September 2014 Big Grower, Grower News

MAKING CENTS: The Sails Are Up, But Where’s the Wind? By Charlie Hall

I just returned from the newly revamped Cultivate conference and was saying to colleagues that it was one of the best ever. Was it the quality of the educational sessions or the continuous networking or the new events? Yes, all of the above. Perhaps the best part was that I did not run into a single Eeyore (remember the always pessimistic character from Winnie the Pooh). It just goes to show some change is actually good and as you’ve heard me say before: If you always do what you’ve always done, you’ll always get what you’ve always gotten.

Rebounding Forward

So with all these changes going on, is the economy changing as well? Of course, it is. It changes every day! Despite the hits from the harsh winter weather earlier in the year and the recent return of Middle East geopolitical risk, I remain optimistic about the second half of 2014. Consumer spending appears to have swung back positive since the winter doldrums, particularly with job and income growth holding up relatively well. Data from the housing sector even shows activity continues to muddle along during the seasonally slow period of the year.

Following the first quarter’s surprising 2.9 percent decline in GDP, most economists are anticipating a nice rebound in Q2 of approximately 2.5 percent, reversing most of the Q1 decline. The previous quarter’s sizeable decrease came as exports and inventories detracted 1.5 percent and 1.7 percent from GDP, respectively. Perhaps even more notably, personal consumption expenditures grew at an initially reported 3.0 percent pace, but the figure was revised down to only 1.0 percent.

While the decline in Q1 GDP was rather discouraging, economic indicators thus far in Q2 have been much more upbeat. While we still see net exports putting a drag on economic growth, inventory building should provide a boost in Q2. Personal consumption expenditure growth is expected to ramp up modestly, rising at a 2.2 percent annualized pace, and business fixed investment should also be a solid contributor.

There have been a few false alarms about a possible upsurge in inflation in the United States in the past few years, even as core inflation on most measures has remained extremely subdued. Another such scare has been brewing recently and I was asked several times at the Cultivate conference whether we should be worrying about it. Nope, not yet, was my response because it seems probable that part of the recent jump in core inflation was just a random fluctuation in the data. But the main reason for the lack of concern is that wage pressures in the economy have remained stable on virtually all the relevant measures. Bottom line? This has been yet another false alarm on U.S. inflation.

Employment Up, Housing Down

Job growth has been one of the most positive stories in the first half of 2014. Prior to seasonal adjustment, the economy added 3.85 million private-sector jobs between February and June. Part of that, however, reflects weather-related weakness in the early part of the year. Job destruction has remained low (it hasn’t been an issue in the last few years) and new hiring appears to have picked up. However, there is a fair amount of statistical noise in the payroll figures (the monthly change in payrolls is reported accurate to ±90,000). So it’s not unusual to get a string of monthly figures above or below the underlying trend. Hence, the recent trend in payroll growth is encouraging but hardly conclusive. Unfortunately, financial market participants (that’s us) essentially have to take the payroll numbers at face value.

On the other hand, the indicators are not universally positive. Housing starts, which had been running above one million units, dropped to 893,000 in June. Building permits also declined. For the economy to move toward 3 percent real growth in the second half and for unemployment to continue heading to lower levels, housing has to be strong. Recent data on housing has been mixed, and the drop in starts is troubling, but there are enough other positive signs that I am not altering my favorable forecast. If housing continues to be weak, however, I will probably have to change my view.

Many investors are worried about a shift in Federal Reserve policy triggering a serious correction in the market. Based on Chairman Yellen’s recent comments on the economy, I do not think an increase in short-term interest rates is imminent, but if GDP growth looks like it will exceed 3 percent real sometime in the second half, a rate hike is possible. My own view is that we won’t see a rise in rates until mid-2015.

Geopolitical Factors

Finally, given all the geopolitical unrest recently, taking a look at the economies around the world is probably useful. The United States is currently growing at 2 to 3 percent real, Europe at 1 percent and Japan at 1.5 percent. The emerging nations are generally growing faster. I continue to believe real economic growth in the United States will move toward 3 percent during 2014, and S&P 500 profits will be up 7 percent, with a similar increase next year. I see neither a recession nor a bear market in sight even though we are five years into the economic and market recovery. Let’s hope geopolitical turbulence doesn’t upset that outlook.n