In last week’s installment of Big Picture, we explained why the Federal Reserve’s updated economic projections for the US appear overly optimistic–an outlook that suggests the central bank’s proposed phase-out of quantitative easing will likely be delayed. Against this backdrop, the recent surge in bond yields appears to be a massive overreaction.
Several prominent Fed officials agreed with our assessment and moved to clarify Fed Chairman Ben Bernanke’s statement. Federal Reserve Bank of Atlanta President Dennis Lockhart last week commented that the markets might have “misread” Bernanke’s comments, while Fed Governor Jerome Powell asserted, “Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy.” John Williams, president of the Federal Reserve Bank of San Francisco, indicated in remarks to the Sonoma County Economic Board that it’s too early for the central bank to begin tapering. “We need to be sure the Fed can maintain its momentum in the face of ongoing fiscal contraction,” Williams added.
The Fed’s jawboning worked: Yields on 10-year US Treasury notes dropped to less than 2.5 percent from a high of more than 2.6 percent on June 25. Stocks also responded, with the S&P 500 finishing last week above 1,600.
Despite the market’s newfound traction, we still see the risk that the S&P 500 could retest 1,500, though predicting the timing and magnitude of such a correction is notoriously difficult. Investors should look to gradually build their stock portfolios over the next three to six months.
Whereas many investors are fixated on the Federal Reserve and the potential for rising interest rates, we’re more concerned about lackluster economic growth in the near term.
The US Bureau of Economic Analysis (BEA) lowered its estimate of first-quarter growth to 1.8 percent–well below the Bloomberg consensus estimate of 2.4 percent. A downward revision to personal consumption expenditures, a reflection of consumer spending, accounted for much of this downgrade, though the BEA also reduced estimates of US exports.
This lower-than-expected economic growth may reflect the federal tax hikes and spending cuts that occurred at the beginning of 2013; higher payroll taxes, for example, reduced consumers’ discretionary income. Cuts in government spending and investment reduced US gross domestic product (GDP) by less 1 percentage point in the first quarter.
With US GDP likely to grow by less than 2 percent in the second quarter, the Fed’s optimistic forecast for 2013 appears increasingly out of touch with reality; the country appears to be in the midst of another summertime slowdown. For this reason, the central bank is unlikely to begin scaling back bond purchases after the Federal Open Market Committee’s September meeting.
On the whole, economic data indicate that GDP growth remains sluggish. But a few parts of the economy continue to strengthen. The housing market provided a welcome boost in the first quarter, with private investment in residential housing contributing about one-third of percentage point to US GDP. This pocket of strength helped to offset some of the headwinds from higher taxes; rising house prices make consumers feel wealthier and increase their willingness to spend.
In June the S&P/Case-Shiller Composite 20-City Home Price Index increased 12.05 percent from year-ago levels, topping analyst expectations of 10.6 percent.
We expect US house prices to continue their recovery through the remainder of the year, thanks to a significant decline in the inventory of unsold homes.
At the height of the housing bust, US inventories of new and existing homes for sale surged to record levels, contributing to spiraling real estate valuations. But this market has healed gradually over the past five years. Now, reduced supply relative to demand is pushing prices higher.
Although a sharp rise in interest rates would reduce home affordability and curtail price increases, we don’t expect the Fed to take the punch bowl and end the party until the economy exhibits stronger momentum.
We expect the US economy to rebound in late 2013 and early 2014, with GDP expanding at a rate of about 3 percent by the end of 2014. In this scenario, the Fed would almost certainly wind down its quantitative easing, though any consequent rise in borrowing would likely be offset by stronger demand for housing thanks to better economic conditions. A robust housing market is one of the major reasons that this year’s summer soft patch won’t deteriorate into a recession.
Investors should continue to buy high-quality stocks when the market dips. If our economic outlook pans out and GDP growth accelerates in late 2013, investors will likely shift capital from fixed-income investments to equities. As we highlighted in The Great Rotation, investors will likely move money from consumer staples and other defensive groups that have been bid up, to underperforming cyclical sectors such as energy, financials, industrials and technology.
In Capitalist Times Premium, we continue to fill out the Wealth Builders Portfolio with this outlook in mind.
Elliott H. Gue is founder and chief analyst of Capitalist Times Premium and Energy & Income Advisor.