Bouncing Back

July 12th, 2014
in contributors

Macro Strategy Review for July 2014

Written by , with David Martin and Jim O'Donnell, Forward Markets

U.S. Economy

As expected, the U.S. economy has bounced back nicely in the second quarter after an especially dismal first quarter. The Bureau of Economic Analysis (BEA) reported that gross domestic product (GDP) fell [-2.9%] in the first quarter after revising its second estimate of a [-1.0%] contraction.

Follow up:

At the end of 2013, we noted that inventory accumulation had boosted GDP growth in the third and fourth quarter. We anticipated that growth was likely to slow in the first half of 2014 as companies pared production in order to lower inventory levels, especially if sales slowed. Inventories were slashed in the first quarter, which subtracted 1.7 points from first-quarter GDP. Had inventories remained unchanged, GDP would have declined [-1.2%], rather than falling [-2.9%]. Based on additional information about healthcare spending, the Commerce Department's recent "Quarterly Estimates for Selected Service Industries" report showed that healthcare spending actually fell [-1.4%] in the first quarter, rather than rising [9.9%]. The significant revision to healthcare spending subtracted [-1.2%] from GDP. Had inventories and healthcare spending remained constant at their fourth quarter levels, GDP would have been unchanged in the first quarter. The point in reviewing this detail is to highlight how much noise often occurs in every estimate of quarterly GDP.

Disappointing economic data opens the door for heightened political vitriol, which was the case after the BEA announced that GDP contracted [-2.9%] in the first quarter. Politicians of both parties often assess blame for poor outcomes on the other party, hoping that most members of the public are clueless on most subjects beyond sports, reality TV and social media. This is concerning since consumers comprise almost [70.0%] of GDP and play a significant role in the direction of our nation's growth. Therefore, focusing on the level of consumer consumption can provide a clearer picture of the economy's health than the headline GDP figure.

In the first quarter, real personal consumption expenditures (PCE) rose just [1.0%], compared to a [3.3%] increase in the fourth quarter. The severe weather that gripped much of the country in January and February certainly contributed to the decline in consumer spending, as consumers found their couch more comfortable than braving subzero wind chill factors. The snapback in consumer spending during the second quarter supports this view. The economy was in better shape than the third estimate of GDP suggested. Any suggestion that another economic downturn had started in the first quarter was nothing more than partisan political hyperbole for the party faithful.

A recent survey of economists by the Wall Street Journal found that the consensus for second quarter GDP growth is [3.5% to 4.0%]. These economists expect GDP to hold above [3.0%] for the balance of 2014. Whether the improvement seen in various data points in the second quarter are truly sustainable is the challenge. Our view remains the same. After a rebound in the second quarter, growth is likely to slip back to under [3.0%] by the end of the year. There are, however, a couple of long-term patterns in small business optimism and consumer confidence that bear watching.

The Federal Reserve's (The Fed) flow-of-funds data released on June 5 showed that credit extended to small businesses reached $4.2 trillion on March 31, an increase of [3.8%] over the prior 12 months.

The increase not only reflects a healthier credit environment  and willingness by banks to extend more credit, but also an improvement in the economic outlook held by small business owners. The National Federation of Independent Business' (NFIB)

Index of Small Business Optimism rose to 96.6 in May, which is the best level since September 2007. This is important since small businesses account for more than [60.0%] of new job creation. However, a look at the NFIB's optimism index during the last 30 years shows it has merely recovered to a level that has separated periods of growth from the onset of prior recessions. Readings of 97 and higher have been coincident with sustained economic expansions. Readings below 97 are usually indicative of recessions.

It is remarkable that five years after the recession ended the index is just now approaching 97. Since small businesses drive job creation, the lack of small business confidence in the recovery partly explains why job growth during this recovery has been the weakest of any recovery since World War II. If the index can rise above and stay above 97 in coming months, it would increase the probability that growth will be better than we expect during the second half of this year.

The preliminary Thomson Reuters/University of Michigan Consumer Sentiment Index for June fell to 81.2 from May's reading of 81.9. Historically, the area of 80-82 has been the demarcation between recovery and recession. During the last 18 months, consumer confidence has been bobbing above and below this level. Job growth for most of this period was steady, averaging 185,000 new jobs. Over the last four months, monthly job growth has been above 200,000, but consumer confidence has not really picked up. This is likely because income growth has not accelerated, so the majority of workers who already have a job have experienced no improvement in their personal finances. If consumer confidence can break out above 82 and continue to improve, it would bolster the chances of a [3.0%] growth rate being maintained.

In May, employers added 217,000 jobs, which lifted total employment above the January 2008 peak. While this is good, it should be tempered by the fact that the population aged 16 and over has increased by 14.2 million since January 2008. The labor force participation rate in May was [62.8%], near a 36-year low. A number of studies suggest that just over half of the decline in the participation rate's fall from 66.4% in January 2007 to its current level is the result of baby boomers retiring. Adjusted for this factor alone, the labor participation rate would have fallen from [66.4% to 64.6%]. Applying this adjusted rate to the increase in the working age population since 2008 means an additional eight million jobs should have been created to keep the participation rate steady.

Those jobs weren't created, and if all those potential workers  were actively seeking jobs and counted in the Labor Department's employment survey, the unemployment rate would be closer to [8.5%], not [6.3%].

The underemployment rate combines the 7.1 million workers who are working part time but would prefer to be working full time, and those who are unemployed but discouraged. In May, the underemployment rate was [12.2%]. The low participation rate and high underemployment rate suggest there is still a fair amount of slack in the labor market, despite the decline in the official unemployment rate. Average hourly earnings rose [2.1%] from May 2013, equal to the [2.1%] rate of inflation in May, based on the Consumer Price Index (CPI).

For the past four years, average hourly earnings growth has been stuck around [2.0%], barely more than the increase in the cost of living for most workers. At this point in the average post-World War II recovery, wages should be growing closer to [3.5%] a year. According to Sentier Research, real median income (income adjusted for inflation, including cash government benefits but excluding capital gains and losses) is down more than [4.0%] since the recovery began  in June 2009. This has never occurred during a recovery since World War II. For African-American households real income is more than 10% below where it was in June 2009, more than [9.0%] lower for those under 25, and off by more than [7.0%] for single women with children. According to the Fed, as of March 31, household net worth was $81.8 trillion-an all-time record. The $1.5 trillion increase in net worth during the first quarter was driven primarily by gains in the stock market. The Fed hoped that quantitative easing would lift the stock market and real estate values enough to fuel strong job and income growth. Instead, it increased income inequality and created a greater concentration of wealth held by the top [10.0%] of Americans. Most consumers are not economists. They see the economy through the lens of their own experience and what they see is a daily struggle to make ends meet.

As the Fed was discussing the unwinding of its third quantitative easing program last year, the official line was that it would rely on the unemployment rate to assess the health of the labor market. But as the unemployment rate nose-dived toward its original trigger target of [6.5%], the Fed realized the labor market has not been behaving in textbook fashion during this recovery. Historically, discouraged workers have resumed looking for a job when it became evident that the economy was improving. Since those not looking for a job are removed from the official unemployment rate calculation, the unemployment rate often rose as discouraged workers became job seekers. Over the last 18 months, discouraged workers have not reentered the labor market.

Since the number of job seekers didn't increase, the unemployment rate declined from [7.9% to 6.3%]. This was a much larger decline than the Fed had forecast. The Fed concluded that the unemployment rate was no longer providing an accurate assessment of the labor market's health. As a result, the Fed has indicated that it will rely on a number of labor market indicators to assess the labor market, including the participation rate, underemployment rate and annual wage growth. While this makes sense from an analysis standpoint, it will make the Fed's communication job more difficult as it relies more heavily on forward guidance.

Over the past three months, retail sales were up [4.3%] from a year earlier and only slightly ahead of the [4.1%] annual increase in May 2013. Retail sales are not adjusted for inflation and include auto and truck sales. Adjusted for CPI inflation of [2.1%] during the last year, real retail sales increased [2.2%], pretty much in line with GDP growth. In the March Macro Strategy Review (MSR), we noted that car manufacturers like to keep 60 to 80 days of inventory. However, at the end of December, General Motors, Ford and Chrysler were carrying inventories from 105 days to 114 days. Inventories became even more bloated in January and February since most people avoid car shopping in subzero temperatures or during a blizzard.

We expected car dealers to offer special deals in the spring to move overstocked inventories. According to Autodata Corporation, vehicle sales reached an annual rate of 16.77 million in May, the highest level since February 2007. In May, [85.0%] of all new cars sold were either financed or leased, as buyers responded to very attractive financing and lease offers. Even though vehicle sales were up [9.4%] from May 2013, the rate of increase in overall retail sales was only ahead by [4.3%] versus an annual gain of [4.1%] in 2013 when auto sales were [9.4%] lower. This suggests that consumers who purchased a new car were forced to curb other spending since their income growth has not been strong enough to support additional expenses.

While recent economic data has been stronger, the rebound from the weak first quarter has not been better than we expected. The key point is that income growth has not accelerated from the pace of the past four years. Absent a surge in wages, it seems unlikely that the economy will be able to sustain growth above [3.0%] in the second half of this year.

Federal Reserve

Since food and energy are somewhat indispensable to sustain life, the exclusion of food and energy from consumer inflation seems counter-intuitive. The concept of core inflation was introduced by Arthur Burns, who was the Fed Chairman in the 1970s. In 1973, the Organization of Petroleum Exporting Countries (OPEC) exercised its power by reducing the supply of oil flowing out of the Middle East. Virtually overnight the price of oil soared from $3 a barrel to $12. Agricultural products like corn, wheat and soybeans rose significantly, spawning the phrase "beans in the teens." Since monetary policy can't increase the supply of grains or oil, Burn's logic of removing food and energy and the non-monetary-related volatility they represented in the CPI made sense.

The Fed continued to use the CPI-Core Inflation Index as its primary inflation tool until 2012, almost 40 years after it was introduced. After the Federal Open Market Committee (FOMC) meeting on January 25, 2012, the Fed announced the following change in its post-FOMC statement:

"The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures [PCE], is most consistent over the longer run with the Fed's statutory mandate targets."1

The PCE is the broadest measure of prices in the economy. During the past 25 years, PCE inflation has been about [0.5%] less per year than the core CPI.

The Fed has indicated that it will not contemplate increasing interest rates until the labor market improves broadly and inflation increases toward its target of [2.0%]. The Fed's preferred inflation gauge, the PCE, was up [1.6%] from April 2013 (most recent data available as this is being written on June 20). The 12-month moving average of the PCE provides a more intermediate view and it was up [1.18%] through April.

The CPI rose a seasonally adjusted [0.4%] in May from April, and was up [2.1%] from a year ago. Since mid-2012, the CPI has bounced between [1.0% and 2.0%]. The 12-month moving average, which smooths out monthly volatility, was [1.54%] as of May. Core inflation, which excludes food and energy in the CPI, was up [0.3%] in May from April and up [2.0%] from May 2013, with a 12-month average of [1.72%].

Although inflation appears relatively tame no matter which inflation index is used, there does seem to be more bubbling of inflation under the surface. Car insurance has increased [4.8%] since May 2013, while prescription drug prices have risen [3.6%]. Eating is getting more expensive. For example, egg prices have jumped more than 10.0% from last year, bacon prices are up [15.0%], while oranges and tangerines will set you back by more than [17.0%]. No surprise, food prices in general popped [0.5%] in May, the most in 34 years. Since everyone buys food every week, these increases are more noticeable than purchases of items made less frequently. This has the potential to affect inflation expectations, which are almost as important to the Fed as actual price increases.

In April 2013, Congress lowered the Medicare reimbursement to doctors, which is one reason why the PCE was only up [1.6%] through April, versus an increase of [2.0%] in the core CPI through April. This one-time reduction in healthcare costs in April 2013 will have less of an impact on the annual PCE starting in May. This could result in a bit of catch-up by PCE inflation to core inflation in coming months, since healthcare has a larger weighting in the PCE than in the core CPI Index.

The PCE is the Fed's benchmark for quantifying the level and trend of inflation, but it is also focusing on inflation expectations, as measured by the five-year breakeven inflation rate. As the June 18 FOMC statement noted,

"It likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer- run goal, and provided that longer-term inflation expectations remain well anchored."2

Unfortunately, market participants are likely to be less discriminating. The monthly CPI information is far more visible than the status of the five-year-breakeven inflation rate, so market participants will respond far quicker to the CPI data. If the CPI is consistently above [2.0%] in coming months, it will spark conjecture about when the Fed will raise rates in 2015, even if inflation expectations remain contained. This guessing game is also likely to be spurred by speeches by Fed governors who have worried that the unprecedented increase in the monetary base and the Fed's balance sheet has sowed the seeds of a coming inflationary surge. The Fed has repeatedly stated that it is data dependent, and will take its cues for any decision based on incoming data. This point was reaffirmed in the June 18 FOMC statement:

"The Committee will closely monitor incoming information on economic and financial developments in coming months."3

No one knows with certainty how the economy will be performing six months from now, let alone a year from now. Members of the FOMC who are responsible for making the decision on when the Fed will start raising rates, probably won't know until well into 2015. But this won't stop the talking heads from interviewing "experts" providing their guesses. We don't envy the Fed as it attempts to provide forward guidance in the middle of the coming circus.

An inflation rate of [2.0%] sounds fairly benign, but over the long term it results in an insidious erosion of purchasing power. Like rust, inflation never sleeps. Using the "Rule of 72," a [2.0%] rate of inflation rate means prices will double in 36 years and quadruple in 72 years.

In terms of purchasing power, it means $1 in savings or income will lose half of its purchasing power in 36 years, and [75.0%] after 72 years. The average life span is now around 80 years. For the average person born in 2014, prices will at least quadruple in the course of their lifetime. This outcome assumes the Fed will execute monetary policy perfectly over the next eight decades, so inflation averages exactly [2.0%]. One might compare the chances of the Chicago Cubs winning the World Series before 2094 to the Fed meeting this goal.


The lack of lending by banks in the eurozone has been one of the biggest headwinds facing many of the countries in the European Union (EU). Through May, lending in the EU was still [2.0%] below May 2013. On June 5, the European Central Bank (ECB) announced several changes to its monetary policy to improve access to credit for small- and medium-sized businesses, increase economic growth and ultimately raise the level of inflation in the eurozone. The ECB is the first major central bank to charge its banks 0.10% for carrying excess reserves with a central bank. By adopting a negative deposit rate, the ECB hopes this unprecedented step will incentivize banks to convert dormant excess reserves into new lending.

It also announced the Targeted Long-Term Refinancing Operation (TLTRO), which will make €400 billion (approximately $540 billion) available to banks at the refinancing rate, which was lowered from [0.25% to 0.15%]. The TLTRO funds come with a number of stipulations. The TLTRO cannot be used to lend to households to buy homes, so the banks will have to use the funds to lend to small- and medium-sized business. Banks will be required to show that lending to firms increased as a result of the TLTRO program. Even though they are four-year loans, funds borrowed in the TLTRO program must be paid back in 2016 if not used to increase lending.

The reduction in the refinancing rate from [0.25% to 0.15%] is not likely to spur an immediate pickup in lending to small- and medium- sized firms. Banks aren't likely to lend to struggling firms no matter how low the refinancing rate, and demand from healthy firms is not likely to surge just because loans have become [0.10%] cheaper. The negative deposit rate took effect on June 11. On June 12, eurozone banks withdrew almost $35 billion of the cash they had on deposit with the ECB. After these withdrawals, cash on deposit with the ECB fell to just $18.4 billion-the lowest level since 2011. It would appear that banks have pulled their deposits from the ECB simply to avoid paying the [0.10%] negative deposit rate rather than responding to a sudden interest to increase their lending.

The biggest impediment to a pickup in lending is the ECB's Asset Quality Review (AQR) of the 128 largest EU banks. The AQR is expected to be completed by the end of August, with results to be published in October. It is unlikely that all 128 banks will receive a clean bill of health. As discussed in previous MSRs, banks have been strengthening their balance sheets by selling poor performing assets, increasing their loan-loss reserves, raising capital through stock sales and buying assets that better meet increased capital rules.

Spanish banks have significantly increased their holdings of Spanish government bonds, and now hold $384 billion worth, 2.9 times the precrisis average. Italian banks own $562 billion of Italian government bonds, about 2.4 times what they were carrying before the crisis. Clearly these outsized purchases have contributed to the significant declines in Spanish and Italian 10-year government bond yields. During June, these yields briefly fell below the 10-year Treasury bond yield.

The Center for Economic Policy Research is tasked with determining when recessions begin and end for the 18 nations that use the euro currency. It is composed of nine economists and is Europe's equivalent to the National Bureau of Economic Research, which is the official arbiter of the business cycle in the U.S. For the four quarters ending March 31, 2014, the EU economy has grown just under [1.0%]. Despite this growth, the Center for Economic Policy Research recently noted,

"It is too early to call the end of the recession in the eurozone...Economic times in the eurozone are bad. They are bad if we are still in a recession, but they might be worse than we feared if this is what expansion looks like in the eurozone."4

Coming into 2014, we said the eurozone would have trouble growing more than [1.0%]. The recent announcement by the ECB is not likely to change that outlook.

In late 2013, we believed the ECB would take actions that would result in a decline in the value of the euro, since its strength had caused inflation to fall further below the ECB's target of [2.0%]. In April, Mario Draghi stated that the increase in the euro from July 2012 had shaved [0.4%] from the eurozone's annual inflation, which confirmed our view that the ECB wanted the euro to decline. After the ECB's meeting on May 8, Mario Draghi said,

"The ECB's governing council is comfortable to easing policy at their meeting in early June."5

He also reiterated the connection between the euro and the low rate of inflation:

"The strengthening of the exchange rate in the context of low inflation is a cause for serious concern."6

After these comments, the euro peaked at 139.93 on May 8 and then reversed lower. As we noted in last month's MSR, the peak at 139.93 was just 0.46 above the [50.0%] retracement of the decline from the July 2008 peak at 160.38 and the June 2010 low of 118.77. In addition, the euro experienced a weekly key reversal during the week ending May 9, as the euro made  a higher high and lower low than the prior three weeks. These were technical indications that the trend in the euro versus the dollar had turned down.

During the last few weeks, an additional technical indication was provided as the euro fell below the uptrend line from the July 2012 low. From its recent low of 135.03, the euro could bounce to 137.48, which is the [50.0%] retracement of the decline from 139.93. After any bounce, which serves to alleviate the euro's short-term oversold condition, the euro has the potential to decline to 131.00-132.00 in coming months, where there is a trendline connecting the lows during 2013.

Stock Market

Most institutional investors remain constructive on the economy, and still expect GDP growth in the second half to hold above [3%]. Whether or not that proves to be true doesn't matter in the short run. The lack of selling pressure has been one of the main supports under the market for some time, and that's not likely to change.

Stock buybacks by corporations have also been a factor, especially since volume has been low since the end of 2012. In 2013, corporations purchased almost $550 billion of their own stock, and purchases are running at a similar pace so far in 2014.

The ECB's decision on June 5 to adopt a more accommodative posture and assurances from the Fed that any rate increase is well off into the future have simply coalesced bullish sentiment.

The percent of bulls in the Investors Intelligence weekly survey of sentiment has exceeded 62%, which is the highest since 1987. However, the stock market doesn't decline just because there are too many bulls. The recent correction from early March into May was a rotational correction in which small cap stocks were sold in order to rotate into larger cap stocks. As the rotational correction progressed, technical indicators based on momentum, market average divergences and the shrinkage in the number of stocks making new 52-week highs, only set the stage for the market to potentially experience a decline. By late May, small cap stocks were oversold and ready to at least bounce. With no overall reason to sell, the market has rallied to new highs and some of the technical weakness has been repaired.

A meaningful decline (greater than [7.0%]) is not likely until investors have a reason to sell all stocks. The S&P 500 Index continues to make higher highs and higher lows, which is the technical definition of an uptrend. The rally since the May low has carried the Major Trend Indicator (MTI) above 3.0, which is significant for the intermediate outlook. Such strength reconfirms the bull market that was signaled by the MTI on November 30, 2011. It also increases the probability that any correction is unlikely to exceed [4.0% to 7.0%]. A decline below 1,810 would be negative for the intermediate trend.

Treasury Bonds

Since the January MSR, our view has been that the Treasury yield was likely to decline from [3.0%] to under [2.5%]. In April and May,  we refined the target to a decline to [2.46%]. Last month, we wrote,

"The yield could dip below [2.40%], but to drop appreciably further would take a geopolitical event resulting in a flight to quality, or far weaker economic data than we expect."

On May 29, the yield on the 10-year Treasury bond fell to [2.402%], and then reversed higher. We continue to believe that the 10-year Treasury yield is more likely to just drift higher in coming weeks toward [2.75%-2.84%].

Definition of Terms

  • 10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.
  • Consumer Price Index(CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation.
  • Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.
  • Gross domestic product (GDP)is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.
  • Quantitative easing (QE) refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.
  • Personal Consumption Expenditures (PCE) is a measure of price changes in consumer goods and services. Personal consumption expenditures consist of the actual and imputed expenditures of households; the measure includes data pertaining to durables, non-durables and services. It is essentially a measure of goods and services targeted toward individuals and consumed by individuals.
  • S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.
  • Small Business Optimism Index measures the economic health of small businesses through quarterly surveys of the National Federation of Independent Business's small-business owners/members.
  • Thomson Reuters/University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly and based on answers from 500 telephone interviews of persons living in the continental United States.
  • U-6 unemployment rate includes all the total amount of people unemployed and those marginally attached to the labor force, plus total employed part time for economic reasons.
  • Volatility is a statistical measure of the dispersion of returns for a given security or market index.
One cannot invest directly in an index.


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

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