ECONOMY EXPECTED TO GAIN ALTITUDE

The economy looks to have ended the first quarter with a lot more momentum than it started with. After a couple of months of disappointing economic data, a number of indicators over the past several weeks have begun to reflect more robust rates of economic growth. The more data we see, the more we are reassured that the drop-off in the preceding few months was largely due to the unusually severe winter weather. The recent resurgence in activity and employment means we are also more confident about our longer-term outlook. With the fiscal drag fading and the Fed intent on keeping monetary policy exceedingly loose, we believe the improving conditions in the private sector are in place for the economy to expand at a somewhat stronger pace.

June will mark the five-year anniversary of the end of the Great Recession, and aggregate growth has improved substantially. Interestingly, five years has also been the average length of postwar U.S. economic expansions. Although, given the sluggish recovery in the labor market, as well as the lack of inflationary pressures, the current expansion still closely resembles an economy in the early stages of recovery, and we see none of the buildup in excesses or imbalances that ultimately sow the seeds of the next economic downturn.

The natural tendency is for economies to expand, and with consumer and business fundamentals firmer than in recent years, growth is more likely to strengthen than weaken going forward. In the short term, we expect the economy will benefit from some catch-up in activity that was postponed during the winter months. Longer term, the sluggish nature of the expansion means that the economy is still rich in supply of pent-up demand, which should be put to work as employment and income growth slowly but steadily improves.

Greater demand, in turn, should create a positive feedback loop to more job creation – a virtuous circle of greater business investment to boost production, employment growth, and higher economic activity that today stands primed for motion. Although, this does not mean the economy is set to start firing on all cylinders. Due to a number of long-term structural challenges still facing the economy, the improvement in job and income growth over the next couple of years will likely be modest. However, this is also a good thing as modest growth will help keep inflation and higher interest rates at bay for as long as possible.

While we have been encouraged by the recent improvements evident in the incoming data, investor sentiment has been more mixed, with equity markets exhibiting a fair degree of volatility as of late. Though stock prices are once again back near all-time highs, another decent-sized pullback would not surprise us. Still, in our minds, equities continue to be attractive on an absolute basis, as well as relative to fixed income. With the economy continuing to expand, corporate profits growing, and valuations still reasonable, we would advise clients to stay the course.

THE FED The release of the minutes from the most recent meeting of the Federal Open Market Committee (FOMC) – the monetary policy-making arm of the Fed, showed a more “dovish” assessment for monetary policy than what the market had been anticipating. It confirmed that the Fed is in no hurry to hike the federal funds rate and, when it does start raising rates, it may be done at a lower trajectory than what was previously thought by the market. The economic discussions were quite limited. In general, the FOMC saw weaker data in the first two months of the year, attributed only in part to the bad weather. The FOMC was surprised by the downward revisions to economic growth in the fourth quarter, which served to start this year off at a weaker base. Additionally, they were concerned that the housing market had been hurt by the rise in mortgage rates (see page three for more details on the housing market). While the labor markets improved, there was a range of views as to how much slack really exists; Chairwoman Janet Yellen, along with a majority of the members, believed there was too much slack.

EMPLOYMENT A spring thaw is occurring in the labor market as two consecutive months of nearly 200,000 gains in nonfarm payrolls has put this metric back in line with long-term averages. Job creation had plunged during the winter months as unusually brutal winter weather held payroll growth to an average of just 114,000 in December and January. The unemployment rate is 6.7% and has trended higher in the past two months after hitting a low of 6.6% in January. This increase is for “good” reason as the labor force is increasing, indicating more people are interested in looking for a job. One important threshold was surpassed when employment in the private sector reached an all-time record high. Due to weakness in the government sector (the average has declined 836,000 since its peak in April 2009), total payroll employment is still 437,000 below its high. Chairwoman Yellen has spoken frequently about the slack in the labor market. This is especially evident in wage growth as average hourly earnings grew a feeble 2.1% in the past year, while over the past four years hourly earnings growth averaged just 2.0%. Normally at this stage of the expansion (almost five years since the recession ended) wage growth would likely be around 4.0%.

INFLATION The annual change in consumer prices had been on a decelerating trend since September 2011, before bottoming this past autumn at 1.0%. Since then it has been increasing slowly and now stands at 1.5%, which is still well below the Fed’s target inflation rate of 2.0%. A key factor in this small increase in recent inflation reports can be attributed to the ongoing improvement in home prices. When the housing component of consumer price index (CPI) is calculated, it is not the change in the value of the home but rather the change in the price of what one would have to pay to rent the home: the owner equivalent rent. Since home prices are moving up, rental prices for similar homes are also moving up. Additionally, for those that rent, prices are moving up in response to dropping vacancy rates. These two components account for 31.0% of CPI. Another component putting pressure on inflation is food prices, which have increased 4.0% of the annual rate over the past three months. This increase has been heavily influenced by the drought in California.

RETAIL SALES After several months of inhospitable weather that kept consumers and their wallets in hibernation, retail sales – along with the thermometer – have snapped back. The warmer temperatures and two months of hearty job gains are serving as the main catalyst for increased spending. It is important to note that, since the recession ended, consumers have been spending moderately. With that being said, there has been a marked increase in the rate of purchases of cars and light trucks. New motor vehicle sales are now above the annual rate of 16 million, roughly the same level they were prior to the economic downturn. The retail sales calculation of auto dealer sales (new cars plus used cars and parts and service) are up 9.5% in the past year, which is 2.5 times the rate of overall retail sales. The fact that the age of the fleet of cars on the road exceeds 11 years has many forecasters believing that vehicle sales are expected to stay strong for some time.

CHARTS OF THE MONTH

The housing market saw strong growth in 2012 and 2013 but peaked at its highest last summer. Harsh weather, rising home prices, higher mortgage rates, and stringent lending standards have been blamed for the slowdown.

Housing activity is more susceptible to weather distortions than most other parts of the economy – it is hard to build when the ground is muddy or frozen.

Yearly change in home prices have been increasing for five years. This is a good thing for existing homeowners as it increases household wealth. For new home buyers, it is far more problematic as it makes it more difficult to qualify for financing. Home prices have increased 13.0% in the past year, easily outpacing the modest increase in income for most new home buyers.

 

Mortgage rates have increased more than 1.0% in the past year. For every $100,000 in mortgage value, this increase equates to another $702 in the monthly mortgage payment on an annual basis.

 

A combination of higher home prices and higher mortgage rates has caused a downward shift in the Housing Affordability Index. Considering the way this Index works, a value of 100 means a buyer with median income has exactly enough income to qualify for a mortgage on a median-priced home. Given the current index level of 169, this means a buyer has 169% of the income necessary to qualify for that same home. On a historical basis, the affordability index is very favorable, but home-buying attitudes tend to be short term.

 

The housing sector is still in the early stages of a very long recovery. As the economy continues to grow it should gradually pull traditional buyers back into the market.

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