City National Rochdale Economic Perspectives
U.S. Economic Outlook: Gaining altitude
After starting the year on a slow note, the U.S. economy
appears to be ending 2013 with some renewed momentum.
Despite the partial Federal government shutdown earlier
in the quarter, in many respects, recent economic data has
not only held up, it has shown improvement. Thanks to
record-high equity markets and strengthening job creation,
consumer confidence is rebounding and translating into
more household spending. Businesses too are shaping
up in order to support the increase in the pace of hiring.
Industrial production has finally risen above its prerecession
level, and the manufacturing ISM (Institute for
Supply Management) sits at its highest level in more than
two and a half years. Even the housing market has picked
up following a pause this past summer when mortgage
rates jumped, with housing starts now at their highest rate
In the public sector, the aftermath of the government
shutdown has brought a compromise that is expected to
reduce fiscal drag further in 2014 and — importantly — to
help remove much of the uncertainty that has weighed on
economic growth for much of 2013. Helping offset cuts at
the federal level even further, state and local governments
have organized their finances to such an extent that they
are now raising spending and, consequently, boosting both
GDP and job growth. All told, the ingredients are in place
for stronger growth in 2014, and we have become much
more upbeat about prospects in the quarters ahead.
The Fed’s recent unexpected tapering announcement
comes on the heels of the strengthening momentum in
the economy. Citing progress in the labor market and
more balanced risks to the outlook, the Federal Open
Market Committee (FOMC) has decided to scale back the
pace of its monthly asset purchases beginning in January.
For some time, we have been of the opinion that asset
purchases were never meant to go on forever, and that
a gradual return toward more normal levels should be
viewed as a healthy development indicating that economic
growth is more self-sustaining and in less need of support.
Of course, the economy is far from hitting on all cylinders,
and with the unemployment rate still elevated and inflation
well below its target rate, the Fed has not put its foot on
the brake, but only slightly lifted its foot off the gas pedal.
Since early this summer, the markets have been uneasy over
when the Fed would slow the pace of its asset purchases,
but the reaction so far has been positive. Tapering will be
more gradual than expected, and short-term interest rates
will most likely not be raised from near-zero until later
than previously thought. Given these circumstances, it is
no wonder that markets have taken the news in stride, with
stock prices rallying, Treasury yields rising minimally, and
market interest rate expectations falling. It seems investors
have gradually realized that tapering is very different than
tightening and that policy will remain accommodative for
a long time.
As economic fundamentals continue to rebalance
toward a slightly stronger pace of economic growth, our
recommendation is to stay overweight risk. After years of
avoiding stocks, retail investors reversed course in 2013
and have been rewarded with a great year, seeing most
equity markets up over 20%. While these outsized gains
have left some investors skeptical as to whether or not the
current rally will have more room to run, we believe that
with an improving economy and corporate profit growth,
stock prices should continue to advance.
Equity valuations may not be as attractive as they were
a year ago, but they are not overly stretched and still
represent reasonable value, especially relative to current
historically low-yielding bonds. Indeed, in the coming
months we see potential for greater investor flows into
stocks with mid- to longer-term interest rates poised
to rise, while shorter-term rates remain anchored near
zero. Although the impressive gains in stocks thus far are
unlikely to continue, and a pullback is likely at some point,
we believe patient equity investors should continue to be
rewarded in the year ahead.
THE FED Five years after reducing the federal funds rate
to near zero, and following three separate programs of
quantitative easing, the Federal Reserve Bank is satisfied
enough with its assessment of the economy and the pace
of the labor market recovery to initiate a reduction in the
massive amount of stimulus that it provides. Beginning
in January, the Fed will lower its monthly pace of asset
purchases by $10 billion per month, to $75 billion per
month. In its communiqué, the Fed indicated that it
will continue to reduce the amount of asset purchases at
future meetings based upon the strength of the incoming
economic data. In the press conference that followed,
Chairman Bernanke indicated that, in his view, the most
likely path would be to taper $10 billion per meeting.
Additionally, the Fed also made an important comment
in which it emphasized that the federal funds target rate
will remain exceptionally low, even past the time that the
unemployment rate falls below 6.5% (currently at 7.0%),
especially if the projected inflation rate continues to be
below the Fed’s 2.0% long-run goal (currently at 1.1%).
At the end of each quarter, the Fed publishes a range of
economic projections. For 2014, the midpoint of its ranges
are as follows: GDP growth 3.0%, Unemployment rate
6.45%, and Inflation 1.5%.
EMPLOYMENT The labor markets were a little brighter
in the first two months of the fourth-quarter with nonfarm
payrolls above 200,000 for two consecutive months. In
the past three years, we have seen a trend develop in which
nonfarm payrolls have had stronger growth in the fourth
and first quarters and weaker growth in the middle two
quarters. The variance in the average monthly gain is
around 50,000 jobs, and is thought to be linked to seasonal
adjustments. The unemployment rate is down to 7.0%, the
lowest level since just prior to the economic downturn.
Since the Fed began its latest round of quantitative easing
(QE3) in September 2012, the unemployment rate has
fallen from 8.1% to 7.0%, and during that same period
2.8 million jobs were created. Average hourly earnings have
been increasing at a 2.0% rate, practically unchanged for
the past three years and at the lower end of the range for
the past 30 years. Normally in the business cycle, as the
unemployment rate falls, which it has for the past three
years, workers’ earnings will accelerate. However, that is
not happening this time, due in part to productivity gains
and the soft labor market. If history is any guide, wages
will most likely not increase until the unemployment rate
pierces the 6.0% level.
INFLATION Price pressure continues to weaken, a trend
that has been in place for about two years. It has been
driven by lower commodity prices, weak wage growth,
and banks with restrictive lending policies. The core
Personal Consumption Index, the Fed’s preferred metric
for measuring inflation, has been growing at 1.1% in the
past year, near its all-time record low and well below the
Fed’s target interest rate of 2.0%. The Fed has stated its
discomfort in the low level of current inflation, and there
are no meaningful signs of acceleration. However, the
Fed’s longer-term view is much closer to its target rate.
So the risk of deflation (falling asset prices) does not look
CONSUMPTION There has been some good news in
the past month showing some strengthening of demand
for goods and services. First, the consumption component
of second-quarter GDP was revised from a paltry 1.4% to
2.0%. This jump puts the pace of demand back on track
to the average pace that has occurred since the end of the
recession. Second, the monthly retail sales reports, which
gives us a more current view of demand, has increased
substantially in the past few months and the most
recent report for November was unambiguously strong.
This improving trend has economist increasing their
estimates for a stronger consumption component in
GDP for the third and fourth quarter. Finally, consumer
confidence has begun to rebound after the partial federal
government shutdown. Since consumption accounts for
more than 2/3rds of GDP, the recent increase can play
an important role in helping to elevate overall growth.
Charts of the Month
HOUSING AND MORTGAGE RATES Although the
housing market has suffered some volatility of late, we
believe the recovery will continue well into the new year.
Strong fundamentals of a gradually improving economy,
and the combination of historically low mortgage rates
coupled with an improvement in home prices makes for
an environment of increased demand.
The housing recovery, which began in 2010 and
accelerated in 2012 and the first half of 2013, has begun
to taper its rate of growth.
The recent slower rate of housing growth is due in part
to a run up in interest rates this past summer, which was
linked to Fed Chairman Ben Bernanke’s comments that
the central bank might reduce its bond buying program.
But in September, the FOMC chose not to initiate the
taper of QE3, and fixed-rate mortgage rates moved down
somewhat. Then, tapering discussions began again and
on December 18, the decision to taper was made. Thus,
mortgage rates have moved up a bit. Hybrid mortgage
rates (fixed for five years, then floating rate, for example)
continue to be near historically low levels.
The latest S&P Case-Shiller 20-City Home Price Index,
which measures constant-quality home prices, shows
prices rising 13.8% over the past year. This remarkable
increase is the largest since February 2006 and marks
the 20th consecutive monthly increase. Helping to keep
this number elevated are two important issues. First, the
supply of homes is low compared to the past few years.
Second, there are significantly fewer distressed properties
for sale. The large number of distressed properties had
bogged down the price of homes the past few years.
The higher mortgages rates, combined with higher home
prices, have reduced the housing affordability index. Yet,
on a historical basis, the index is relatively high, indicating
the relative “cheapness” in affordability of buying a home.
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