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Weekly Commentary by Dr. Scott Brown

Global Worries (And Some Benefits)
October 13 – October 17

In the latest update of its World Economic Outlook, the IMF revised lower its expectations of global growth in 2014 and 2015. None of that should have surprised anyone. At this point, the IMF expects that European GDP will be relatively weak in 2014 (+0.8% 4Q14/4Q13) and should improve in 2015 (+1.6% 4Q15/4Q14). However, risks are weighted predominately to the downside. Weaker European growth and a stronger dollar will have a significant impact on many U.S. firms, but may have some benefits for the economy as a whole.

Global investors have worried a lot about Europe in the last few years. However, the key fear, that we’d see a breakup of the monetary union, was largely put aside when ECB President Mario Draghi promised to “do whatever it takes.” Issues present at the creation of the monetary union had finally come to a point where they had to be addressed. Critics cautioned early on that Europe needed a banking union and a fiscal union to make the monetary union work. European authorities have made progress in recent years, but still have a long way to go.

While Europe’s crisis of the last few years has been called a “sovereign debt crisis,” government debt was not the catalyst for weakness. It’s been a crisis of capital flows. With lower borrowing costs, money poured into the peripheral countries when the euro was introduced (contributing to housing bubbles in Ireland and Spain), then capital started to flow out during the global financial crisis. Many had expected Europe’s difficulties to lead to a flight-to-safety in the U.S. dollar. However, the safety flow went largely to Germany, leaving little impact on the exchange rate. More troublesome, the misdiagnosis of the cause of the crisis led to the bad prescription: austerity.

Government budget deficits and debt levels are important long-term issues. There are well-known concerns about using fiscal stimulus (lower taxes, increased government spending) to boost growth (how big, how to unwind), but what’s clear is that fiscal tightening (higher taxes, reduced government spending) in an economic recovery is a bad idea. It contracts the economy. Growth will be slower than would have occurred otherwise. Moreover, slower economic growth means a slower recovery in tax revenues, and less budget improvement than was anticipated. It’s a self-defeating policy.

Europe is now in a much more precarious phase. Inflation is trending very low. Economists note that it’s real (that is, inflation-adjusted) interest rates that matter. For any given level of interest rates, lower inflation implies a higher real rate of interest – and slower economic growth than you’d see otherwise. The European Central Bank has lowered benchmark interest rates to near zero (and in case of the interest rate on the deposit facility, negative). It can’t go lower.

Saddled with the zero lower bound on interest rates textbook economics (granted, graduate-level textbooks) suggest that the central bank can expand its balance sheet to support economic growth. The ECB is embarking on an asset purchase program, but this is more akin to the Fed’s TALF, the Term Asset-Backed Securities Loan Facility (from March 2009 to June 2010). The central bank receives asset-backed securities and gives the banks cash, which they will use to make more loans (or at least, that’s the theory). This is different from outright quantitative easing, but has similar economic effects in the short-run. The ECB is widely expected to undertake real quantitative easing (the outright purchases of sovereign debt) in the months ahead (at the clear objections of the Germans).

Whether the ECB’s efforts to spur growth will work soon enough is an open question. The key point for financial market participants is not that Europe’s economy will necessarily fall apart, but that the downside risks are considerable. Weak European growth will have a negative impact on countries like China, which remain dependent on exports (China may also have to contend with the collapse of a housing bubble).

European weakness will have a significant impact on many U.S. firms, which are expected to see weaker earnings growth from Europe and a loss in the currency translation (due to the stronger dollar). However, while we should see a decline (or at least softer growth) in exports to Europe, that weakness is unlikely to drag the broader economy down.

There may be some parallels with the Asian financial crisis of 2007 (of course, there are many more differences than similarities to the current situation in Europe – just hear me out). In the Asian financial crisis, the hit to U.S. exports subtracted a full percentage point from GDP growth. However, the crisis put downward pressure on inflation and boosted capital inflows, which was far more significant. Similarly, we are now seeing a stronger dollar put downward pressure on commodity prices. Increased capital inflows should help keep long-term interest rates relatively low and the stronger dollar will likely delay the Fed’s first increase in short-term rates.

Gasoline prices have drifted lower in recent months, but not enough for a sharp boost in consumer spending (note that gasoline prices normally fall about 12% from May to December, and have fallen about 10% so far this year). However, gasoline prices are likely to fall faster in the near term and a further decline (to below $3 per gallon) would add more significantly to consumer purchasing power into early 2015.

The Asian financial crisis had a negative impact on the U.S. stock market, but that turned out to be a great buying opportunity. We may see some imbalances develop (a wider trade deficit), but the U.S. may benefit from Europe’s weakness.


The September Employment Report
October 6 – October 10

The headline figures from the September jobs report were better than expected. However, the details were more consistent with moderate growth and a continued high degree of slack. Fed officials aren’t going to jump to any conclusions.

Payrolls rose by 248,000 in the initial estimate for September, while figures for July and August were revised a net 69,000 higher. Part of September’s strength reflects a rebound from two special factors that reduced the August total (a seasonal adjustment quirk in autos and labor difficulties at a New England grocery chain). One can ex-out this impact, by averaging the last two months (a +215,000 average, vs. a +261,000 pace over the four previous months). Private-sector payrolls averaged a 217,000 monthly gain in 3Q14 (+216,000 over the 12 months).

Seasonal adjustment adds some uncertainty to the headline payroll figures for September. Prior to adjustment, we added 1.487 million education jobs (vs. +1.416 million in September 2013), and shed 786,000 non-education jobs (vs. -823.000).

The unemployment rate fell to 5.9% in September (from 6.1% in August), the lowest since July 2008. However, most of the drop was due to a decrease in labor force participation (which may have reflected seasonal adjustment issues at the start of the school year). The employment/population ratio was flat at 59.0%, up just 0.4 percentage points from a year ago. The participation rate is now at its lowest point since October 1977.

Some short-term job market measures, such as weekly claims for unemployment benefits and the percentage of people out of work for less than half a year, are at levels we normally associate with an economy that has fully hit its stride. However, other gauges, such as the employment/population ratio, long-term unemployment, and involuntary part-time employment, continue to suggest that a lot of slack remains.

For Fed policymakers, the September employment figures tell us nothing new. The job market is improving, but we’ve a long way to go. The Fed has plenty of time to decide when to begin raising short-term interest rates. The economic figures over the next several months should dictate that decision, but we didn’t really learn much that was new last week.


Looking Back, Looking Ahead
September 29 – October 3

Real GDP is now estimated to have risen at a 4.6% annual rate in 2Q14. However, the second quarter’s strength must be balanced against the first quarter’s weakness (a -2.1% pace). As the third quarter ends, we still don’t have a complete picture. However, figures are likely to suggest a moderately strong pace of growth and a gradual taking up of economic slack.

Consumer spending accounts for 70% of Gross Domestic Product. Inflation adjusted spending fell 0.2% in the initial estimate for July, following a 0.2% gain in June – suggesting very little positive momentum into the early part of 3Q14. Those figures will be subject to revision in this Monday’s report on personal income and spending. The August spending figures and September auto sales data will help to fill in the consumer picture for 3Q14. Motor vehicle sales snapped higher in August, which should drive overall spending up.

Weak growth in real average wages has been a restraining factor for consumer spending in recent months. Labor compensation has been rising roughly 2% year-over-year, vs. a normal pace of 3.5% to 4.0%. The average worker is barely keeping up with inflation. Lower gasoline prices ought to help in the remainder of the year. Retail gasoline prices normally fall about 12% between May and December. They’ve already fallen 8.7% this year. Spending less to fill their gas tanks, consumers should be left with more to spend on other things over the next few months. The 13-week average is good for gauging the lagged impact on consumer spending.

Business cycles are characterized by swings in capital expenditures. Business fixed investment rises in economic expansions and crashes in recessions. The aftermath of the tech bubble was large, but the pullback in investment in the financial crisis was a lot steeper. The monthly data on shipments and new orders tend to be choppy, but the three-month averages have shown a strong trend in recent months. Business fixed investment rose at 1.2% annual rate in the first quarter, but accelerated to a 9.7% pace in the second. Data for July and August suggest continued strength in the third quarter.

Capital expenditures are driven largely by profits, although businesses are not going to expand if they don’t think the demand will be there. Recent strength in capital spending suggests a renewed optimism regarding economic growth over the next several quarters. Note that firms have a tendency to hire new workers as they increase capital expenditures. Hence, good economic news could feed on itself.

Faster inventory growth added 1.4 percentage points to GDP growth in 2Q14 (vs. -1.2 ppt in 1Q14). While we have limited information at this point, inventory growth is likely to have slowed in 3Q14, subtracting from overall growth.

Global growth has been a lot weaker than expected this year. The dollar is a lot stronger. Hence, export growth ought to be restrained in the months ahead and imports (which have a negative sign in the GDP calculation) should be somewhat stronger. However, while foreign trade is likely to limit the overall pace of GDP growth in the next few quarters, domestic demand is likely to be significantly stronger.

Where does this put Federal Reserve policymakers? The key questions are how much slack remains in the economy and how rapidly that slack is being taken up. A low inflation environment allows the Fed more time to make these assessments.


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.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

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