Should Be an Eventful Week
July 28 – August 1
The economic calendar is packed with important items this week. Oddly, Wednesday afternoon’s policy announcement from the Federal Open Market Committee may be the least interesting. One shouldn’t put too much weight on the advance GDP estimate, as the figures will be revised, but the initial estimate, along with annual benchmark revisions, should have important implications for the outlook for growth in the second half of the year. Payroll figures from the employment report are subject to a fair amount of statistical noise, but the financial markets will have to take the reported figures at face value.
The Federal Reserve has well telegraphed its intention to taper the monthly pace of asset purchases by another $10 billion. However, Fed officials are not expected to provide any fresh clues on exactly when short-term interest rates will begin to rise. Fed officials are researching and debating the mechanics of policy normalization (the tools and the order of steps to be taken as the Fed begins to remove policy accommodation), but won’t provide details in the near term. There may be some minor changes in the wording of the Fed’s economic outlook.
There’s nothing magical about the size of the Fed’s balance sheet. By itself, a large balance sheet does not imply a higher inflation rate. It’s a question of loan growth and whether that’s leading to inflation pressure in resource markets. When appropriate, the Fed can drain bank reserves through reverse overnight repos, issuing time deposits to depository institutions, or by raising the interest rate that the Fed pays on excess reserves held at the Fed (IOER). There are a number of issues regarding the ability of the Fed to take these steps in sufficient size, but officials are working on the details and expect to let the public know their conclusions by the end of the year.
The advance estimate of GDP growth is always an adventure. The government does not have a complete picture for the quarter and has to make assumptions about foreign trade, inventories, and other components. The GDP figure will be revised in late August and again in late September. Compounding the uncertainty this time, the government will also release annual benchmark revisions to the GDP figures for the last few years. This will be a “garden-variety” benchmark, one based on revised source data rather than any major change in methodology (although figures will incorporate the recently improved international transactions data). Typically, this kind of revision will shift some GDP from one quarter to the next, but not raise or lower the level of activity by much. Nevertheless, it will be interesting to see how much of the reported plunge in 1Q14 GDP holds up in revision. The PCE Price Index, the Fed’s chief inflation gauge, will be subject to revisions, but the recent history is unlikely to change by much.
Investors are likely to focus on the headline GDP figure, but the more important issue is what the data suggest about GDP growth in the second half of the year. Monthly figures on personal income and spending will be released on Friday, including benchmark revisions. Most likely, the recent figures will be consistent with many of the other major economic reports such as retail sales and industrial production. These reports showed a relatively strong rebound from the first quarter’s weather-related weakness, but with some loss of momentum heading toward the third quarter. That apparent loss of momentum is worrisome, as it suggests that second half GDP growth may be softer than was hoped for earlier.
Income inequality has been a political issue this year and the debate has largely focused on taxes. However, the more important concern should have been the whittling away of the middle class. Inflation-adjusted average wage income has been essentially flat. Last week, the Bureau of Labor Statistics reported that median usual weekly earnings for 2Q14 were down 0.3% from 2Q13 (note: the median refers to the middle point in the distribution – half had higher earnings and half had lower earnings). Adjusting for inflation, median usual weekly earnings were down 1.2% from a year ago and are roughly at the same level as ten years ago. Aggregate wage income (and in turn, aggregate spending) can still increase as long as job growth is positive, but the weakness in inflation-adjusted average wages has been a limiting factor for consumer spending growth.
Last week, the report on durable goods orders and shipments included some disturbing details. Shipments of nondefense capital goods excluding aircraft fell 1.0% in June, the third consecutive quarterly decline. Shipments still rose moderately in 2Q14 (thanks to a 2.2% weather-related rebound in March), but the trend points toward a subpar pace in 3Q14.
Job growth has been one of the most positive stories in the first half of 2014. Prior to seasonal adjustment, the economy added 3.85 million private-sector jobs between February and June. However, part of that reflects weather-related weakness in the early part of the year. Job destruction has remained low (it hasn’t been an issue in the last few years) and new hiring appears to have picked up. However, there is a fair amount of statistical noise in the payroll figures (the monthly change in payrolls is reported accurate to ±90,000). It’s not unusual to get a string of monthly figures above or below the underlying trend. Hence, the recent trend in payroll growth is encouraging, but hardly conclusive. Unfortunately, financial market participants essentially have to take the payroll numbers at face value.
By week’s end, economists will have a clearer (but still distorted) picture of the near-term trends, which may lead to downward revisions to GDP growth expectations for the second half of the year (a bit below 3%, rather than a bit above).
Are Interest Rates “Too Low?”
July 21 – July 25
In her monetary policy testimony to Congress, Federal Reserve Chair Janet Yellen offered no new clues regarding when the central bank will begin raising short-term interest rates. The Fed has been criticized for being “behind the curve” on inflation and for fueling bubbles. Neither criticism is right.
Inflation figures have picked up in recent months. The Consumer Price Index rose at a 2.6% annual rate in the first five months of 2014, a 2.3% pace ex-food & energy. The Fed's official gauge, the PCE Price Index, rose at a 1.9% annual rate, a 1.7% pace ex-food & energy (vs. the Fed’s official goal of 2%).
In the depth of the recession, when the Fed began its extraordinary policy measures, a number of critics said that inflation would soon take off and some even suggested that hyperinflation was “just around the corner.” More sober commentators noted that the huge amount of slack in the economy, especially in the labor market, would keep inflation in check. Nearly six years later, higher inflation has yet to arrive. In her testimony to the Joint Economic Committee last month, Janet Yellen dismissed the recent pickup in the CPI as “noise” and there's good reason to believe that's the case. The Producer Price Report (recently expanded to include services) suggests no significant pipeline pressures. Import price figures show no pressure in raw materials or in finished goods. Wage pressures remain relatively contained.
The inflation mongers dismiss low inflation readings as meaningless the government either isn't measuring inflation correctly or is purposely distorting the figures. There are a number of empirical issues in how inflation is measured, but the Bureau of Labor Statistics does a remarkably good job. Consider MIT's Billion Price Project, which tracks online retail prices and shows inflation relatively close to the official figures. Note that one's personal inflation rate will vary, depending on what goods and services the individual purchases.
At some point, of course, the Fed will need to begin to normalize monetary policy, but there’s nothing to suggest that the Fed is currently behind the curve on inflation.
The other main criticism of monetary policy is that the Fed is fueling bubbles. From the Monetary Policy Report to Congress:
“With regard to asset valuations, house prices have continued to increase, but, for the most part, these increases have left aggregate price-to-rent ratios within historical norms. Moreover, growth in residential mortgage debt has remained anemic, suggesting that the recent increases are not fueled by excessively aggressive lending conditions. More broadly, aggregate measures of the household debt burden appear reasonable despite recent rapid growth in auto lending and student loans, which has strained some borrowers, particularly those in the lower half of the income distribution.”
“However, signs of risk-taking have increased in some asset classes. Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms. Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened. For example, average debt-to-earnings multiples have risen, and the share rated B or below has moved up further for leveraged loans. The Federal Reserve continues to closely monitor developments in the leveraged lending market and, in conjunction with other federal agencies, is working to enhance compliance with previous guidance on issuance, pricing, and underwriting standards.”
So, the Fed definitely sees signs of excess in some areas, but this is not a widespread problem for the financial sector as a whole. Yellen promised that the Fed will continue to monitor the situation closely. Earlier this month, she indicated that the Fed would not use monetary policy as the first line of defense against bubbles, but would instead rely primarily on supervision. Yet, she noted that the Fed's regulatory powers, while having increased since the financial crisis, are not where they need to be. Hence, she didn't rule out a tightening of monetary policy as a tool to restrain financial bubbles if need be. Of course, the track record on this is not very good. Tightening to address a bubble, the Fed risks weakening the economy. The financial crisis demonstrates the problem of not tightening soon enough.
One regularly hears that stock prices are artificially inflated due to the Fed's actions and that the market is bound to correct once the Fed begins to raise short-term rates. Let's consider the logic here. Broadly speaking, there are two ways to value stocks. One is to think of the price as a risk-adjusted discounted stream of future earnings. A lower interest rate means that future earnings are discounted less hence, a higher stock price (all else equal). As the economy improves, earnings should increase, but higher interest rates mean greater discounting of those earnings. It may not be clear whether the increase in earnings will offset the greater discounting, but risk and uncertainty should decrease as the economy improves. However, note that the shape of the yield curve implies an expected path of interest rates, which should be incorporated into the discounting of future earnings. So, stock market valuations should therefore depend not on whether interest rates rise, but on whether they rise faster or slower than the market currently expects. That's the key question.
The other way to value stocks is the same as the way one values art. That is, what’s the next person willing to pay? Technical analysis, the study of chart patterns, is one way to measure market sentiment. That's beyond my ken, but interest rates are probably right about where they should be.
Reaching Escape Velocity?
July 7 – July 18
The strong pace of growth in nonfarm payrolls suggests much more than a rebound from bad weather. While recent economic figures have been generally mixed, the job market is clearly improving, led by increased hiring at small and medium-sized firms. The hope is that good news will feed on itself, lifting the pace of growth in the second half of the year. However, there are a few concerns in the outlook.
Small and medium-sized (essentially, newer) firms typically account for more than their fair share of job growth in an expansion. These firms have been restrained in the recovery, but demand appears to have improved to the point where many of them must hire new workers to keep up.
Prior to seasonal adjustment, nonfarm payrolls rose by 582,000 in June (education down 847,000, but up 1.429 million otherwise), up 3.8 million since February. That’s a pretty good spring. Note that unadjusted private-sector payrolls usually trend only gradually higher in the second half of the year.
The unemployment rate fell to 6.1% in June, the lowest since July 2008. The employment/population ratio rose modestly and has been trending only gradually higher over the last year. The aging of the population suggests that we’re unlikely to get back to the pre-recession level on employment/population, but we should be able to make up at least two-third of the ground lost. We still have a large amount of slack in the labor market.
Short-term unemployment has returned to normal levels, but long-term unemployment remains elevated.
There are three concerns in the economic outlook: 1) wage growth has remained low, limiting the potential upside for consumer spending growth; 2) geopolitical tensions could escalate, boosting gasoline prices and increasing the degree of caution in business hiring and capital spending; 3) there is little scope for expansionary fiscal or monetary policy should that be needed. However, strong job growth may be sufficient to boost consumer spending in the near term, which in turn, would lead to even more job growth in the second half of the year.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
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