Economic Update and the Political Standoff in Washington

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Economic Update and the Political Standoff in Washington

The S&P 500 had a great 3rd quarter—up 5.2% and 19.8% for the year—as the economy continued to show signs of improvement. As a result of the growth in stocks and real estate, along with the reduction of interest rates, overall household net worth hit a new record of $76 trillion, surpassing the high set in 2007 by $8 trillion. With the tremendous growth in equities, many investors question their valuation.

Stocks closed the quarter at a 14.3 times price to forward earnings multiple. That’s a slight discount to the average since 1985 of 14.9 times earnings. It’s rare that the market would peak at historical average valuations, as investor optimism generally pushes equities significantly higher before they fall. However, with earnings growth slowing and the equity markets approaching fair valuation, we do not anticipate the robust equity growth we’ve experienced in the last 3 years.

Bonds, particularly treasuries, remain expensive despite a selloff in the 3rd quarter. The yields on treasuries bottomed at 1.7% early in the year and have increased nearly a full point to 2.61%. This has caused the housing refinance market to slow considerably, as many homeowners locked in record-low long-term rates. However, there continues to be a housing shortage in the U.S.; the number of homes for sale is at 2.3 million, among the lowest in 30 years. In addition, housing starts are at 891,000, well below the average of 1.4 million. As a result, we continue to believe real estate will appreciate, albeit at a much slower pace as mortgage rates increase.

We expected the Federal Reserve to taper the quantitative easing program in September, which it did not do. The Fed continues to buy roughly $85 billion of bonds per month from banks in an attempt to keep rates low and keep the economy growing. We do have concerns long term about this program and its ability to increase inflation and deflate the value of the dollar. However, with core inflation at 1.8%, the risk will not likely present itself until the economy shows much higher growth.

The unemployment rate continues to decline as the economy adds roughly 180,000 jobs per month; it’s now at 7.3%, down from a peak of 10% in October 2009. In addition to added job growth, we’ve seen the overall labor force decline from 66% in 2007 to 63.2% today. Part of decline is disgruntled workers and young Americans staying in college, but the vast majority of the labor force decline is due to a demographic shift. The Baby Boomer generation is reaching retirement age, putting downward pressure on the labor force. We expect the labor force to increase in the coming years at a slow pace. If the addition of jobs continues, we should be at a 6.5% unemployment rate by mid-2014, the rate at which the Fed indicated it will likely end the quantitative easing program.

What’s Happening Now

There are significant risks to economic growth that have emerged in the last two weeks that can possibly derail the economy. House Republicans and Senate Democrats have not reached an agreement on the budget, causing non-vital areas of the government to shut down and the markets to sell off about 4% from the peak. This political gamesmanship has the potential to cause devastating economic effects, particularly if the debt ceiling is not raised by October 17. The news today is a proposal by House Republicans to extend the debt ceiling for another six weeks but keep the government shutdown in place. The White House insists that Republicans must also agree to end the government shutdown. Stocks rallied on the news, but this is far from a done deal.

The U.S. government has a projected borrowing amount of $642 billion for fiscal year 2013 or about 19% of its total spending budget of $3.5 trillion. If the government doesn’t raise the ceiling, it will have to immediately reduce spending to match the level of tax receipts—which will have potentially devastating consequences. In that scenario, the treasury will likely prioritize spending and continue to pay the interest on government debt to appease bondholders and maintain stability in the U.S. debt market. After all, interest payments to bondholders represent less than 10% of tax receipts. However, under this scenario, it will likely not have the funds to pay the full amount of Social Security obligations to seniors and veterans benefits on November 1. Given the fact that foreign countries own about half our government debt, the headlines would see that as favoring foreigners over seniors and veterans.

We feel some agreement will be reached close to or shortly after the October 17 deadline, perhaps to extend the implementation of parts of Affordable Care Act short term in exchange for funding the government and increasing the debt ceiling. However, the longer this plays out, the more damage it can cause. We feel risk assets such as stocks will have downward pressure until an agreement is reached, at which point they will rally.

We believe the best antidote for volatility and uncertainty is diversification, and ultimately, common sense will prevail. Unfortunately, the road toward a solution will be volatile and frustrating. We remain cautious short term in light of the current political pressure.

By | 2017-06-02T17:58:54+00:00 October 14th, 2013|Quarterly Newsletter|

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