The U.S. economy appears to be sustaining its renewed momentum, and it is hard not to be optimistic given recent developments. Labor market indicators have strengthened further, both manufacturing and non-manufacturing Institute for Supply Management (ISM) surveys now sit at multi-year highs, and most categories of aggregate demand have bounced back solidly. Although weaker global indicators, especially in Europe, and rising geopolitical tensions have raised some concerns, gradually improving fundamentals support strong U.S. economic growth into 2015 – beyond what we have already seen so far in this expansion.
The environment of credit restraint, which persisted since the bursting of the housing bubble and financial crisis of 2007, is showing signs of genuine improvement. We believe a better-functioning lending market will be necessary to reinforce and sustain a period of above-trend growth. The Fed’s latest Senior Loan Officer Survey shows considerable progress, as banks eased lending requirements across nearly all categories of loans, amid a widespread increase in demand.
Rising demand for commercial and industrial loans indicate firms’ growing willingness to invest once again in their businesses. On the consumer side, the broadest-based improvement in loan demand seen in years is a testament to much improved household financial conditions and confidence. Perhaps most encouraging is the number of banks reporting recently relaxed mortgage lending criteria (the largest loosening in lending standards on record). However, the level of credit conditions remains stricter than the average seen since 2005. Because supportive credit policy takes time to implement, this represents a critical first step toward helping the housing market, which has stumbled since the recession ended five years ago.
Evidence that housing may have turned a corner this summer is beginning to accumulate. Homebuilder confidence surveys have risen and the favorable sentiment is also reflected in hard numbers. Existing home sales hit a 10-month high in July, and new home starts rebounded 15.7% – more than recovering declines in the two previous months. Building permits also grew at a faster pace, indicating that the pickup is more than temporary. While challenges still remain, the firming in the housing market provides an opportunity for the beleaguered sector to contribute to a pickup in aggregate growth over the next couple of years.
Stronger consumer spending growth will be the key factor in determining whether the economy can sustain its second quarter momentum. The recent acceleration in job growth, rising household wealth, and greater availability of credit all suggest that the outlook for consumption is improving. In particular, gauges of labor market health continue to strengthen: jobless claims are at a seven-year low and private job openings are at a level last seen in 2001. Other survey-based employment measures suggest that businesses intend to fill those positions, keeping the hiring momentum going in the second half of this year.
At the same time, lower energy costs, decreased debt service, and a strong U.S. dollar are leaving more money in consumers’ pockets, which helps balance still-modest wage growth. Wages, however, should pick up as the labor market continues to slowly tighten. The recent acceleration in hiring has rekindled debate about the timing of the next interest rate move amidst concerns that tightening labor conditions will exert upward pressure on wages and fuel inflation. While the tide is clearly turning, there still seems to be slack in the job market, and with inflation remaining below target (restrained by tame labor costs and well-anchored expectations) it is unlikely we will see the Fed rushing for the exits anytime soon. Rather, policymakers will move slowly and cautiously, giving every chance for fundamentals to improve further and economic momentum to build.
THE FED There has been considerable news from the makers of monetary policy in recent weeks, especially as a number of economic reports show greater strength in the domestic economy. This has a few members of the Federal Open Market Committee (FOMC) initiating conversation on when the Fed should begin to raise the federal funds rate (referred to as “lift off ”). Most notably, inflation, as measured by the Consumer Price Index (CPI), has jumped to 2.0% from 1.1% in February. Additionally, improvements in the labor market, as noted by the significant drop in the unemployment rate, have been far greater than the Fed had anticipated. However, the Fed is not ready to start hiking rates in the near term. The Fed looks at weak wage gains (just around 2.0%) as evidence that the labor “slack” remains prevalent enough to warrant the need to keep interest rates at the present level. The Fed Chairwoman Janet Yellen and other leaders of the FOMC are determined not to raise interest rates too early and risk hurting the improving, but delicate economy. In short, the Fed would most likely rather risk dealing with high inflation, if it were to happen as a consequence of keeping rates too low for too long, than to deal with another economic downturn by raising rates too early.
INFLATION There has been a slight cooling in inflationary pressures this past month, which is a welcome relief since CPI grew at a 3.5% annual rate in the second quarter. The yearly change in CPI is now at 2.0%, right at the Fed’s target rate. Energy prices played an important role in helping to moderate inflationary fears. Gasoline, electricity, fuel oil, and natural gas prices all fell in July – a welcome surprise to consumers despite the recent increase in geopolitical tensions.
Inflation has been ticking upward since hitting a cycle low of 1.0% in October 2013. Since the recession ended more than five years ago, inflation has oscillated in small cycles of higher and lower inflation. Many of these swings have been caused by the instability in commodity prices. Most major countries outside the United States have not had economies strong enough to keep a consistent demand on commodities, which has resulted in rapid and volatile price fluctuations. Since the end of the recession, the commodities component of CPI has moved in a range of -5.6% to 6.7%. Meanwhile, during the same period of time, the service component of CPI has been in a very narrow range of just 0.3% to 2.8%.
EUROZONE The recovery in Europe is sputtering as economic growth in the Eurozone continues to disappoint. Second quarter growth remained unchanged from the first quarter (the year-over-year rate is just 1.1%). Second quarter economic growth in Germany, the Eurozone’s largest economy, contracted 0.2%; France, the second largest economy, has had no growth for two consecutive quarters; and Italy, the third largest economy, fell into its third recession in six years. Surprisingly, many of the peripheral countries had positive performance. This may be a result of a reversal from the severe decrease in the level of economic output they experienced over the past five years, which has opened up the opportunity for investment spending and hiring.
Inflation, or a lack thereof, is also a concern for the Eurozone. CPI, which is just 0.3%, has been on a downward trajectory since the end of 2011. There is a fear that food prices will fall in the coming months, putting further downward pressure on inflation. The European Union’s trade sanctions and Russia’s counter-sanctions will cause an oversupply of food within the Eurozone, which may cause prices to plummet.
Mario Draghi, president of the European Central Bank’s (ECB) Governing Council, has noted that the risk to the economic growth outlook remains on the downside. There is unanimous agreement at the ECB to use unconventional monetary stimulus when it becomes necessary. It is highly expected that the ECB will initiate Quantitative Easing soon.
MANUFACTURING American factories have gained momentum in the second quarter. This is a welcome development given the lack of conviction that business leaders had just a few months ago. The transportation sector is enjoying robust growth and a high sense of optimism. With auto sales near the same level they were before the recession started, there have been shorter than usual seasonal retooling plant closures in the auto industry, all so that manufacturers could keep up with demand. Additionally, other areas such as electrical equipment, computers, and paper products are witnessing robust growth. The petroleum and coal products sector of the economy is having a growth boom thanks to fracking and other technological advances. Salaries for engineering labor are increasing faster than general inflation due to market competition and shortages of certain specialty skills. So far this year, employment in manufacturing has grown 107,000.
CHARTS OF THE MONTH - CONSUMER SPENDING
The consumer plays a vital role in the U.S. economy, with consumption making up about two-thirds of total economic output.
Despite strong spending, the rate of growth has been slowing in recent years. Consumers have become more cautious, irrespective of increased confidence, strong employment gains, and improved household wealth.
One possible reason for the slower rate of spending growth may be workers’ wages, which are increasing at a meager 2.0% rate. This rate is about the same level as inflation, making it difficult for incremental consumer spending beyond food and rent (both of which are growing at a rate faster than overall inflation).
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