After accelerating at the end of last year, the economy slowed in the first quarter of 2014, weakened by severe weather. Reported economic growth in the second half of 2013 was relatively strong, though temporary factors, including surges in inventories and exports, were significant drivers. Inventory investment contributed to almost half of GDP growth during that period, and economists are looking for weaker numbers in the near term as businesses work off the excess inventory.
More recently, cold weather kept shoppers out of stores and prevented some Americans from driving to work. The much-dreaded polar vortex struck in early January, affecting an estimated 200 million people or more in parts of Canada and the United States east of the Rocky Mountains, and as far south as Central Florida. Winter storms have been blamed for an estimated $5 billion in lost productivity, contributing to a disappointing jobs report and dismal auto sales. Research firms generally estimate a 0.2 percent to 0.5 percent impact on GDP.
The Institute for Supply Management reported a large decline in manufacturing conditions for January, as new orders and production plummeted. A number of comments from the panel cited adverse weather conditions having a negative impact on their businesses, while others reflected optimism and increasing volumes in the early stages of 2014. Small business owners are cautiously optimistic about their own sales and anticipate more hiring, with the strongest job creation plans since 2007.
Sales of new homes plunged at year-end as the cold weather discouraged buyers, yet the sector recorded its best year since 2008. Sales were further depressed by weakened affordability and rising interest rates. Conditions also weighed on home construction, as housing starts fell ten percent from 1.1 million. Nevertheless, builders are upbeat about the outlook for the residential market, which will need to expand to meet the demands of a growing population. Household formation is back to normal, with more than 1 million units being created annually. With rental vacancy rates at their lowest level in more than a decade, there will be room for expansion in the purchase market.
Growth Stronger Than Expected
Most Federal Reserve policy makers viewed the second-half growth spurt as stronger than expected, boosted by transitory factors relating to inventory accumulation. The Federal Open Market Committee (FOMC) expected these factors to wane, and still thought the most likely progression will be “moderate in nature.” A number of Fed officials regarded the latest employment reports as anomalous, and not indicative of a meaningful shift in hiring intentions.
The committee deemed these developments as warranting another cutback ($10 billion) in their bond purchase program and saw further reductions in the pace of purchases as likely. The committee was attuned to signs of excessive emerging market stress, but believed risks to the U.S. outlook were broadly balanced. Most market participants predict the committee will continue to decrease purchases by $10 billion per meeting and conclude in October. At the moment, the FOMC has set a high bar to altering its taper plans.
The Federal Funds Rate will be kept near zero until at least mid-2015, when most economists expect the first rate hike. Trading in LIBOR futures places the first increase in the third quarter of next year. Data on the appropriate timing of policy firming show most policymakers would begin raising rates in 2015 or later, with Fed funds bumping up to 2 percent by the end of 2016.
On the hopeful side, some groups are calling for 4 percent GDP growth this year on the back of pent-up demand for housing. The contribution could come directly via the increase in residential investment, or through the purchase of consumer items for the home and a general increase in consumer spending from rising housing wealth.
According to the February release of Blue Chip Economic Indicators, the consensus of 50 forecasters puts 2014 and 2015 growth at 2.7 percent and 3 percent, respectively. The FOMC’s February 2014 Monetary Policy Report to Congress revealed that the committee expected growth to run 2.8 percent to 3.2 percent this year and 3 percent to 3.4 percent in 2015.
Slow And Steady Climb
The most likely scenario is continued modest growth in the economy, and steady improvements in the job and housing markets. Bond market traders are preoccupied with the Fed’s debate about changes to the unemployment and inflation target it cites as conditions for any policy shift, a preliminary step well before any actual rate hike could occur. The Fed appears far from finding a consensus view on how to proceed with “forward guidance” and how to interpret the drop in the unemployment rate. In this environment, Treasury yields are likely to trade between 2.60 percent and 3.00 percent, and are unlikely to soon rise much above the top end of the range. For year-end, the consensus is calling for a 3.50 percent 10-year.
Given recent equity price appreciation and the expectation for higher interest rates, stocks could face periodic headwinds. With reasonable valuations and mostly positive momentum in the global economy, most analysts have an upbeat outlook for the U.S. stock market. Over the past 50 years, the average PE multiple of the stock market has been around 15.5 times forward earnings, similar to the level today. Should earnings hold up, the stock market could return another five to ten percent this year, a respectable though not spectacular performance.
Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at bob@atlanticcapitalstrategies.com.
