Quarterly Market Update
Economic Outlook Revolves around the Fed
We project that barring exogenous jolts to the U.S. economy, the job market should return to pre-recession levels by the summer of 2014.
The trend of steadily improving job numbers continued in second quarter. The 195,000 jobs created in June were ahead of consensus indicating that the job market has some potential for upside. Job growth on average for the year hovers around 175,000, slightly more than that which is needed to support new entrants into the labor market.
The most encouraging aspect of the last few job reports is the improvement in the labor force participation rate which measures both the employed and those looking for a job. At one point during the recession, the unemployment rate dropped as people left the work force altogether. Recently the unemployment rate has been relatively stable at 7.6% as people demonstrate increasing confidence in their ability to secure a job at this point in the economic cycle.
While this development does not move the meter on the unemployment rate, it is nonetheless a sign of optimism.
The job market has seen a nice pickup in construction hiring which is driven by the recovery in the real estate and housing markets, both of which are attributable to historically low interest rates. The crash of 2008 hit the construction sector particularly hard and while it is not quite back to pre- 2008 levels, progress is being made. We project that if the current rate of job growth continues, we will regain all the jobs lost during the great recession by the summer of 2014.
Sequester’s Impact is Muted
The impact of the sequester which was announced in early February and implemented beginning in April has not been the financial drag that many initially feared, nor has it stopped the progression of the stock market, unlike the fiscal cliff in the summer of 2012. Many of the job losses have come in the form of furloughs, or a temporary loss of employment. While no one wants to lose their job, the sequester marginally improved the deficit and subsequently the U.S. fiscal situation. Overall, while the full impact of the sequester is yet to be seen, it could be a more benign event than politicos would have us believe.
Figure 1 - U.S. job growth can change significantly from month to month.
Housing Market Continues to Improve
Driven by historically low interest and refinancing rates, the housing market continues to recover much earlier than was expected. Existing home sales, new home sales and new starts are growing at double-digit rates and new home prices are up 15% year-over-year. Such improvements have positively impacted homeowners who were underwater and unable to refinance during the financial crisis and first time buyers are increasingly purchasing houses to take advantage of low mortgage rates while such rates are still available.
The question increasingly turns to the potential impact of higher rates. Until mortgage rates increase by 1.5 to 2%, the market is still fairly affordable. A 50 to 75 basis point spike in mortgage rates is probably manageable for buyers who have the credit, a down payment and the ability to make payments. The key continues to be the availability of credit. The post-financial crisis credit standards went from one extreme to another, from very loose to very tight. We see signs that credit is beginning to loosen at least relative to a year or two ago. Improved credit availability will help those buyers that were probably on the margin a year ago, perhaps not by historical standards, but by those of the post-financial crisis.
Figure 2 - Both existing home and new home sales numbers have improved.
All Eyes on the Federal Reserve
The U.S. economy has improved and unemployment appears to be fairly steady in that layoffs have subsided and there is decent job growth on a monthly basis. No doubt, the Federal Reserve’s (the Fed) quantitative easing policy has increased stock prices, lowered interest rates and improved the housing market. The Fed has made clear that the economy is now stable enough to begin the process of normalizing interest rates. When Chairman Bernanke recently indicated that a slowdown in bond buying, or tapering, could happen as early as August his comments led to a sharp sell-off in bonds and pushed the yield on the 10-year Treasury to 2.59% on June 25.
Consumer and Business Confidence Continue to Improve
We continue to see consumer confidence improving to pre-recession levels. Increasingly the labor force has an improved sense of job security or their job prospects for those who are unemployed, 401k’s and stock portfolios are increasing in value and both have occurred without a spike in the cost of goods and services.
Given their experience during the downturn, business memories are longer than those of consumers, and businesses remain cautious on hiring. However many companies are taking advantage of historically low interest rates to execute stock buybacks and improve their balance sheets. While business profits and bottom lines are strong, increased revenue growth brought on by strengthening consumer consumption which makes up 70% of the economy is needed to kick confidence into higher gear. In order to thrive, businesses need consumers with jobs, houses and open wallets. A continuation of these trends will make companies more confident in the economic expansion.
The ISM manufacturing index has hovered around 50 in a relatively neutral, but consistent, position. Above 50 is considered an expansion, below is contraction. The housing market and other sectors will need to continue to advance to materially impact manufacturing and weakness from orders abroad needs to abate.
The outlook revolves around the Fed and their stance regarding quantitative easing. We anticipate that the Fed will be very deliberate in how they exit the program, decreasing in a very gradual and well-telegraphed manner to the market. Following the latest correction, the U.S. stock market may be a bit more comfortable with the concept of tapering. The cessation of quantitative easing will undoubtedly cause shortterm volatility in both the stock and bond markets. Long term we believe that the Fed’s winding down of quantitative easing sends a positive sign to the markets and is a overall a positive evaluation of the U.S. economy as a whole.
Where the U.S. economy experienced a high level of political risks including the fiscal cliff, the upcoming elections and the flare-up in European sovereign debt issues in the second and third quarters of last year, these appear to have subsided. Currently political drama from Washington politics, fiscal cliffs and sequesters have taken a back seat to what is happening in the economy and some of the political risk have been removed from the picture.
We continue to project a U.S. growth rate of 1.8% with some upside potential if economic measures continue to pick up in the second half of the year.
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