Quarterly Market Update
2012 Outlook Remains Highly Dependent Upon Policymakers
Action by the Federal Reserve and the European Central Bank is historic in the sense that both are simultaneously undertaking open–ended stimulus initiatives.
Sales of the recently debuted Apple iPhone 5 are estimated to add as much as a half a percentage point to U.S. gross domestic product (GDP) this year. Arguably Apple is one of the most important companies in the world, and the new iPhone may very well be the best–selling electronic product in history, but for a single product to make such a significant contribution to GDP tells as much about the economy as the product. While the economy is still expanding, it is doing so at a very moderate pace. Economic growth in the second quarter (the most recent available) was weaker than expected due to slower consumer spending and a drought in the Midwest. The annual rate during second quarter was recently revised downward to 1.3% from the previously reported 1.7%.
Although employment numbers started the year with a bang, primarily due to seasonal issues associated with warmer than normal weather, by mid–year job gains were cut in half, going from an average of over 200,000 new jobs a month down to 100,000 or less. After nonfarm payrolls tallied just 96,000 for August, the Federal Reserve (the Fed) introduced another round of quantitative easing (QE3) at their September FOMC meeting. Under this program, the Fed will buy $40 billion mortgage–backed securities per month in the open market until unemployment comes down. At 8.1% unemployment, we suspect the Fed could be buying for some time.
In early September, the President of the European Central Bank, Mario Draghi, announced a bond buying plan to keep Eurozone sovereign debt yields below the magic threshold of seven percent. Market participants view long–term financing above seven percent as unsustainable, and we have seen associated stress on the equity side when this level is breached. The action by the Fed and the ECB is historic in the sense that both are undertaking unprecedented open–ended stimulus activity to prop up languishing growth. Furthermore, over the past year, there have been roughly 250 new stimulus programs initiated around the globe.
The Fed likely moved ahead with QE3 because we are beginning to see a structural unemployment problem caused by the growing divide between employer needs and employee skills. Consider, for example, the number of new computer programs that become available each year. Persistently high unemployment conditions such as the U.S. has experienced since the credit crisis began in 2008 create a band of workers who have no experience with these new programs.
Interestingly, the unemployment rate has gradually fallen over the past several months. While at first blush this appears to be a positive, closer examination reveals that the drop is influenced by the fact that discouraged workers have stopped looking for jobs, leading to a decline in the labor force participation rate. In such a situation, workers begin losing existing skills while simultaneously missing opportunities to acquire new ones. Such structural problems have very negative long–term implications for the labor force and this was paramount for the Fed’s unprecedented action.
Figure 1 – U.S. job growth has slowed as the year progressed.
The recent expansion in the housing market has come as an upside surprise as the consensus only a year or two ago was that it could be several years before the market recovered. While housing has by no means returned to pre– 2007 and 2008 levels, we are seeing consistent improvement in the existing home sales and new home price data as the economy improves and outstanding foreclosures are absorbed. Historically low interest rates have also helped, while the Fed’s ongoing commitment should accentuate the recovery being observed. Last month new home prices were up across the entire 20 geographic areas/ locations surveyed and were at the highest level since March 2007. July was the best month in two years for existing home sales.
Concerning commodities, a third round of quantitative easing and a weak U.S. dollar should push prices up. However, since QE3 was announced, concern that demand may be weak going forward has created an offsetting effect on prices. Seasonal factors also influence crude prices. Typically the higher demand associated with the summer driving season declines in the fall along with prices. Issues with Iran and Saudi Arabia could change those dynamics quickly, but otherwise we are likely to stay within a band of $80 to $100 a barrel with some marginal relief for the consumer at the pump this fall.
September’s consumer confidence index rose to 70.3, a seven–month high, although the index is still down by historical measures. Retail sales rose 0.9% in August, the largest jump since February. Some states, including Texas, are seeing a pickup in hiring, much of which is related to technological advances in the energy sector. The previous quantitative easing programs have pushed up asset prices, increasing investor confidence in terms of higher 401k balances, a phenomenon the Fed refers to as the “wealth effect.” The combination of these factors could encourage consumer spending and accelerate growth in the fourth quarter.
Outlook for the remainder of the year
Risk–based assets benefited from the policy initiatives announced by the Fed and the ECB. We have seen an equity rally which pushed up the S&P 500 Index by over 10% from June 1st through the end of the recently–ended quarter. But Wall Street has a very short memory, and we expect market focus to soon shift to the fiscal cliff and what happens with tax rates and spending initiatives.
The first two rounds of quantitative easing lifted the prices of stocks and other risk–based assets, but had only a marginal impact on unemployment or economic growth. The bigger issue for unemployment, and something the Fed has emphasized frequently over the course of the summer, is that monetary policy will only go so far. Congress must come together and provide more clarity in terms of addressing the fiscal cliff once the presidential election is over. When GDP growth is anticipated to be a modest two percent for the year, spending and politics which have the potential to subtract three–to–five percent from that number could catapult the economy back into recession.
Considering the number of issues the economy has encountered this year, we believe the U.S. economy is stronger than it may appear. Housing is an important indicator and its nascent rebound is encouraging. The correlation between housing sales and the job market is high, and a decent pickup in employment should further bolster the housing sector. Although the Fed’s ultimate goal with QE3 is to put people back to work and ultimately be financially able to afford a home, the monetary stimulus also provides a cushion or a floor for other economic issues.
The critical barometers for the remainder of the year are getting clarity on the fiscal cliff, seeing tangible results from the Fed’s latest policy action and determining whether the ECB program can contain sovereign yields. Policymaker action is the most important determinant of how the year ends, even more important than who wins the presidential election, at least for 2012. Regarding the U.S., if we do not have at least a deferment in terms of taxes and spending, market volatility will pick up and the failure to act will impose another drag on employment and GDP growth.
In summary, we remain optimistic on the accommodative monetary policy being enacted around the globe and are constructive on the slowly improving U.S. economic picture while still mindful of the potential headwinds from Congress and the ever–present European debt crisis.
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