Volatility has returned to the financial markets in recent weeks amid rising concerns about the strength of global growth, especially in Europe, and the path of Fed tightening. Risks have increased to some extent, but our base case has not changed very much. So far, overseas concerns have not washed up on American shores, leaving U.S. economic activity largely undisturbed. Investor anxiety has been difficult to comprehend with the solid outlook for U.S. economic growth ahead.

Despite small declines in September, the Institute for Supply Management indices indicate that economic growth has finally broken out of the lackluster pace of 2.0%, which has been the norm since 2010. The deterioration in Eurozone economic prospects coupled with the rising dollar most likely explain why the survey measures have pulled back a bit. However, the U.S. economy is relatively resilient to a slowdown in global demand due to its closed, domestically oriented nature. In addition, industrial production rose sharply last month, and the surveys are still consistent with decent gains in manufacturing output going forward.

Importantly, the labor market remains a key pillar for U.S. growth, and recent data reinforce the positive fundamentals heading into the fourth quarter. The surge in job openings has reached its highest level since 2007, while initial jobless claims fell below 300,000 per week. The latter is almost unprecedented and is symbolic of a healthy labor market. Looking forward, continued improvements in the labor market should support a rise in household consumption and, in turn, a pickup in business investment as many industry sectors run close to full capacity.

The U.S. cannot be completely immune to a loss of momentum in the global economy; however, recent data suggests fears are somewhat overdone. The fact that global purchasing managers’ indices (PMI) held broadly steady in the major economies this month is a good reason to doubt the message from markets that the world economy has slowed sharply. At the same time, the recent decline in oil prices and long-term interest rates should significantly offset the negative effect of weaker foreign growth here at home.

With domestic demand indicators remaining strong, policymakers will need to weigh the ongoing mending of labor market conditions against threats that might derail continued progress, and an eventual normalization of policy. While U.S. growth prospects do not appear in jeopardy, given swirling global risks and muted inflation expectations, there is little reason to believe the Fed will be in a rush to raise rates. Rather, we expect policymakers to move cautiously and remain highly data dependent.

Although the risks of an external shock can never be fully discounted, and volatility could continue, equity investors should keep the bigger picture in mind. The U.S. economy continues to grow, corporate earnings are strong, monetary policy remains accommodative, interest rates are low, and global growth is not falling off of a cliff. All things considered, we believe these ingredients are a good recipe for higher stock prices in the long run.

LABOR - September’s employment report showed impressive job growth – a nice bounce back from the lull noted in August’s report. The unemployment rate, which ticked down to 5.9%, has not been this low since July 2008, when the federal funds rate was 2.0%. Payrolls jumped to 248,000, putting payroll gains on track for an increase of 2.7 million this year. The rise in payrolls, in conjunction with the stable workweek (33.7 hours), suggests that labor income is growing at a healthy pace. The effect should be a lift in consumer spending.

With the consistently strong average monthly gains of over 200,000 new jobs, the labor market continues to move down the path toward normalization and full employment. Fed Chair Yellen has stated that the natural rate of employment is somewhere between 5.25% and 6.0%; we are now in that range. This will, of course, play heavily into the Fed’s decision to normalize interest rates in 2015.

THE FED - The current economic view of the Federal Reserve policymakers is similar in tone to their views of the past year: economic growth remains modest to moderate and inflationary pressures continue to remain elusive. The Fed continues to be crystal clear that the future of monetary policy will depend on evolving economic data; if incoming economic data exceeds expectations, the Fed is poised to raise interest rates sooner than expected, and vice versa. The current market expectation is for the first rate hike to occur in June 2015.

The Fed is facing some new and growing concerns; primarily, the deteriorating economic situation in Europe and the growing risk of deflation. Both are serving to put upward pressure on the value of the U.S. dollar, which could have some adverse effects on the domestic economy. In addition, the stronger dollar may crimp U.S. exports as our products become more expensive to our trading partners. It may also reduce the value of imported goods and services, which may keep inflation well below the Fed’s target of 2.0%. The Fed has also mentioned that it is concerned about the geopolitical trouble in the Middle East and Europe.

INFLATION - With the strong dollar, significant decrease in energy prices, and Europe dancing close to deflation, the rate of domestic inflation has been attracting attention lately. The consumer price index is currently at 1.7%, about the average rate since the end of the recession, and slightly lower than the Federal Reserve’s target level of 2.0%. The Federal Reserve currently has a dual mandate – to increase employment and keep prices stable. Since employment has been steadily improving and moving toward full employment, how inflation moves in the near future will play a role in when the Fed decides to start raising the federal funds rate.

The decrease in energy prices in each of the past three months has made the most significant impact on bringing the inflation rate down. Oil prices, which peaked in late July at $108 per barrel, have traded down to $82 per barrel by mid-October (a decrease of almost 25%). Weaker global demand combined with the substantial increase in supply (brought on, in part, by fracking) have caused the prices to move down. However, with all the international turmoil, we believe oil will continue to be a wild card with respect to the inflation rate.

FEDERAL DEFICIT - The federal government’s fiscal year-end was September 30th. On this day, the budget deficit came in at $483.35 billion; this value represents a decrease of almost one-third from last year. This is the lowest level in six years, and a far cry from the trillion dollar deficits that occurred during the four year period between 2009 and 2012. The improvement this past year was prompted by a combination of higher tax receipts and relatively stable expenditures. Revenues, which shot up 9.0%, were propelled by a stronger economy and the expiration of certain tax provisions found in 2013 – mainly, the expiration of the temporary cut in payroll taxes and the increase in tax rates on the income earned above certain thresholds. Expenditures were up only 1.0%.

Altogether, this brings the deficit closer to the realm of fiscal normalcy as it fell to 2.8% of gross domestic product (GDP) [this measure is preferred by economists because it offers the greatest context]. In this respect, the deficit has achieved its lowest level in seven years, placing it below the 4.0% average of the past 40 years.

CHARTS OF THE MONTH - THIRD QUARTER GDP

Third quarter GDP came in at solid 3.5%, marking the 19th consecutive increase. For the trailing 12 months, GDP has increased an average of 2.3%, which is a distinct improvement over the 1.8% average growth rate since the recession ended. This above-trend growth is absorbing some of the slack in the system – a sign of an increasingly self-sustaining economy.

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GDP got a boost from government spending (sharp increase in defense spending) and from net exports, as a significant increase in exports offset a minimal decline in imports.

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After four years of cost cutting, defense spending has turned around. In the past quarter, it increased $26.2 billion, a 16% increase (annualized rate).

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Improved exports have been growing and are an important part of this business cycle.

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