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BBVA Compass

Quarterly Market Update

Economic Outlook

Fed Announces Measured Exit

As the Fed tiptoes out of its stimulus stance, the economic expansion should become more organic in nature.

Financial markets shadowed the Federal Reserve for much of the year, waiting nervously for the tapering of the most unprecedented monetary stimulus in history to commence. Good news became bad news as improving economic data including stronger job numbers for the July-through- September period led to concerns that the Fed was about to end its bondbuying program and subsequently bring an abrupt halt to its support of the economy and, indirectly, equity markets.

In December, the Fed ended conjecture by putting forth a plan for "measured" tapering. Reiterating that he believed the economy was in a moderate recovery phase, Chairman Bernanke announced that, beginning in January, the Fed will reduce monthly purchases of Treasuries and mortgage-backed securities by $10 billion, to $75 billion, and will continue to dial back the program steadily throughout the year as long as the economy continues to advance without such support. During the process, the Fed Funds Rate will remain unchanged until 2015.

Thanks in part to the Chairman’s reassuring tactics which left all options open should the economy once again falter, and perhaps partially due to lessons learned during the Fed’s dress rehearsal announcement earlier in the summer, financial markets responded favorably. Rather than the massive sell off predicted earlier, the Dow responded by posting one of the best days of the year. Interest rates rose slightly but did not spike as they did with the Fed’s original announcement.


Economic Outlook

Figure 1. Monthly job gains averaged 182,000 in 2013.

Job Gains Continue to Hold Key to Economic Expansion

Monthly job gains averaged 182,000 for the year, largely unchanged from 2012. However, job gains picked up steam as the year advanced, and employers added an average of 200,000 jobs a month from August through November. This helped to lower the unemployment rate to 6.7%, a five-year low.

Other economic indicators including expansion in manufacturing, stronger exports and better than anticipated GDP growth also seemed to indicate that the expansion was strengthening after two tepid years. GDP growth was revised up to 4.1% for third quarter, the most recent available, the fastest pace since 2011. Consumer confidence and spending picked up which is critical to economic expansion as approximately 70% of GDP is driven by consumer consumption. The housing market had one of its best years and housing starts, new home prices and building permits posted double-digit growth despite a mid-summer 50 basis points uptick in traditional mortgage rates.

Not all indicators were positive. The labor participation rate declined to 62.8%, a 35-year low. There has been little wage growth in the last few years as employers have tightened costs and tried to get as much from existing employees as possible without adding to their payrolls. Some increased consumer spending was attributable to the wealth effect. Despite the tepid economic expansion, 2013 was a great year for the equity markets and the S&P 500 return of over 32% was a top-ten year for the modern era of markets.

Outlook – Steady Economic Improvement Ahead

2014 should be brighter and reflect a more organic and self-sustaining growth that originates from consumer demand because wages and income growth are improving. While work hours and productivity levels have increased during the expansion, we do not believe the current pace is sustainable. Employers have been reluctant to hire throughout the recession and into the expansion, but eventually firms will have to increase hiring to keep up with output and unemployment will subsequently fall. For the last few years we have seen strong seasonal jobs growth at the beginning of the year, but going forward we anticipate a more continued job expansion, particularly in the first six months.

Downside risks have been moderated at home with the recent two-year budget agreement reached by Congress which will prevent some of the automatic spending cuts planned in the 2013 sequester, and therefore will create less of a drag on the economy. The housing market is still affordable and while the market had huge gains this year it was off a very low bar. The U.S. economy is still the most attractive place in terms of the global landscape although Europe’s sovereign debt crises of the past few years appear to be on the decline.

The largest challenge will be the Fed’s ability to implement a smooth exit from QE3. The new chairwoman, Janet Yellen, who will replace Chairman Bernanke in February is generally viewed as someone who is going to remain on-point as it relates to monetary policy and who will steer the economy, and subsequently the markets, in a very careful direction.

While we are not forecasting strong growth, we do anticipate steady improvement in the first six months of the year. The latter half could be interesting with risk more likely to the upside. We anticipate that in the U.S. annual growth will be 1.8% for 2013 and forecast 2.5% for 2014.

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.

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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.

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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).