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BBVA Compass

Quarterly Market Update

Economic Outlook

Auspicious Quarter Wrests the Economy Back on Track

Second quarter results went a long way towards restoring credence to the U.S. economic expansion after the final estimate for first quarter GDP growth came in at -2.9%, the largest economic contraction since the recession. The slump was blamed on temporary factors, chief of which were extreme weather conditions that kept consumers indoors during most of first quarter. Winter conditions eased by the end of March, business activity rebounded and the economy appeared to be back on track, even reaching some psychologically important milestones.

In May, the expansion hit an important milestone when the U.S. economy recouped all 8.7 million jobs lost in the Great Recession. In June, a surprising 288,000 new jobs were created, the fifth straight monthly gain exceeding 200,000. Employment gains were spread broadly across most private industries, led by growth in professional and business services, retail trade services, and health care. Federal and state government employment also rose after budgets had been constrained for a time by the federal sequester. The unemployment rate fell to 6.1%, the lowest level since September 2008.

The labor force participation rate which measures the active portion of an economy’s labor force remained stable at 62.8% for the third consecutive month. The decline in unemployment rate coupled with rising participation spoke to an improvement in the confidence levels of those seeking employment as well as the long-term unemployed.

The housing market was also hit by bad weather in first quarter, but both building starts and sales of new and existing homes rebounded strongly in second quarter. With prices up and supply down, a number of multi-year highs were reached for the first time since the recession began. Consumer confidence climbed above its 2013 peak to its highest level since the recession. The equity market welcomed the news and the S&P 500 hit 25 new highs on a year-to-date basis.


Economic Outlook

Figure 1. 8.7mm jobs were lost during the 2007-2008 period, but four years later all jobs lost have been regained.

Economic Data Plays into the Hands of the Fed

The improvement in economic data was extremely relevant to the Fed playbook – continued economic expansion, employment growth, and low inflation. Such metrics allowed the Fed to make the fifth $10 billion reduction in monthly bond purchases, bringing them down to $35 billion at the end of June. Before the reductions began in December, purchases stood at $85 billion per month. With the current pace of tapering the Fed is on track to exit Quantitative Easing III in October.

Outlook

We anticipate that economic data will continue to improve and subsequently a stronger second half of the year should propel GDP growth to 2.5% for 2014, up from 1.9% in 2013. Over the coming months, the investment community’s primary focus will be the anticipated time frame for the first federal funds rate hike after the key short-term interest rate has been held at zero since December 2008. With market consensus for this to occur during the second half of 2015, a stronger-than-anticipated improvement in the economy could accelerate the hike to first or second quarter. Such a move could create financial market volatility in the short-term, although longer-term an earlier increase is a good indication that the economy can withstand higher interest rates and tighter money flow.

Undoubtedly the Fed will implement any changes in a measured fashion due to the implications for the financial and real estate markets. Investors have not lost money in bonds for five or six years, but sharp interest rate increases would likely push money out of bonds, and we do not know if the money would move into equities. The Fed witnessed how even the whiff of a short-term rate increase impacts the housing market 18 months ago when an interest rate spike pushed mortgage rates over 4.0%. Although the economy is stronger now, overall housing has so many ancillary effects on the U.S. economy that the Fed will carefully telegraph any change to the key interest rate.

Stronger consumer demand which accompanies a healthier economy is certainly evident and with it comes the need to add to the work force. The recovery has been so protracted primarily because companies have been hesitant to add to payrolls, but improving labor market conditions are certainly supportive of our stronger growth outlook for the remainder of the year. The 300,000 jobs number is psychologically important, as is recouping the 8.7 million jobs lost during the Great Recession.

Although many of the new positions are in the services industries rather than manufacturing, this is reflective of our economy which is increasingly service and consumer oriented, and less manufacturing based. While not necessarily a bad thing in and of itself, the issue is that newly created jobs are at a lower pay and skills level. Corporate profits have not taken a big hit despite the downturn because they have kept input costs low, particularly labor costs, doing more with less. There are obviously other economic factors behind many manufacturing jobs moving abroad including increases in the minimum wage, corporate tax rates, and other overhead costs which pressure margins.

Finally, although difficult to predict, geopolitical issues are always a possibility. Emerging market currency issues pushed the market down five percent in January and later the situation involving Russia and the Ukraine was impactful. It is difficult to predict where the next issue will surface, or how it will impact the U.S. economy.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).