construction

Although recent headlines have focused on all the uncertainty surrounding Europe and its tenuous relationship with Greece, as well as concerns over several of the larger emerging economies, the U.S. economy is continuing to expand. This ongoing strength has led the Federal Reserve to signal that it is likely to raise short-term interest rates later this year. This in turn is an indication that the central bank believes most sectors of the economy are experiencing tailwinds that are returning us back to “normal.”

The Fed has held interest rates in the range of 0% to 0.25% since December 2008. For the Fed to begin raising rates, it needs to feel that it has fulfilled its dual statutory objectives of maximum employment and stable inflation. The unemployment rate is currently at 5.3%, just above the 5% to 5.2% rate that is considered “full employment.” When unemployment falls below that rate, wage pressures are expected to build – contributing to inflation. That has not happened yet. As of now, the Core Personal Consumption Expenditures Index (core PCE) price deflator (the Fed’s preferred inflation indicator) has been below its target rate of 2% for more than three years. However, inflationary pressures are beginning to build, as seen in other proxies for measuring price movements. The Fed does not have to see inflation at 2% before it raises rates – the policymakers just have to be assured that inflation will eventually get to that level.

While this has been a slow and arduous recovery, with many fits and starts, we believe the U.S. economy is now at a level of strength that can tolerate higher interest rates. Starting from these low levels, the Fed will not be raising rates to restrain economic growth, but rather, to bring them back to “normal” territory. Fed Chair Janet Yellen and other key officials have made it clear that they will raise rates very gradually, with some even hinting that it will be several years before the federal funds rate gets to the Fed’s “long-run projection,” which is currently at 3.75%.

One area that has been slow in recovering from the recession, in part because it was a primary cause of the recession, is the housing market. However, that is beginning to change. While growth in this important sector has been unusually slow compared with past economic recoveries (see chart), it now appears to be on an improving and, hopefully, sustainable track. There are many fundamental drivers in place to support this trend, most notably the improved employment picture, which is leading to the creation of more new households (up 1.5 million in the past year). This alone has led to a strong increase in new home starts this year. In addition, the inventory of existing homes for sale is at very low levels, leading to increases in home prices.

Overall, there has been a significant shift in the nature of demand for homes compared to a decade ago. Long gone is the excitement of a “McMansion” in the suburbs. Demand has shifted toward homes in urban areas and near mass transit. The propensity to rent instead of own is greater as well. This could be because first-time home buyers have seen how volatile housing prices can be and do not want to take on that perceived volatility. It could also be the difficulty in obtaining mortgages under the strict underlying standards now in place. Either way, the popularity of renting has pushed up demand for rental properties and reduced vacancy rates. It also has contributed to significant increases in the creation of multifamily homes. Overall, while the nature of the housing market appears to have changed somewhat, it looks to finally be on an upward trajectory.

quarterly update graph

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Index Definitions

The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

Core Personal Consumption Expenditures Price Index (core PCE) is the personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

Shanghai Composite Index (SHCOMP): A capitalization-weighted index. Th e index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.

Shenzhen Composite Index (SZCOMP): An actual market-cap weighted index (no free float factor) that tracks the stock performance of all the A-share and B-share lists on Shenzhen Stock Exchange.

MSCI China Index (MXCN): A free-float weighted equity index. It captures large and mid-cap representation across China H shares, B shares, Red chips and P chips.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.