Download ECONOMIC UPDATE Commentary Now that we have a short

Written on 11/15/13
ECONOMIC UPDATE
November 2013
By Andrew Kohl
Commentary
Andrew Kohl
Senior Vice President
Director, Advisory Services
Balance Sheet Solutions, LLC
(wholly owned by Alloya)
Now that we have a short-term reprieve from the fiscal battles, the focus has turned back to the Fed. This
week, Janet Yellen testified before the Senate Banking Committee as part of the confirmation process to
become the next Fed chairman (she is fully expected to be confirmed). As expected, she was very
supportive of the current Fed policies and downplayed the potential risks of inducing asset bubbles. The
stock market cheered (and made brand new highs), as it appears that Yellen’s monetary views are very
similar to Ben Bernanke’s and that an accommodative Fed is here to stay.
The questions are, what will the accommodative policies look like and how will the market react? We
believe that the Fed will start to taper its pace of asset purchases in early 2014. The tapering process will
likely be slow, and likely accompanied by a modification in the forward rate guidance (short-term rates
lower for longer) and/or the unemployment threshold (lower the threshold from 6.5% to 5.5%). We
believe that the Fed wants to transition out of quantitative easing (QE), and more towards extending
forward guidance. If that doesn’t help to spur the economy, we expect to see an explicit inflation target
that is above what is considered the “normal’ inflation level of 2%. The Fed wants to keep bond yields
low and at the same time, increase inflation expectations in an effort to lower real (inflation-adjusted)
interest rates. This will be a difficult trick, as bond yields typically rise with an increase in inflation
expectations.
Inflation has again become a problem in many developing countries. The difference between this time and
decades ago, is that the problem is now falling inflation (a.k.a “deflation”) instead of rising inflation. The
average inflation rate in OECD countries is 1.5%, which is down from 2.2% in 2012. Inflation in the Euro
area is below 1%, and it is just a touch above 1% in the U.S. Deflation is especially dangerous in
economies with high debt. This is because debt is fixed in nominal terms. If wages fall, it increases the
burden of paying off the debt. Deflation also weakens an economy since once people expect prices to
decrease, they put off purchasing items today. Outright deflation is not on the doorstep of the U.S., but the
Fed must be vigilant to ensure that it doesn’t take hold. It is useful to remember that in Japan’s case,
deflation didn’t set in until seven years after the asset bubble burst.
On the economic growth side, early indications are that the federal government shutdown in early October
had only a minimal impact to the economy. Business surveys have held up well, the stock market is at alltime highs, and the latest employment report was solid. Consumer confidence did take a hit, but it never
dipped near the levels seen in 2011 when the U.S. debt rating was cut amid the previous debt ceiling
battle. We don’t see any lingering effects of the shutdown, but warn that the budget battles gear up again
in January. Our base-case estimate is that there won’t be another shutdown, but with the highly polarized
state of our political system, it can’t be ruled out.
The initial reading on GDP for the third quarter came in at 2.8%. This was well above the consensus of
2.0%. A large portion of the gain was due to inventory buildup that we don’t expect to continue in the
Written on 11/15/13
ECONOMIC UPDATE
November 2013
fourth quarter. Looking into 2014, we do expect growth to be closer 3.0%. This is largely due to the
lessening of the fiscal drag. In addition, the economy has experienced significant structural repair since
the recession officially ended in June 2009. On a longer-term basis, the U.S. still needs to fix its debt
issues. The budget deficit will likely shrink over the next few years, but the longer-term problem of
paying for an aging population will start to increase deficits again in later years. There still is time to fix
the longer-term issues, but we need politicians that are brave enough to do so.
Fixed Income Outlook
Longer-term interest rates have increased since the end of October, as the better-than-expected labor
report shifted in the market’s expectation of when the Fed will start to taper its asset purchases. Shortterm rates have barely moved, since the economy is still far from the Fed’s pre-established thresholds that
would lead to an increase in overnight rates. Overall, we believe that the yield curve is fairly valued at the
current time. There is a risk that longer-term yields bounce higher when the Fed starts to taper, but we
believe that the tapering will be combined with a different type of accommodation and therefore, the
impact should be muted. The Fed is fully aware of the impact that higher mortgage rates had on the
housing market and we believe they will prefer to err on the side of providing too much stimulus, rather
than too little.
Written on 11/15/13
ECONOMIC UPDATE
November 2013
Inflation Readings
(Data source: Bloomberg)
Inflation Rate Remains Low
Inflation, as measured by the Personal
Consumption Expediture (PCE) index,
continues to remain well below what is
considered "normal' for the economy. The
Fed has an implicit inflation target of 2.00%.
The inflation rate has declined substantially
since early 2012, despite a massive amount
of quantitative easing. The continued low
inflation has increased the debate as to
whether the Fed needs to provide even more
stimulus.
Inflation Expectations Remain Subdued
Given that multiple rounds of quantitative
easing have not caused a much-feared spike
in inflation, the public's expectation for
inflation in the future continues to be
subdued. This provides the Fed room to
maneuver, if they want to keep asset
purchases at their current pace and/or
provide further stimulus.
Written on 11/15/13
ECONOMIC UPDATE
November 2013
Housing
(Data source: Bloomberg)
Pending Home Sales Decline
Pending home sales fell in September for the
fourth consecutive month and by the largest
amount in more than three years. The
significant move higher in mortgage rates
since May seems to have had a much larger
impact to housing market activity than many
economists, and the Fed, expected.
Homebuyer Affordability Declines
Given the recent increase in mortgage rates
and housing prices, homebuyer affordability
has fallen from its highs earlier this year.
Despite the decrease, the affordability
measure (which compares median income to
the median home price) remains well above
historical levels. The index averaged 120 in
the 1990s, which is considered a more
“normal” housing market.
Written on 11/15/13
ECONOMIC UPDATE
November 2013
Labor
(Data source: Bloomberg)
Unemployment Rate Ticks Up
The unemployment rate for October
increased from 7.2% to 7.3%. The numbers
were impacted by the government shutdown,
as furloughed federal government employees
should have responded that they were
unemployed (10/6-10/12). Stripping out the
impact of the government shutdown, it
appears that the unemployment would have
remained static at 7.2%.
Payroll Job Growth Strengthens
Job gains in October exceeded estimates.
October payrolls gained 204,000 versus an
estimate of a 120,000 gain. In addition, the
prior two months were revised upwards by a
total of 60,000 jobs. The payroll figures
were not distorted by the government
shutdown, since furloughed employees
would still have received pay during the data
collection period. The three-month and 12month moving average payroll growth have
both moved to approx 200,000 per month.
The 12-month moving average is near its
highest level since the recession ended.