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Quarterly Market Update

Economic Outlook

Choppy Growth Pressures GDP Forecast

  • A slow start to the beginning of the year means economic growth in subsequent quarters must exceed 3.5% in order to reach the current 2.9% annualized GDP growth forecast.
  • Slower-than-expected recovery in the housing sector and weak manufacturing growth are holding back the domestic economy. The strong U.S. dollar remains a significant headwind for the export-dependent manufacturing sector.
  • Job creation is a bright spot, although the rebound from the first quarter stall is short of the robust mid-year surge seen in 2014.
  • Inflation continues to lag the Fed’s 2.0% target.
  • Global economic conditions hint that the initial fed funds rate hike could be delayed.

Second-Quarter Bounce Could Disappoint

Weakness in the first quarter and indications that the second quarter might also disappoint are casting a pall on 2015 GDP estimates. It had appeared that the economy was moving beyond the factors that contributed to a contraction of 0.20% in the first quarter – harsh winter conditions, the strong U.S. dollar, spending cuts in the energy sector, and a West Coast port strike. But the anticipated bounce failed to materialize after first-quarter corporate earnings were lackluster, Greece defaulted on its debts, and payroll gains failed to rebound from the first-quarter stall at the same pace as in 2014. The spell of patchy growth combined with the crisis in Europe suggest that the U.S. economy may be in for a bumpy ride for the remainder of the year. (The second- quarter GDP and corporate earnings data will not be available until after the closing date of this publication.)

First-quarter economic growth is traditionally weaker than subsequent quarters, but going forward, quarterly GDP growth must exceed 3.5% to reach BBVA Research’s currently projected 2.9% annualized growth rate. Weaker economic activity is exerting pressure on the estimate, and a downward revision is possible.

Economic Outlook

Figure 1. A look at some of the closely followed economic data points indicate that the U.S. economy continues with slow, steady progress.

Payroll Gains Less than Rosy, but Still the Bright Spot

The June U.S. jobs report was mildly disappointing – payroll gains were slightly below expectations while April and May gains were revised lower by 60,000. The U.S. economy added 223,000 nonfarm payroll jobs in June. Including monthly revisions, year-to-date monthly payroll gains have averaged 208,000, trailing the 260,000 monthly average in 2014.

The headline unemployment rate (the U3) dropped to 5.3% in June, a new recovery low and near levels usually consistent with a healthy labor market. However, the number is somewhat mitigated by the fact that the labor-force participation rate stands at 62.6%, the lowest level since 1977, and a level which is inconsistent with an economy approaching full employment. Indeed, the government’s broadest measure of unemployment (the U6) which includes “discouraged workers,” or those who have given up on finding a job and those who have settled for part-time rather than full-time employment, is 10.5%. While the gap between the U3 and the U6 has narrowed over the past year, the gap suggests that an unusually large number of Americans are underemployed considering the steady job creation of the past few years. Certainly, further declines in the participation rate have the potential to influence the Fed’s rate setting decision.

That said, job creation is headed in the right direction, and is one of the bright spots on the economic front. We anticipate that average monthly payroll gains for the balance of the year will be in the vicinity of 250,000. Despite the solid payroll gains, we do not expect to see wage inflation accelerate until the capacity utilization rate moves well above its current level of 78.4%.

Economic Outlook

Figure 2. Year-to-date monthly non-farm payrolls have averaged 208,000, trailing 2014’s monthly average of 260,000.

Low Inflation Continues to Puzzle

The Fed has twin mandates – full employment and a 2.0% target for inflation. While the Fed gets high marks for full employment at least on a headline basis, it has not been as effective on the inflation side of the equation. The persistence of low inflation despite easy monetary policy in the U.S. and abroad for a number of years has been both a puzzle and a critical variable in the delay of the first rate hike. The Fed continues to anticipate that a tightening labor market will soon boost wage inflation, although average hourly earnings were flat in June and decelerated to a 2.0% year-over-year growth rate.

Consumer Confidence and Consumption on the Uptick

The Conference Board Consumer Confidence Index for June stood at 101.4, a significant rebound from the all-time low of 38 in October 2008 when the financial crisis weighed on household budgets. Consumers appear to be in better spirits which could lead to a greater willingness to spend. Given that the U.S. is a consumer-driven economy with personal consumption making up more than 70% of GDP, advances in the confidence index which translate into consumption gains create an economic tailwind. Indeed, according to the Commerce Department, consumer spending surged in May (the most recent available) to its largest increase in nearly six years, indicating that consumers may finally be loosening the grip on their wallets and spending, rather than saving, some of the windfall from lower gasoline prices.

Surprisingly, retail sales fell -0.3% in June, and April and May numbers were revised downward, primarily due to broad-based weakness in discretionary categories. Even categories that had been strong, restaurant and building materials, witnessed sales declines in June.

Manufacturing Hamstrung by Exports

The manufacturing sector, which accounts for approximately 15% of U.S. GDP, continues to be a concern.

Although, according to the ISM Manufacturing Production Index, manufacturing is expanding moderately. The Index reading in June stood at 53.5. Anything above 50 is considered an expansion. Nonetheless, compared to other sectors of the economy including construction and services, manufacturing has been the weak link as it has the highest correlation to exports which are struggling due to the strength of the U.S. dollar. Within manufacturing, automobile sales have been a bright spot – production estimates for 2015 stand at $17 million, up from the past three years.

Economic Outlook

Figure 3. Commonly watched measures of inflation continue to lag the Fed’s 2.0% target rate.

Housing Market has a Long Memory

The housing market, which constitutes approximately 3% of U.S. GDP, continues to improve. However, new-home starts are well below the historical average, contributing to a shortage of inventory that can lead to higher home prices, particularly in markets such as Denver and San Francisco which have been growing at a faster pace than much of the rest of the country. Housing starts are short of the long-term annual average of 1.4 million recorded from 1959 until 2015, but well north of the record low of 478,000 posted in April 2009.

Because home affordability is currently so attractive and mortgage rates so low, we would expect new construction to be stronger. Perhaps the biggest deterrent is a hangover from the housing crisis that raged from 2007 thru 2009. Additionally, the millennial generation, which is coming of age to buy houses and start families, appears more inclined to rent or even live with parents. Pundits predict this will change as the economy and wages improve, but the pendulum has not yet swung in that direction.

Energy Prices May Have Found a Floor

The effects of slowing U.S. crude oil production, improving global crude oil demand, and risks of unplanned supply outages from the Middle East and North Africa have supported the slight rise in crude oil prices since the beginning of the year. The West Texas Intermediate (WTI) crude price per barrel closed the quarter at $59.83, up from the year’s record low of $43 reached on March 16.

We anticipate that oil production will continue to fall for the remainder of the year, perhaps recovering in 2016. Oil prices are waning as the summer driving season slows post the 4th of July. In addition, the economic slowdown in China combined with sluggish growth in the U.S. are putting little global pressure on energy prices. Oil prices could be further pressured if a nuclear arms treaty is reached with Iran, allowing that country to bring additional supply online. However, current prices probably already reflect at least some additional supply from Iran. (Our next issue of Market Outlook will include additional information on the status and impact of the nuclear arms treaty.)

The longer energy prices remain suppressed, the more likely it is that U.S. producers using more expensive methods like fracking will be forced to reduce headcount and close wells. Prices around $60 per barrel are considered to be the level at which most U.S. manufacturers break even, but should prices fall below that level, it takes supply off the market. Such an event would negatively impact oil-based economies including Texas, Louisiana, the Dakotas, and Alaska.

U.S. Dollar Benefits from Lower Global Interest Rates

The U.S. dollar-to-euro exchange rate closed the quarter at 1.11, above parity but stronger than it has been for the last few weeks after weak U.S. economic data had prompted many economists to push back their expectations for the timing of the Fed’s first interest rates hike. The greenback has strengthened as economic growth in the U.S. outpaces much of the remainder of the developed world and, more importantly, the Fed remains on track to raise interest rates at a time when other central banks are going the opposite direction – implementing quantitative easing to intentionally keep their currency weak. The lower the currency, the more attractive the exports, so there is a race for the bottom on currencies in most non-U.S. countries. Likewise, the strong dollar acts as a headwind for the U.S. economy.

Interest Rate Hikes Remain on the Table for 2015

According to the “dot plot” (individual FOMC member forecasts plotted as dots on a graph, reflecting the Fed’s best estimation of the future path of short-term rates), the FOMC consensus calls for the fed funds rate to end the year at 0.62%. Given that there are four FOMC meetings remaining this year – July, September, October, and December, the dot plot indicates that the Fed could possibly raise rates in September and again in December. Market participants, on the other hand, appear to anticipate a 25% chance of a rate hike in September and a 50% chance of a second rate hike in December.

Forecasts aside, the Fed has again stressed that there is no time-based parameter for tightening and that the decision remains data dependent. The Fed will continue to review the economic situation on a month-to-month basis. In addition to jobs growth and inflation, another, perhaps unspoken, variable in the Fed’s decision making process is the relative strength of the U.S. dollar. Great purchasing power around the world is an enviable position, but not to the point that it places excessive pressure on exports.

In our opinion, there is a 50% chance that a single rate hike occurs in 2015 and a 50% chance that there is no rate hike until 2016. The determining factor is whether the U.S. economy can grow fast enough to be self-sustaining despite events on the international stage, particularly in Greece and China. That is, will there be sufficient wage growth to increase consumer spending to the level necessary to propel production forward, thus generating the positive feedback loop that drives U.S. GDP. So far, without the Fed priming the economic pump, this has not proven to be the case.

Economic Outlook

Figure 4. The U.S. housing market continues to see a slower-than-expected recovery.

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