Quarterly Economic Review Fourth Quarter 2014


Executive Summary

Forecasters in 2014 had their share of wins as well as losses. As expected, the Federal Reserve discontinued the purchase of government securities, also known as quantitative easing, in the fall. The dollar also gained strength and the U.S. stock market continued to deliver gains, albeit at a slower pace than in 2013. On the flipside, housing had a somewhat lackluster year, and interest rates, widely expected to rise, essentially went straight down throughout the year. Domestic bonds and other interest rate sensitive investments such as utilities and commercial real estate, widely expected to be duds for 2014, were some of the year’s best winners.

As mentioned, although U.S. stocks rose, gains were predominantly concentrated in large capitalization companies. Smaller companies delivered more modest returns. International investments, both stocks and bonds, lost ground, and commodities were hammered. The primary culprit behind international losses was strength in the U.S. dollar, which also weighed on commodities.

As with any year, 2014 brought a series of unforeseeable events as well. Islamic State (ISIS) rose from obscurity to become the world’s most dangerous terrorist group, military conflict erupted in Ukraine, Ebola became a global health threat, Israel and the Islamist group Hamas fought their third and deadliest war in five years, and Republicans had a nearly unprecedented sweep at midterm elections. Of course, from an economic standpoint, the year’s biggest shock was a 46% decline in the price of oil, the steepest drop since 2008.

Looking forward, 2015 poses a number of opportunities and challenges. The U.S. economy is on a more solid foundation. Domestic growth has both accelerated and become broader based. The consumer is reasonably healthy, job markets have improved markedly, and mid-year softness in housing seems to be abating. On the whole, lower energy prices should also be a near-term positive. Consumer spending should pick up as a result of lower gasoline and energy bills, and the balance of trade will improve for a nation that remains a net importer of energy. That said, the longer term impacts of lower oil prices are less clear. Employment and capital spending will be hurt over time, as will the development of energy infrastructure — a driver of longterm economic growth. Geopolitical risks will also mount as Russia, the Middle East, Venezuela and other energy dependent economies deal with the resulting intense and escalating economic pressures.

In contrast to a somewhat positive U.S. outlook, other major economies face challenges. China’s growth is ebbing and the nation faces material economic imbalances. European growth has stalled and a troubling web of deflation is spreading across the region. Japan’s efforts to reinvent its economy have thus far come up short due to a host of factors from unfavorable demographics to a lack of will for structural reform. Lastly, a substantial decline in commodity prices and the prospect of higher U.S. interest rates are headwinds for many emerging nations.


Economic Review and Outlook

Key Economic Fundamentals

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Following a disappointing start to 2014, U.S. GDP grew at its fastest two quarter pace in over a decade. Forecasts of 3.1% growth in the fourth quarter would bring full year growth to 2.4%. The domestic economy is expected to grow better than 3% in 2015.

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Growth in the third quarter was well balanced. Key positives were consumer spending on long-lived items, business investment, growth in exports while imports declined (both are positives for net exports), and a jump in Federal government outlays due to increased defense spending.

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Low inflation is a concern for many world economies, including the U.S. The Federal Reserve’s preferred inflation metric, the Personal Consumption Expenditures (PCE) Deflator, has been below the Fed’s 2% target for 32 consecutive months. Lower oil prices will cause a further, albeit temporary, drop in inflation in coming months.

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In 2014, the U.S. dollar rose more than 9% against a trade weighted basket of currencies. Though positive on the surface, dollar strength detracts from international investment returns, has negative implications for the trade balance, pushes commodity prices down, and introduces deflationary forces on the economy.

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In contrast to U.S. strength, other major economies are stumbling. Euro zone growth is lethargic and deflation is taking hold in the region. China, growing at its slowest pace in 24 years, likely missed its growth target last year. Finally, Japan, falling short of needed reforms, entered a recession in 2014 and delayed a second round of tax hikes.

Employment
The labor market showed strong improvement in 2014. Payrolls grew faster than any year dating back to 1999 and jobless claims fell to lows of that same era. Job openings eclipsed previous records back to January 2001 and the unemployment rate, at 5.6%, is rapidly approaching what most economists believe is optimal. Pockets of weakness do remain, however. The economy still has an excessive number of people working part time for economic reasons as well as individuals unemployed for over six months. The percentage of adults actively engaged in the labor market has plummeted to lows of the 1970s and continues to fall. Lastly, according to a recent Federal Reserve study, between 2010 and 2013, median incomes rose for only the top 10% of households.

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Consumer
Notwithstanding a lack of wage growth, the U.S. consumer is in fairly good shape. Consumer confidence, now at pre-crisis levels, attests to as much. Household balance sheets are much improved as well. Debt relative to GDP has plummeted to a 2002 low and net worth is at an all-time high. Consumption is also healthy and auto sales in 2014 rose to a level last seen in 2006. Lower energy prices have already fattened wallets and are expected to boost consumer spending as 2015 gets underway.

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Business Activity
The U.S. is showing strength as service and manufacturing metrics suggest continued expansion. Capacity utilization also exceeded 80% recently – a new post crisis high.

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Real Estate
The housing market slowed in 2014 and generally failed to meet expectations. Building and sales activity both flat-lined and prices fell modestly at mid-year. That said, mortgage rates have declined materially and price stabilization may lead to more effective industry dynamics. Data toward year-end suggests these factors are already at play. Importantly, this includes a resumption of sequential monthly price gains across all major markets.

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Capital Markets Review

Returns

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Equity Markets

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Fixed Income Markets

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Alternatives

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Disclaimers

his commentary was written by Robert W. Lamberti, CFA, VP and Co-Chief Investment Officer of Summit Equities, Inc. and Summit Financial Resources, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600, Fax: 973-285-3666. Securities and Investment Advisory Services offered through Summit Equities, Inc. Member FINRA/SIPC, and Financial Planning Services offered through Summit Equities, Inc.’s affiliate Summit Financial Resources, Inc. Sources of Performance: Morningstar®. Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Wilshire 5000 Index is a market capitalization-weighted index of the market value of all stocks actively traded in the United States. The index is intended to measure the performance of all U.S. traded public companies having readily available price data. The MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in global emerging markets. Emerging markets are considered risky as they carry additional political, economic, and currency risks. Real Estate Investment Trusts, REITs, are securities that invest in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, however, have liquidity constraints. The Barclays Capital U.S. Aggregate Bond Index is a market capitalization-weighted index comprising Treasury securities, Government agency bond, Mortgage-backed bonds, corporate bonds, and some foreign bonds traded in the U.S. Fund Category Performance is not inclusive of possible fund sales or redemption fees. Investment grade bond analysis included bonds with ratings of AAA, AA, A, and BBB. Municipal and Corporate Bonds are backed by the claims paying abilities of the issuer. TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection of government securities available to investors. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding market of other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.

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