Quarterly Market Update
The Fed Prepares to Remove the Training Wheels
The Fed is preparing to exit quantitative easing programs as evidence grows that the economy can stand on its own two feet without large monthly infusions of liquidity. Subsequently, strong economic data will become more important than it has been for some time.
Job growth continued in line with what has become modest expectations in third quarter. Initial reports for September indicated the economy added 248,000 jobs. July and August numbers were revised upward, pushing the quarter’s monthly average payroll gains to roughly 224,000. Although short of the 300,000 level which would be expected this far into the recovery, the data was nonetheless welcomed by financial markets after August’s disappointingly weak 142,000, later revised to 180,000.
The unemployment rate dipped below 6%, down to 5.9%, for the first time since July 2008. But wage growth continued to hover in the neighborhood of an anemic 2.0% where it has stood for nearly five years. The decline in the unemployment rate was also accompanied by a simultaneous decline in the labor force participation rate to 62.7%. Federal Reserve Chairman Janet Yellen attributed much of the decline in the participation rate, which has stabilized in the last year, to structural issues which may improve with a stronger labor market. Despite such somewhat modest data, a recent online study by Harris Poll on behalf of Randstad indicates that U.S. employee confidence in their personal employment situation is now better than at any time since September 2008.
Figure 1. Nonfarm payrolls grew by more than 248,000 in September as the unemployment rate fell to 5.9%, its lowest level in six years. Expectations were for a gain of 215,000 with the unemployment rate expected to remain at 6.1%.
Upward revisions to exports and residential investment pushed second-quarter GDP to 4.6% from 4.0%, the strongest pace for quarterly growth since fourth quarter, 2011. The stronger growth helped to offset the first quarter’s 2.1% contraction which has been attributed to weather- related phenomena.
During the reporting period, economic activity in the manufacturing sector expanded for the 16th consecutive month. Retail sales also improved relative to the same period one year ago, boosted by lower gas prices and better job growth.
Figure 2. Lower gas prices and better job growth helped U.S. retail sales to rise a seasonally adjusted 4.30% in September 2014 over the same month in the previous year.
Figure 3. Economic activity in the manufacturing sector expanded in September for the 16th consecutive month, and the overall economy grew for the 64th consecutive month, according to the nation’s supply executives in the latest Manufacturing ISM® Report On Business®.
However, signs of an uneven housing recovery continued in August. Sales of existing homes which account for 90% of all housing transactions, fell for the first time in five months. The decline reflected elevated home prices in conjunction with tighter inventory – the number of distressed (i.e. affordable) properties has declined significantly – and increasing mortgage rates. The disappointing demand for existing homes was partially offset by sales in new homes. New home sales surged 18% in August over July, their highest level since May, 2008.
The Fed announced that tapering would end on October 29. The U.S. dollar strengthened on the expectation of higher interest rates subsequent to continued GDP growth at home, relative to abroad, where central banks in the Eurozone and Japan are introducing looser monetary policy to combat deflation and slower economic growth.
Stock market volatility picked up during the quarter on anticipation of the end of tapering and a confluence of other factors. Geopolitical events in the Ukraine and Russia, Hong Kong, and in Syria and Iraq, Portugal’s banking crisis, the West African Ebola outbreak, and company- specific issues including problems with the operating system of the new IPhone 6 and computer hackers at Home Depot and Chase Bank were reflected in higher market volatility after the rather sanguine bull market advance of the past two years.
Inflation remained muted. The Consumer Price Index for all Urban Consumers decreased 0.2% in August on a seasonally adjusted basis due primarily to a decline in energy prices, particularly gasoline. Although the indexes for food and shelter rose, the increases were more than offset by the declines in energy indexes. Many investors would like to see inflation expectations pick up as stocks have the best correlation with inflation, and a whiff of higher prices might just be the ticket to move equity prices higher.
Unless third and fourth quarter economic growth proves to be gangbusters, the data continues to support a baseline scenario of real GDP growth of 2.0% growth for 2014. First quarter’s negative number creates a significant drag despite GDP being up almost 5% in second quarter. A bit of inflation and an above average increase in monthly job gains is needed to push GDP upwards. But job growth for the remainder of the year is unlikely to break out of existing trend lines, although there is a very slight risk to the upside. The stronger dollar will drive investment towards the U.S. which on balance is a positive as it translates into a stronger economy.
Mid-term elections come right after the projected end of quantitative easing. Some pundits believe the Senate is up for grabs which could shift the focus off the Fed pretty quickly. But overall, politics is not a big driver of the market except on a day-to-day basis. Geopolitical events can roil the markets for longer periods of time, but often they are simply noise – issues that investors must be prepared to address in terms of asset allocation. Seldom do they bring bull markets to an end.
Figure 4. According to a statement by the Commerce Department, housing starts slumped in August, primarily due to a slowdown in multifamily projects which have led the U.S. real estate rebound. Beginning home construction fell 14.4 percent, to a 956,000 annualized rate.
The upcoming quarter’s witching hour falls on October 29 when the Fed stands ready to exit quantitative easing. There could be something of a “buy the rumor, sell the news” activity surrounding the event. Financial markets have become addicted to the stimulus and there is always the question of what markets will do when the stimulus is no longer there. Everyone has the end in sight, but the stimulus has gone on for so long, and been of such unprecedented magnitude, that concerns surrounding its conclusion are unavoidable.
Without question life after QE3 must be strongly supported by economic data. The Fed is making an exodus based on confidence that the economy can stand on its own two feet without large monthly infusions of liquidity. Once the Fed is no longer backstopping the economy, the data– primarily jobs, but also manufacturing numbers, consumer confidence, and housing – must become the ultimate backstop.
Early fourth quarter mixed economic data may even leave open the possibility of further purchases by the Fed, in effect, extending QE3. However, this seems unlikely at this point unless we see more extreme deterioration in economic releases for the balance of October.
The related concern is how higher rates next year will impact the housing market, consumer credit, and highly- levered companies. If the economy continues to improve then the Fed signaling higher interest rates should be ok, but if the economic data is not sufficiently strong, then we anticipate increased market volatility.
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).