Mid-Year Report 2014 Past: Where we have been in the economy
Hello everyone. My name is Michael Conway, CEO of the Conway Wealth Group at Summit Financial Resources. Today in our midyear report we’ll discuss where in the economy we have been, where we are today, and where we may be going. We’ve created a series of three short videos to take a look at the recent past, the present, and the future of the economy. We hope you will find them informative, and insightful.
Let’s begin our video series with where we have been, and take a look at the first half of this year. We will review financial markets, economic recovery, geopolitics, wages and jobs, housing, the fed, inflation, and interest rates.
In the financial markets, the S&P 500, representing domestic equities, was up 7.1% for the first six months of the year. The MSCI All-Country World Index ex US was up 5.6%. The Barclays US Aggregate Bond Index, representing domestic bonds, was up 3.9%, and commodities were up over 7% for the period.
Stocks have continued to rally despite economic weakness in the first quarter of 2014. Meanwhile, corporate profits continue to improve, and most importantly, investor sentiment has increased. However, uncertainty surrounding federal reserve policy changes remains a tailwind for equities. Also, as the bond market continues to perform well, bond yields are so low investors are forced to take on risk given the unattractive dynamics of other, traditionally lower-risk investments.
Considering widely-held expectations for faster growth this year, results in the first quarter were disappointing. US economic output fell at a seasonally-adjusted annualized rate of 2.9%. The contraction was the second of the nearly five-year-old economic recovery, and by far the largest in magnitude. As a matter of fact, it was the largest drop that was not part of a recession since World War II. Weakness, generally blamed on harsh winter weather, was widespread. Although the 2.9% figure has since been revised up to 2.1%, the dip remains the sharpest contraction since early 2009 in the depths of the great recession. Nevertheless, the financial markets resiliency this year has shown that investors believe that most economic softness is temporary, and that pent-up demand for many goods and services from consumers and corporations alike could be realized later this year.
Serious geopolitical issues posed risks to growth in the first quarter. In particular, rather than annexing the southeastern part of Ukraine, as it did with Crimea, it appears Russia’s goal was to hinder Ukraine’s European ambitions. However, as the quarter drew to a close, a number of factors helped stabilize the Ukraine situation. First, US and European sanctions have been impactful. Second, Russia has experienced material capital outflows and currency weakness due to geopolitical fears, and their economy is on the verge of recession, and third, Ukrainian presidential elections held at the end of May demonstrated an overwhelming desire to remain independent, and move in favor of a pro-European platform.
Risks surrounding the Russia-Ukraine crisis and conflicts in Iraq certainly remain, but it seems many of the initial shocks from geopolitical tensions proved to be temporary. Several overseas conflicts this year, at least temporarily, roiled financial markets, and such issues remain a focus for Wall Street.
Following weather-related weakness, the labor market bounced back in the second quarter. In fact, the economy has now replaced all jobs that had been lost in the recession. However, the recovery fails to account for population growth of 15.2 million since the previous peak. The resulting 10 million increase in the labor force suggests significant repair is yet needed to fully heal the labor market. Nevertheless, initial jobless claims, weekly hours worked, and job openings relative to job seekers are all back to pre-crisis levels. Even the rate of unemployment, at 6.1%, is not tremendously above the 5.5% rate that economists believe to represent full employment.
Other key metrics remain out of sync with historical norms. The participation rate has declined dramatically, and wage gains had been weak in the post-crisis recovery. Both have negative implications for economic growth. Additionally, the number of people working part time that would prefer full time work is high, and workers classified as “long-term unemployed,” in excess of 27 weeks, remains elevated.
The housing market has shown some signs of improvement from various headwinds over the past year. First, mortgage rates were at a seven month low, and housing affordability has improved from last summer. Second, new and existing home sails improved recently, including an upward spike in may. Third, sequential monthly price gains continue, but in fewer markets, and at a much slower pace. Fourth, US home builder sentiment rose nicely in June.
On the downside, building permits have shown little progress over the past year, and inventory of new homes remains low. Both are impediments to construction, and activity in future sales, and while homeowners are in better shape, with delinquency rates down 24% in the first quarter from the prior year, many are not out of the woods just yet. Over six million families are still underwater on their mortgages.
The US consumer is also showing considerable strength in the automobile sector. Light vehicle sales had an outstanding month in May, reaching an 87 month seasonally-adjusted annual rate of 16.7 million automobiles sold. Strong demand for high-ticket items is typically a good sign for the health of the US economy, which is driven mostly by consumer expenditures.
The federal reserve has continued down the path of buying fewer assets each month, which we expect will continue throughout the year, until they are no longer buying additional bonds, however, this doesn’t mean the fed is planning to raise interest rates in the short-term. The fed is simply buying less each month, and has no intentions to sell what they’ve already purchased at this point. We expect the fed will remain highly-accommodative to the financial markets. Interest rates will likely remain suppressed until the fed reverses course. However, this will not happen until economic growth is clearly improved, which is not yet the case this year.
With a 2% inflation target, the fed has continued to fight low inflation with aggressive and unconventional monetary policies, and recent price gains have moved closer to, if not above, the fed’s target. Evidence suggests pricing pressures are in the pipeline. The Producer Price Index is a leading indicator of future consumer prices. Its overall trajectory speaks for itself. In addition, price components of the ISM indexes portray not only rising prices, but accelerating price gains for the past year. Ingredients for more rapid inflation are coming together, and data suggests the economy may be in the early days of such an environment. If so, the fed plans may change, and policy rates may move earlier or faster than current guidance or market expectations.
The market will not achieve sustainable inflation until Americans have larger paychecks. Although employment has improved, wages haven’t increased much at all after the recession. Expectations are for this to change over the next 12 months, according to a survey of Chief Financial Officers, but until we actually begin to see American households bringing home more money to spend, it’s hard to envision how economic growth can accelerate.
This concludes our first video. In episode two, we’ll examine the current state of the economy.