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Running Against the Wind

by David C. Blough, CFA, Senior Vice President & Investment Manager  


"You can preach a better sermon with your life rather than your lips." - Oliver Goldsmith 

The U.S. economy is showing signs of stronger growth during this year’s second half. Despite strong headwinds in the first half of 2013 from large tax increases and reduced federal spending (sequester affect), economic indicators are turning more positive. The ISM manufacturing index jumped to 55.4 in July, its highest level over the last 12 months. U.S. automotive sales have revived to 16 million annual units at mid-year. Housing starts are likely to total about one million units over the next twelve months, as home prices (up over 12% in the latest twelve months) recover further and foreclosures keep declining.  The labor market has been expanding by more than 175,000 new jobs per month, on average, over the last year. Unemployment is down to 7.4% at the end of July and will likely fall to 7% by early 2014. Consumers are starting to feel better and spend more, due to improving labor markets and the “Wealth Effect” from strong advances in both stock and house prices.  Retail sales were up more than 5% year-over-year in June.  The economy is also benefitting from the increased U.S. energy production and less reliance on energy imports. Even the weather is also cooperating this summer. With plentiful rainfall in the Midwest, U.S. agriculture should achieve nice gains in production and the farm income.
     
Inflation has remained well contained and is unlikely to be a problem through at least 2014. The consumer price index rose 1.8% for the year ended June 30, while Core CPI was up just 1.6%. The Federal Reserve Bank is much more concerned about reducing unemployment than inflation at this time. The Fed has indicated its desire to “taper” its $85 billion in monthly bond purchases during the next several months. This is a positive sign that the Federal Reserve believes the economy is beginning to stand on its own two legs. The substantial deficit reduction during fiscal 2013 (year ending 9/30/2013) makes reduced bond purchases less painful, as new Treasury debt issues fall substantially due to deficit reduction. The Fed will eventually reduce bond purchases to zero, but short term interest rates should remain near current ultralow levels for the next 18-24 months. The Fed has stated repeatedly that it will not move rates higher until the unemployment rate falls to at least 6.5%, and even then, it may not move rates higher unless the economy is demonstrating strong growth.
      
We forecast economic growth of 2.5% to 3.0% in 2014. Europe’s drag should begin to lift next year and that should help both the U.S. and global economies. The U.S. financial sector has staged a strong recovery and has adequate capital. Bank loans should increase nicely over the next several quarters and provide the fuel for improved growth. 


Stocks soar, Bond prices struggle

Stocks soared to new highs as July ended. For the year ending 7/31/2013, The S & P 500 large-cap stock index returned 25%, the S & P mid-cap 400 returned 33% and the S & P small-cap 600 returned 34.7%. International stocks had diverse returns, with the developed country EAFE index up 23.4%, while the Emerging Market index returned just 2%. Stock prices reflect rising confidence that the U.S. and global economies will grow at a faster rate in 2014, powered by low interest rates and aggressive central bank policies. During 2013, we have increased allocations to large, medium and smaller U.S. stocks while reducing exposure to emerging market stocks.
    
Intermediate and longer-term interest rates rose quickly in May and June, on the speculation that the Fed would begin to throttle back on its bond purchases. The ten-year U.S. Treasury interest rate is nearly 1% higher today than it was in early May. While we do not expect interest rates to move much higher during 2013, we are making some strategy changes to fixed income portfolios to mitigate price declines, as interest rates eventually return to more normal levels.