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Quarter-End Insights

Our Outlook for the Economy

GDP, employment, and consumption growth have all been stuck in a very narrow range--and are likely to remain so in 2014.

  • GDP growth in 2014 should continue at a 2.0%-2.5% rate, inflation at 1.5%-1.8%, and job growth at 190,000 per month.
  • The recovery continues at a snail's pace, with income and consumption growing at half their normal recovery rate due to slower population growth and an aging demographic.
  • The good news is real hourly wage data points to a stronger labor market.

Below is my economic forecast, which includes my estimates for 2013 and 2014, as well as data from 2011 and 2012 for comparison. The table is based on last-period to last-period growth rates, or the last period of data for single data points.

What is most striking to me about the table is that overall GDP growth rates, employment growth, and consumption have all been stuck in a very narrow range, centering on 2%, for the last three years. I expect much the same result in 2014. The U.S. economy appears very much like an ocean liner, finding it very difficult to change either speed or direction. My forecast is little changed from my last quarterly report, though this table now includes more data points.

I expect little change in the overall GDP growth rate in 2014, but the composition of that growth is likely to be somewhat different. Inventories should be a much smaller contributor to growth, net exports are likely to be a larger subtraction from GDP as imports grow, and government spending should be a much smaller negative next year. Consumption, housing, and business investments (excluding inventories) are likely to change little from their 2013 growth rates. I don't see a big boom or a bust.

Others are more bullish on overall GDP growth, but I suspect growth rates in autos will decelerate, existing home sales will likely be flat, and government spending will still be a drag, albeit smaller than the rather large subtraction in 2013. With little change in the 2% GDP growth rate, I suspect employment growth also won't change much in 2014.

Slow growth, a wide output gap (a fancy capacity utilization measure), and a bumper farm crop should all keep inflation in check in 2014, although medical costs may rise faster than in 2013, bringing up the overall rate of inflation. With the Fed officially tapering bond purchases, 10-year Treasury bond rates should move up to reflect the inflation rate plus a spread, now that the Fed is withdrawing its support.

Auto sales should continue to do well in 2014, with continued employment growth, new models, and an aging fleet. Unfortunately, auto sales are now approaching previous highs, and the law of large numbers is beginning to set in, with year-over-year growth rates likely to slow.

I'm still expecting an acceleration in housing starts, as it has taken homebuilders some time to gear up for increased demand (zoning, land acquisition, etc.). However, existing homes will be hard-pressed to grow much given higher rates, more competition from new homes, tight inventories, and lower affordability.

My estimates could be too low if the housing market reaccelerates sharply, if the government fiscal drag is less onerous than I believe, or if businesses sharply accelerate spending. The estimates could be too high if inflation accelerates, there is a large geopolitical event, or if the government continues to trim spending too sharply.

What's New in 4Q
Probably the biggest news in the quarter was that the Fed would begin to taper its large $85 billion bond-purchase program. I was glad to see this program begin a slow and measured close. The bond-purchase program was truly an extraordinary measure to purchase long-term bonds and mortgages in an attempt to directly control long-term interest rates. Never before has the Fed reacted so boldly and so beyond its sphere of short-term interest rates.

Given extraordinarily tight fiscal measures and a slow-growth economy, the program was both helpful and necessary. With the economy at least a little better and an easing of the fiscal tensions, it was probably time to begin ending such an extraordinary program.

Markets had already anticipated the tapering last spring, and interest rates had previously made their move up. This should blunt some of the impact of the actual tapering announcement. Rates still may move up further, as my colleague David Sekera details in his quarterly credit outlook, though the worst of the interest rate increases may be behind us.

Government Spending Remains Under Control, Will Be a Smaller Drag in 2014
Equally important was the two-year federal budget agreement that eased short-term spending limits but kept a tight lid on spending over a 10-year period. The fact that Republicans and Democrats could agree on anything came as a surprise. The agreement should mean a little less fiscal drag from the government sector in 2014, after government spending at all levels shrunk 1% in both 2012 and 2013.

However, the federal government is still tightening in other ways that the market hasn't fully appreciated. An end to extended unemployment benefits for the long-term unemployed will throw about 1.3 million people off of the rolls after Dec. 28. And then there was the Nov. 1 cutback in the food stamp program, affecting 43 million participants. Finally, measures have been put in place to reduce price limits on FHA-backed mortgages and increase fees for certain borrowers. New restrictions on mortgages in the Dodd-Frank legislation will also weigh on the housing market in 2014. I still believe that the government may act to reverse some of these measures, but time is quickly running out.

Strong Headline GDP Growth for 3Q, Likely to Slump in 4Q
At an amazing 4.1%, growth in the third quarter was higher than I believed possible when I wrote my last quarterly outlook. However, a gain in inventories accounted for just over 40% of the growth rate. After numerous revisions, consumption growth now appears to have improved slightly in 3Q. GDP growth is likely to drop back to something more like 1.5% to 2% in the fourth quarter, as inventories provide less of a tailwind. Still, consumption will likely look even better in 4Q than in 3Q.

Retail Sales Show Signs of Life
Consumer spending was soft for a couple of months early this summer before picking up in September. However, both consumption and retail sales data so far in the fourth quarter look considerably better. For example, retail sales were up 0.6% month to month in October and 0.8% in November.

Consumer incomes have been improving for some time, but confusion and uncertainty about the debt ceiling, the budget, and the potential tapering of Fed bond purchases caused consumers to spend less than they made this summer. With some of those uncertainties behind us, the fourth quarter appears to show a marked improvement in consumption, as both sentiment and incomes continue to improve.

Real Estate Takes a Pause
In my last quarterly outlook, a lot of real estate data was continuing to accelerate, but it now appears that is beginning to at least pause. Home prices had been going up faster and faster each month; now those month-to-month growth rates have begun to slow. Home prices are likely to close out the year with December to December increases of about 12%, with most of the bigger gains happening earlier in the year. Therefore, next year's growth is likely to slow, perhaps as low as a 5% growth rate.

Existing home sales had a huge spike over the summer, as buyers rushed to beat interest rate increases. Existing home sales got as high as 5.4 million units on a seasonally adjusted, annualized rate in July, then fell 10% to 4.9 million units in November. Even housing starts are nothing to write home about (when looking at three-month averaged data). The final starts number for all of 2013 is likely to come in at just 925,000, well below most forecasts for a million or more starts in 2013, as momentum in the early part of the year died over the summer.

It's Still a Below-Average Recovery
At the four-year-and-one-quarter mark, the economic recovery that began in June 2009 remains one of the slowest recoveries of the post-World War II era. Consumption growth, at 1.6%, is less than half of the average annual growth rate of 3.9% at the four-year, one-quarter mark (or at the economic peak, if the recovery didn't make it to the four-year mark). Real disposable income data isn't doing much better this recovery.

At least part of the reason for the slowing is continued softness in population growth, which, along with productivity, tends to drive long-term economic growth. Early recoveries were blessed with population growth of as high as 1.8%. The current recovery saw only a 0.8% population growth rate in 2009, when the recovery began. Subsequently that population growth rate has dipped even lower to 0.7%, further impeding overall economic growth. The slower population growth rate is due to a more moderate rate of growth in births and faster growth in deaths as the population ages. Immigration has fallen as well.

The census bureau estimates that the population growth rate will increase slightly for the rest of this decade before beginning a multi-decade decline to a 0.5% growth rate by the middle of the century. And even that depends on a sharply higher immigration rate.

Higher population growth rates have generally been associated with higher GDP growth rates. However when population growth began to slow in the 1970s, it didn't affect consumption immediately for several reasons. First, consumption in the 1970s and 1980s was supported by sources other than income as the gap between spending and income widened. More borrowing or the spending down of assets accounted for some of that and helped consumption stay higher than one might have expected. More women entering the workforce (more income per household) also probably helped push incomes and consumption, even in the face of slower population growth. Finally, the 1970s and 1980s benefited from baby boomers moving into their prime spending and income years.

Total population growth is a very blunt instrument, while a more carefully constructed age-based growth model could provide even more clues to future economic growth. Unfortunately, that is not good news for the decades ahead, as aging populations with large numbers of retirees don't generally grow as fast as countries with a younger average population.

All of this is just a very long way of saying that recently, slower economic growth rates are consistent with a slower-growing, aging population. Those expecting a return to 3%-4% GDP growth could be waiting for a very long time indeed.

The Good News Is Real Hourly Wage Data Points to a Stronger Labor Market
On a much cheerier note, recent hourly wage data suggests that labor markets might be quietly tightening up. The basis for my statement is the recent improvement in real hourly wages for production and non-supervisory personnel.

This is a marker used by notable retail analyst and author Joseph Ellis. The theory behind the indicator is that employers are deeply reluctant to pay workers much more than they have to in order to keep them. As labor market conditions grow tighter, they tend to pay workers more per hour to avoid a sharp increase in very expensive turnover.

Higher wages usually lead the more closely watched employment data. The long-term growth in this number has been pathetic for a very long time, at least partially due to the demise of unions, fewer manufacturing jobs, more low-paying restaurant and retailing jobs, as well as foreign competition for jobs in an ever more global economy. Real wage growth has averaged just 0.7% per year since 1965. More than one third of those observations showed workers didn't even keep pace with inflation.

Nor is this a particularly new phenomenon. Inflation-adjusted wage growth barely got above zero for the whole period from 1977 to 1994.

Currently wage growth has been accelerating and has been improving every month since January.

Indeed, the current reading is in the top third of all readings and is continuing to accelerate. This should lead to more employment growth and more consumption in the months ahead. This is probably not quite as good news for corporations, which may find themselves paying those higher wages.

Our Equity Team Continues to Believe There Aren't a Lot of Bargains
None of our equity teams seems to be finding a lot of bargains, based on their quarterly outlook reports. Overall valuations show the stock market is just a little above fair value, but not by a lot in most cases--certainly, no bubble. However, our tech team warns of greed and meaningful downside risk in the internet sector.

The news was a little thin, too, though manufacturing looks like it is picking up for real, China seems a little better, and Europe isn't getting any worse. Although China is doing a bit better again, that improvement seems to be coming from the old-fashioned way: more lending, more real estate, and more infrastructure spending. However, the push in that direction has been less than other times of weakness and the shift to a more consumption-oriented economy seems to still be the long-term agenda. The reports also seemed to show an increase in both spin-outs and acquisitions. Activity in the telecom sector was particularly strong.

Perhaps the most notable thing I found in the quarterly outlooks was a sizable increase in U.S. oil production, which indicates to me that we are all still underestimating the positive ramifications of the new U.S. oil boom. The ongoing battle between coal, natural gas, and regulators seemed to get an unusual number of mentions, with the utilities team noting many coal plant closures, our industrials team noting weak mining machine activity, and our rail group noting poor (but improving) coal shipments. I am also reminded that all the cheap natural gas is not without real human and economic consequences in the struggling Appalachian coal country.

Our health-care team used their quarterly report to sum up burgeoning opportunities in China, while the consumer team focused on some of the ramifications of increasing e-commerce and the impact on the current holiday season. All of these reports will be released on Dec. 30-31.

Market Performance Recap: Year to Date Performance of Major Asset Classes
--by Tim Strauts, Markets Research Manager | Data from Morningstar Direct

It's been a great year for U.S. stocks and other developed markets, which makes stock-picking so difficult right now. However, not much else did well in 2013, with bonds, emerging markets, and commodities all having a bad year.

This year the major asset classes have had wildly divergent performance. U.S. stocks have led the way returning over 30%, while U.S. bonds, emerging-markets stocks, and commodities have had negative results. Commodities faced declining demand and new supply sources that came online in 2013. These effects hurt emerging-markets stocks and commodities funds.

Bonds did not perform well, because interest rates have been on the rise in 2013. The U.S. stock market posted strong results despite having to deal with a 16-day government shutdown, rising interest rates, and the prospect of the Federal Reserve dialing back its stimulus.

Global Commodity Prices
Each commodity is affected by a different set of economic, political, and global elements, and as the chart below illustrates, the variations in how individual commodities fluctuate are almost as wide-ranging as the price fluctuation itself.

For example, livestock has basically been flat for the entire period analyzed, while energy has fluctuated wildly, experiencing the most extreme ups and downs. Precious metals have performed the best over the full period, but they have declined 40% from their peak in 2011.

Rolling One-Year Category Fund Flows
Bond funds have experienced record inflows since the financial crisis in 2008. But in the last year, investors have dramatically reduced their purchases as interest rates have started to rise. With the recent announcement that the Federal Reserve is beginning to taper its bond-purchasing program, interest rates are expected to continue to rise over the coming years.

On the other hand, U.S. equity funds have had outstanding performance since 2009. The S&P 500 has posted a five-year trailing return of over 17% annualized, but only in the last year have U.S. equity fund flows crossed over the $100 billion mark.

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