The Fed's decision to delay tapering its QE bond buying program came as a surprise to financial markets, sending both stocks and bonds higher on the news. Although economic progress has been made, the sluggishness in recent activity and jobs data has clearly not been enough for the central bank to feel confident that growth can be sustained. The tightening in financial conditions, particularly mortgage rates, was another key worry, as were concerns expressed about the upcoming fiscal debates, the debt-limit issue, and the possibility of a government shutdown (which has since become a reality).
While we agree that economic data continues to be underwhelming, the evidence still suggests to us that an entrenched private sector upturn, led by housing and consumption, is in process and will be hard to dislodge. Rising interest rates appear to have dampened the housing recovery somewhat, and going forward we expect housing to slow to a more sustainable pace. But generally, rising interest rates tend to reflect improving economic conditions rather than the end of recoveries. Likewise, household financial conditions have improved to near pre-recession levels, suggesting that the worst of the consumer deleveraging cycle and its dampening effect on spending appears to be over.
Indeed, the Fed itself acknowledged that there has been "growing underlying strength in the broader economy." This improvement is evident in many key forward-looking indicators and suggests that growth will likely pick up modestly later this year and into 2014. The recent rise in both the manufacturing and non-manufacturing ISM activity indices, for example, is similar in magnitude to the upturn in early 2003, which was followed by several years of stronger GDP growth. With demand expected to rise, the outlook for investment and job creation is improving as well, and the pickup in growth in Asia and Europe bodes well for U.S. exports.
All of this is occurring against a backdrop of fading fiscal drag. Even if you were to exclude the direct impact of government spending cuts and higher taxes, GDP growth over the past year would have been more than 2%, and further fiscal tightening is likely to be much more modest going forward, making it a much smaller headwind for the economy. Although there is the risk that the upcoming fiscal budget and debt-limit debates could further hurt GDP sometime in the fourth quarter, if Congress can manage to avoid disaster as expected, a pickup in growth could be enough to persuade the Fed to finally begin tapering its asset purchases later this year or early next.
Asset purchases were never meant to go on forever, and in our minds, a gradual return toward more normal levels should be seen as a healthy development indicating that economic growth is increasingly more self-sustaining and less in need of support. Of course, until the degree and timing of Fed accommodation is better understood, financial markets will probably be volatile. This is why we believe more than ever that successful investing needs to be viewed through a longer time horizon. While uncertainty and volatility are currently elevated, the economy is quietly showing signs of improving, and we believe investors with a longer-term outlook should benefit.
THE FED At the most recent meeting of the Federal Open Market Committee, the monetary policy arm of the Federal Reserve Bank, the members were tasked with deciding if they would reduce the amount of stimulus they were adding into the economy, or maintain the status quo. This decision became known as "to taper or not to taper," and they decided not to taper. Overall, the members viewed the economic recovery/expansion as a little more tenuous than they thought just a few months ago. The low current level of inflation (Core PCE is at 1.2%) and the headwinds of fiscal restraint from sequestration and of a possible federal government shutdown also weighed heavily on their decision, so they chose to maintain their asset purchases of $85 billion per month.
Beginning in late May 2013 when Chairman Bernanke started to prepare the markets for the eventual tapering, there has been a steady increase in interest rates, most notably in mortgage rates, which increased more than 1.0%. This rapid tightening of financial conditions has concerned the Fed, which believes that a full recovery in housing is needed for the entire economy to recover.
EMPLOYMENT The recent labor report shows moderation in payroll gains. The gain in nonfarm payrolls for the past three months stands at 148,000, which is down from a recent peak in the first quarter of this year when it averaged 207,000. Despite this recent drop, there has not been much change in the 12-month aggregate growth rate, which stands currently at 2.2 million. The unemployment rate came down to 7.3%, the lowest level since December 2008 (it was 8.1% one year ago). This significant fall can be attributed partially to lower labor force participation; many in the baby-boom generation are moving into retirement, while many in the younger generation are delaying their entrance into the workforce by pursuing additional education. Over the past year, average hourly earnings have risen 52 cents, or 2.2%, which is just slightly above the inflation level of 1.6%.
INFLATION Prices have decelerated since 2011. Headline CPI, which stands currently at 1.5%, is down from the recent peak of 3.9% in 2011, and is below the Fed's longer-run target of 2.0%. Helping to keep the index suppressed is the fact that none of the major categories within CPI have exhibited exorbitant price increases. In the past year, only two of the categories have had price increases above 2.0%: housing (the index, which has been weighted 42%, has been up 2.2%), and medical care (a 7% weighting of the index has been up 2.3%). Additionally, two of the categories have had price increases below 1.0%: transportation, which includes gasoline (a 17% weighting in the index, has been up just 0.1%) and recreation (a 6% weighting in the index is up just 0.4%). The outlook for inflation is that it is contained for the near future.
CONSUMPTION Retail sales continue to plod along at a 4.7% year-over-year rate, which is just slightly below the rates in 2012 (5.2%) and 2011 (6.2%). Consumers have been a stable component in the recovery/expansion to date, even though they are spending modestly. Households, which have been more focused on successfully restructuring their balance sheet, have been forced to deal with tax hikes, which have restrained growth in disposable income and, thus, constrained spending. Despite this, auto sales (up 11% in the past year) continue to be an important force behind the growth in retail sales. Much of the strength this year has come as a result of the increased sale of trucks, which signals to some that the improvement in housing has forced contractors to update their aged fleets.
CONSUMER CONFIDENCE There has been a great deal of volatility in the confidence reports this year, and for a few good reasons: the stock market has had many a strong rally and at times has lost momentum; interest rates are up sharply; Washington politics continue to be contentious; and the Mideast has been…well, the Mideast. However, a longer view on this metric shows a sweeping upward trend since 2011, albeit tapering off as of late. This optimistic long-term view is in response to many of the long-term positives, such as the doubling of stock prices, upward pressure on home prices, and the drop in the unemployment rate from the October 2009 rate of 10.0% to the current 7.3%.
CHARTS OF THE MONTH
On September 30, the fiscal year ended for the federal government. And although the year-end financial statement is not available yet, we do have it for the first 11 months of the fiscal year. During this period the deficit improved to just $755 billion, a 35% improvement from 2012.
The sharp improvement in the deficit, one of the fastest on record, is the result of rising revenues and shrinking outlays. It can be attributed largely to tax increases and many one-time factors that won't be repeated (higher income tax payments in April, due to shifting income into 2012, and newly installed accounting changes for Fannie Mae and Freddie Mac). Helping further were the effects of the sequester and better than expected tax revenue (even adjusting for the tax hike).
After many years of consistently large annual deficits, the total amount of federal debt has in 2013 grown to $16.9 trillion. When viewed from a historical perspective, the most common metric used is a comparison of the total public debt to the size of the economy. From the end of World War II to 1981, the value of this deficit shrank to just 29%, mainly as a result of the economy growing at a significantly faster pace than the total amount of debt. Since then, however, the country has been running large annual deficits (with the exception of 1998 to 2001), and that takes its toll. While it currently stands at 99%, another large number, this is still a lower amount than in the years following World War II, and is considered to be manageable.
Relative to other countries around the world, the U.S. total debt is comparable to the level of debt of other industrialized countries. (Here, the IMF uses a slightly different methodology; it uses total debt instead of public debt).
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