,000 jobs per month, while under the establishment survey payrolls increased by just 154,000.
Indeed, despite what looks like a mild slowdown underway in the first quarter, we continue to believe the fundamentals of the U.S. economy are on a firm foundation, and that economic growth in 2014 should surpass 2013. Supported by improved household balance sheets and income growth, consumer spending is likely to pickup at the same time that the negative impact of government restraint diminishes. With an improved sales outlook, business investment and hiring should also accelerate. Positive news continues on the policy front as well, with recent agreement in Washington on the budget and debt ceiling, ensuring that another fiscal drama will not cause avoidable uncertainty.
Investors certainly seem to have looked beyond the recent weak economic news. After a rough start to the year, and despite mixed economic data, equity markets are back near all-time highs. Of course, sentiment can be fickle and caution is advised in the near-term as another pullback is certainly possible given current conditions. Full-fledged corrections in a long and strong bull market are relatively rare, but modest-to-moderate adjustments are not. We continue to believe corporate profits and economic fundamentals remain supportive of equity market strength over the long-term.
THE FED Janet Yellen, the new chair of the Federal Reserve Bank, has issued her first report to Congress on the economy and monetary policy (formerly known as the Humphrey Hawkins Testimony). Although highly anticipated by Wall Street analysts and Fed watchers, it was largely a non-event, especially as she presented a consensus view: the FOMC remains confident that economic growth will accelerate in the coming year and labor markets will show further improvement.
The weaker economic data that has been released over the past few months is a concern for the Fed, but probably will not change the course of its commitment to reducing its pace of asset purchases. Given the current pace of reduction - $10 billion at each FOMC meeting – asset purchases are expected to end in the fall.
EMPLOYMENT The release of the January data brings two back-to-back disappointing employment reports. In January, the gain in nonfarm payrolls was a tepid 113,000. This was not much better than the December report, which had a sluggish improvement of just 75,000. Both months fell well below the monthly average of 205,000 from the twelve previous months. There are several possible reasons for the reduction: it may have been a payback to the robust gains that occurred in October and November, the severe seasonal adjustment that takes place this time of year, or, the more convenient reason that relentless weather has blanketed most of this country. When the economic reports deviate so significantly from the trend, it is difficult to draw a conclusion. The important issue, however, is that employment continues to improve. The average monthly gain in 2013 was 194,000, an improvement from 2012’s 186,000, and 2011’s 174,000. In total, payrolls have gained 7.8 million new jobs since the low in February 2010. The unemployment rate ticked down to 6.6%, the lowest level since October 2008. The good news here is that it came down for the right reason: a large jump in the number of employed - not a drop in the labor force, which was the primary reason for the drop in the unemployment rate the past few years.
INFLATION Despite higher energy prices, resulting from shortages in fuel oil and propane that occurred due to the severe weather across the country, the rate of price increases continues to be muted. Although the shortages should be alleviated, the bigger concern is that higher energy prices reduce disposable income and may take a toll on consumer spending.
The Consumer Price Index (CPI) stands at 1.6%, and the Fed’s preferred metric, Core Personal Consumption Expenditure (CPCE), which excludes the volatile food and energy components, is at 1.2%. Both metrics are well below the Fed’s target of 2.0%.
There is a “new and improved” calculation of the Producer Price Index (PPI), an inflation measurement of prices received for domestic producers. The history of this index goes back to 1947, when producers made up 40% of the economy. As our economy has transitioned to a service economy, producers now account for just 18%. This new measurement reflects 75% of the economy by including prices for services and construction, while incorporating the government and export sectors. Even with the new method of calculating PPI, it has not changed much, increasing only 1.5% in the past year.
CONSUMPTION/RETAIL SALES Households increased spending in the second half of 2013; consumption grew 2.0% in the third quarter and 2.6% in the fourth quarter (the strongest pace of growth since March 2012), well above the average quarterly growth rate of 2.2% since the end of the recession. Since consumption makes up 72% of GDP, many economists thought that the continuation of that trend would help drive overall economic growth, increasing their robust expectations for 2014. However, the January retail sales report was lackluster and the previous two months were harshly revised downward, with auto sales having a large impact on those numbers. Overall, the severe weather across the country has seemed to dissuade consumers from going out and spending. Some of those lost sales will recover – someone who was willing to buy a new car in January will probably buy it when the weather gets better in February or March, but other sales, like restaurant sales, are lost forever. Although weather is an obvious excuse for the slowdown of the recent reports, there are some long-term fundamental issues affecting consumer demands: namely, weak hiring and lack of wage gains. In addition, it is still not fully understood how much of the strength in fourth quarter sales were a result of contemporary issues, such as lower energy prices, gains in the wealth effect from high stock prices, and a drop in the savings rate.
CHARTS OF THE MONTH
Last month, GDP data was released after this publication went to press. Below is our report on the fourth quarter GDP data (which has been updated with the revisions that were issued on February 28, 2014).
GDP Real GDP increased 2.4% in the fourth quarter of 2013, following an increase of 4.1% in the third quarter. This change reflects an uptick in consumption, exports, inventory adjustments, and an overall increase in state and local government spending. Spending at the federal government level and residential fixed investment (housing) were on the negative side.
CONSUMPTION The rate of consumer spending increased 2.6% in the quarter. This is the strongest increase since the first quarter of 2012.
Auto sales, which have been strong all year, continued to add to strong durable goods sales in the fourth quarter, while non-durable sales received a boost from apparel sales and accommodations (hotels).
INVESTMENT Fixed investment spending rose 3.8% in the quarter, getting a big push from spending on equipment (10.6%). This may be due to firms getting investments in place by year-end to beat the expiration of the depreciation bonus.
Inventories, which increased a whopping $117 billion, matching the largest quarterly rise since 1998, marking the first time there have been back-to-back increases of $100 billion in the history of this report.
GOVERNMENT Spending by the government continues to be a drag on the economy, falling 5.6% from the previous quarter and dragged down by a 12.8% decline in spending at the federal level. For all of 2013, federal government spending declined 5.2%, the most since 1971.
Spending at the federal level has now been a drag on GDP for five consecutive quarters. The large decrease in the past quarter was a result of the 14.5% decrease in federal defense spending. But, due to the improved tax base, spending at the state and local government level has been a positive contributor to GDP for three consecutive quarters.
TRADE Exports got a boost from aircraft/engines/parts, which is a volatile group. More importantly, the booming energy sector of the economy continues its trend of improving trade due to technological improvements that have been made in finding and extracting oil. Petroleum exports have hit another record high. With this excess supply of domestic production, imports have reduced, furthering the need for imports.
CONCLUSION This recovery/expansion period is now four and a half years old. It will go down in the history books as one of the longest and one with extremely low levels of growth. The average quarterly increase has been just 2.4%. Economic historians have been telling us to expect this, it is consistent with other recoveries/expansions following a severe financial crisis.
The outlook for the economy is far more favorable as we continue to gain altitude. Tailwinds continue to improve and headwinds continue to fade. The manufacturing sector continues to see significant improvement, led by the auto industry; the energy sector is creating great wealth and helping to reduce our trade deficit, housing, which got a late start should continue to add to growth; and the aggregate growth in the labor force should soon surpass the peak prior to the Great Recession. We expect GDP growth this year to be in a range of 2% to 3%.
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