Quarterly Market Update
First Fed Rate Hike Appears Imminent, But Still Data Dependent
Hopefully, the rally in the U.S. dollar has either run its course or the pace of the rally will slow given that the glide path of future rate increases has been altered by tepid domestic and global data.
GDP Revised Sharply Higher
A strong labor market, lower gasoline prices, and an improved housing sector helped the U.S. economy grow faster in the second quarter than was initially reported, keeping alive the possibility of a Fed short-term interest rate hike before the year ends. Revised gross domestic product expanded at a 3.9% annual pace instead of the 2.3% initial look reported in July. The revised report also indicated that the trade deficit was smaller than previously reported, adding 0.23 percentage points to GDP growth. After-tax corporate profits also rebounded, although profits are still constrained by a strong dollar and, in some cases, lower oil prices. While the revision is in hindsight and the financial markets are always forward looking, at least the revision pushed the annual year-to-date growth rate over the psychologically important 2% level, to 2.05%.
Although second quarter GDP was revised higher, BBVA Research lowered its expectations for 2015 GDP growth from 2.9% to 2.5%. Developed economies, led by the U.S., continue to hold promising growth prospects, but emerging market economies are struggling.
September's Headline Employment Weaker than Expected
The September jobs report disappointed – the U.S. economy added 142,000 nonfarm payroll jobs, while July and August gains were revised lower by 59,000. The unemployment rate was unchanged at 5.1% with the participation rate falling to 62.4%. The government’s broadest measure of unemployment (the U6) which includes those who have given up on finding a job and those who have settled for part-time rather than full-time employment dropped to 10.0% from 10.3%. Average hourly earnings were flat after a 0.4% gain in August, and the workweek slipped to 34.5 hours, a 0.2% decline.
Figure 1. A look at some closely followed economic data points indicates that the U.S. economy continues to expand modestly while inflation remains below the Fed’s 2% target.
Weak September payroll gains, coupled with downward revisions to the prior two months’ jobs gains and flat average hourly earnings, trumped much of the economic data leading up to the payroll report, validating the Fed’s decision to leave rates unchanged at its September Federal Open Market Committee (FOMC) meeting. The Fed took a “wait and see” approach in order to determine what impact slowing economic growth in emerging market economies, particularly China, might have on domestic growth.
Inflation’s Influence on Markets Gaining
Weighed down by the strong U.S. dollar and lower commodity and energy prices, Personal Consumption Expenditures (PCE), the Fed’s preferred measure of inflation, is expected to remain near 1.3%, well below the Fed’s 2.0% target. While the economy is close to full employment, there have been few signs of wage inflation, and the slow pace of wage growth is of concern to the Fed, given that wage inflation is the most important driver of overall inflation rates.
According to some pundits, the rate of inflation has begun to surpass the employment report as the most influential macro indicator for capital markets.
Figure 2. Non-farm payroll gains began to trend lower in the third quarter, 2015.
Consumers Ignore Global Turmoil
Consumers’ outlook on the U.S. economy improved in September despite recent global turmoil. The Conference Board, a private research group, said its index level of consumer confidence increased to 103.0 in September, up from a revised 101.3 in August. The September level was its highest since January.
Retail sales appear to have recovered from the bumpy start in the first quarter, helping to offset the impact of the global slowdown and a weak manufacturing sector. Sales at retailers and restaurants posted a 0.2% monthly gain in August and a 2.2% annual increase, according to the Commerce Department. Households have benefited from lower gasoline prices and cheaper imports. Because consumer spending accounts for roughly 70% of economic output, advances in the consumer confidence index which translate into consumption gains create an economic tailwind.
Auto Sales and Construction Spending a Bright Spot within Manufacturing
Hamstrung by a strong U.S. dollar, weakening global growth, and softer demand for mining and drilling equipment due to plunging commodity prices, manufacturing continues to be the weakest part of the economy. The September Purchasing Managers Index (PMI) registered 50.2, a decrease of 0.9 from the August reading of 51.1, although any number over 50 is still considered to indicate expansion. Of the 18 manufacturing industries, seven reported growth and 11 reported contraction during September.
Many manufacturers contend that while North American business has been steady, international business continues to trend negative. Regardless, domestic auto sales and construction spending remain bright spots. Indeed, according to the Commerce Department, auto makers’ monthly reports showed the strongest pace since July 2005, while construction spending had its strongest gain since August 2006.
Housing Market Improvements
Continue in Second Half of the Year The housing market’s strong run in the first half of the year continued into the month of July. The S&P/Case-Shiller Home Price Index, covering existing single-family homes across the U.S., rose 4.96% in the 12 months ended in July, outpacing June’s 4.89% increase. Investment in nonresidential structures, reflecting stronger spending on commercial and healthcare construction, as well as spending on residential construction, increased.
However, recent indicators have become mixed – price growth remains strong, but the pace of sales of existing homes slowed in August. Some pundits contend that prices in many markets are increasing faster than incomes, making it difficult for younger buyers to afford the purchase of a home, although financing rates remain at historically low levels. Certainly, the market continues to be fragmented with markets in the western part of the country generally stronger than those in the eastern part. A lack of new home inventory could account for some of the weakness in existing home sales.
Price of Oil Stabilizes
Crude oil prices, as measured by the West Texas Intermediate Crude, ended the quarter at $45.09 per barrel, off approximately 22% since the quarter began. Although oil prices came off the low of $38.93 reached on August 24, the overall trend was downward. Commodities in general are down due largely to economic problems in China, the second largest economy in the world. While lower energy prices are primarily being driven by oversupply, many are questioning whether the current trend could actually be a “canary in the coal mine” whereby global growth has slowed so significantly that decreased demand for energy has become something of a structural change. Regardless, concerns surrounding hurricane season and possible Middle East supply interruption caused by conflict in Syria could boost oil prices before year end.
In light of the shale oil boom in the U.S., cheap gasoline prices, and the Iranian nuclear deal, interest is mounting in lifting the 40-year ban on U.S. oil exports. The ban was originally passed in 1975 on the heels of an OPEC oil embargo which sent oil prices skyrocketing. Higher energy prices negatively impacted the U.S. economy which had become dependent on foreign oil. Now, removing the ban could help the beleaguered energy sector without necessarily resulting in higher gasoline prices for U.S. consumers.
Figure 3. WTI crude oil prices ended the third quarter down approximately 22% since July 1.
Upward Trajectory of U.S. Dollar Slows
The strength of the U.S. dollar continues to hurt exports although recent weakness in the September payroll data appeared to slow the trajectory of the dollar and somewhat stabilize financial markets. When the Fed was meeting in September, the International Monetary Fund (IMF) urged the Fed not to raise interest rates. Any increase in U.S. interest rates strengthens the dollar because money flow follows the direction of interest rates, and other countries want capital to flow into their economies rather than into the U.S. Hopefully, the rally in the U.S. dollar has either run its course or the pace of the rally will slow given that the glide path of future rate increases has been altered by tepid domestic and global data. The U.S. dollar ended the quarter at 1.12 versus the euro, after reaching a quarterly high of 1.16 on August 24.
Interest Rate Hikes Still on the Table
While most believe that an October rate hike is pretty much off the table, there remains the possibility of a December increase despite the technical difficulties surrounding that time period. The recent temporary resolution to fund the federal government expires on December 11, the FOMC meeting is scheduled for December 16, and the Christmas holiday, which typically thins staffing ranks, falls the week after the meeting. In a low volume environment, brought about by what is traditionally the quietest period of the year in the financial services industry, the remaining players have the potential to cause significant volatility in the financial markets in reaction to whatever the Fed chooses to do.
The Fed still sees positive economic growth in the future, although it delayed raising short-term interest rates and lowered its 2016 growth forecast at the September policy meeting. The first rate hike still appears imminent as the Fed continues “table setting”. For example, some Fed officials have stated recently that an increase in interest rates remains viable even if monthly payroll gains are only in the mid-to-low one hundred thousand vicinity. And, truth be told, employment is already in line with the Fed mandate as payroll gains have been fairly strong, averaging 198,000 for the year-to-date, the unemployment rate is down to 5.1%, and the U6 unemployment rate has dropped to 10%, its lowest level since June 30, 2008. Based on these combined factors, the Fed could justifiably claim that the economy is fairly close to full employment. The most significant headwind for higher interest rates continues to be the stubbornly low level of inflation.
Although we run the risk of overemphasizing the Fed when reviewing the economy and its impact on financial markets, the U.S. is by no means beset by problems. The economy consists of multiple moving parts, many of which have been strong – auto sales are running around 18,000,000 annualized, consumption has been strong, and the housing market is still on the upswing. For these reasons, the Fed would like to move short-term interest rates off of zero if for no other reason than to create “dry powder” that could potentially be used in the future should economic weakness return.
The Fed’s expectation for where interest rates will be over the next several months/years is still more aggressive (higher) than what investors think. Although Chairwoman Yellen stresses that the “dot plots” are not a projection, but are rather simply the average of each FOMC member’s projection for the fed funds rate, the projections are still higher than what the market anticipates. The most recent dot plot from the Fed lowered their expectation for the year-end 2016 fed funds rate to 1.4%, down from the previous estimate of 1.6%. Based on where fed funds futures are trading, the market is projecting that rates will be even lower than that, but it does appear that the Fed and the market are moving closer together in terms of future expectations of where the fed funds rate will be. Regardless of when the first rate hike occurs, the Fed continues to signal that its approach to rate increases will be slow and cautious.
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