Quarterly Market Update
Congressional Budget Wrangling Impacts Consumer Confidence
The primary impact of Congressional budget wrangling is on consumer confidence, the very spot where it is desperately needed. We continue to see moderate recovery characterized by modest gains in the economic indicators each quarter.
From an economic perspective, the third quarter ended quietly even as political machinations on Capitol Hill escalated. September was widely anticipated to be the beginning of the end of the largest and longest period of monetary easing in the history of the U.S., one that swelled the Federal Reserve’s (the Fed) balance sheet to over $3 trillion. Instead the Federal Markets Open Committee (FOMC) shocked the world by announcing that it would continue the current quantitative easing (QE3) program, at least in the short term.
The move drew mixed reactions – some economists heralded it as another indication of the lack of consensus on the economic outlook while others applauded the Fed’s restraint in light of a summer characterized by lackluster jobs’ growth and an autumn traumatized by yet another debt ceiling debate.
In May, Chairman Bernanke prepped the markets for a wind-down of the asset purchase program beginning as early as September should the economic recovery continue unabated. However, the Fed decided to postpone its withdrawal based on the modest labor market recovery and concerns that the summer’s interest rate increases could weaken the economy particularly in the housing sector which has been a bright spot in the recovery. There was also speculation that the Fed held steady due to the proximity of another expected budget impasse and debt ceiling debacle which could create undue pressure on the markets. Core inflation still well below the Fed’s target of 2.0% supported the decision, providing the Fed with further justification to continue easing.
The summer’s non-farm payroll increases remained in line with the year’s monthly average of between 150,000 and 200,000. The unemployment rate declined to 7.3%, the lowest level since November 2008, as a result of a sharp decline in the participation rate. The August participation rate of 63.2%, which measures those that are either employed or actively looking for employment, is well below the 20-year norm of 66% to 67%.
Figure 1. Monthly payroll gains remain slightly under 200,000 on average for the past year.
Figure 2. August participation rate was down as fewer people are in the job market or are looking for work.
The housing sector has benefited from the Fed’s monthly purchases of $40 million of mortgage-backed securities which drove mortgage rates to a record low of 3.31% this past November. In June, home prices increased 12.1 percent above the same month one year ago, according to the Case-Shiller home price index. But the general uptick in interest rates in anticipation of the commencement of Fed tapering pushed the pre-summer mortgage rates up by over 100 basis points, impacting refinancing activity and slowing existing home sales.
The news that Syria had deployed chemical weapons against their own people, and the threat of a Middle East conflict, made oil prices skyrocket. Prices are still elevated – somewhat in response to the delayed tapering – although a diplomatic solution rather than a military strike was reached.
Government Shutdown Impact
As we have previously stated, the effect of this year’s sequester was perhaps overdramatized and many of the expectations for its ability to spook the market did not come to fruition. The sequester has shored up the federal budget to a small extent without depressing GDP or jobs growth. In second quarter, GDP grew at 2.5%, in line with expectations.
The primary impact of Congressional budget wrangling is on consumer confidence, the very spot where it is desperately needed. Despite the fact that consumer spending is strong, initial job claims are down to 300,000, a six-year low, and job postings are estimated to be up 100% year-over-year, concerns about the economy still abound. There remain a number of people negatively affected by the economic environment and many investors have delayed reentering the financial markets because they lack confidence in the economic expansion. Ultimately the current debt ceiling and budget wrangling should create buying opportunities much like in 2011, but a great deal of cash remains on the sidelines that when and if deployed could take us to the next level in terms of the current rally.
We anticipate getting through the debt ceiling and budget impasse but not without a surfeit of theater. We continue to see moderate recovery characterized by modest gains in the economic indicators each quarter. We anticipate continued GDP growth in the 2.0 to 2.5% range for the balance of the year, with some potential to the upside.
Figure 3. The 1995-1996 government shutdown turned out to be a buying opportunity for equity investors.
The Fed focus will continue. The market is well prepared for the inevitable tapering and September’s pullback likely prepared the market even more so. Inevitably the end of monetary stimulus is on the horizon. We anticipate that Fed bond purchases will drop by $5 to $15 billion per month by the end of the year. Rates will likely rise on that news, but we anticipate that the Federal Funds rate will remain at zero until at least 2015. We ultimately want to get back to a normal interest rate environment with economic activity supporting the U.S. financial situation rather than a government entity like the Fed artificially creating an easy money environment. In our opinion this is very bullish for equities.
Europe is also demonstrating early signs of improvement. The economy grew by a scant 0.3% in 2nd quarter, but barring a meaningful downward revision represents the beginning of the end for the Eurozone recession. There have not been any recent market flare-ups on sovereign debt issues and, in the case of Europe, no news is good news.
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