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The U.S. economy, and corporate earnings, has faced, and apparently overcome, a number of daunting challenges thus far in 2013: the “fiscal cliff,” higher marginal taxes, the resumption of the 2% payroll tax, the prospect of government spending cuts under the budget sequester, and, most recently, fears related to the forthcoming end of quantitative easing. New highs in stock market indexes are attributed to record corporate profit levels, and an economy supported by improving housing and job growth.
While investors search for a catalyst for stronger growth in 2014, an analysis of what seems to be working for the economy right now seems appropriate. But as markets appear to bank on a continued improvement in housing and the labor market, and the continued ability of the economy to absorb higher taxes and reduced government spending, a closer look at each reveals that these areas of strength may not be as robust as investors perceive.
Recent housing statistics have been encouraging. According to the U.S. Census Bureau, building permits and building starts reached levels in the first five months of 2013 that exceeded even the average monthly levels of 2008.1 New and existing home sales have experienced double-digit growth, reducing inventories to less than half their levels of five years ago.
Prices have improved accordingly. The most recent S&P/Case Shiller Home Price report showed that average home prices increased about 12% in the 12 months ended April 2013 for the 10- and 20-city composite indexes.2 The wealth effect associated with such improvement may help explain consumers’ willingness to spend. Higher prices also may improve job mobility as homeowners may be better able to sell their home, and at a profit, freeing them to move toward better job prospects.
However, the recent rise in rates on 15- and 30-year mortgages could dampen sales, prices, and the wealth effect on the economy. If homebuyers finance 80% of May’s $307,000 average home price (based on Census Bureau data) at 3.5%, their monthly interest payment would be $715. At 4.5 %, that payment increases more than 28% to $919. The actual monthly increase will be less after inclusion of principle pay-down, but to the marginal homebuyer, the interest rate rise seen since early May seems likely to have an impact on affordability.
More important is the impact of higher rates on refinancings. In April and May, according to Bloomberg, refinancings accounted for 70–75% of all mortgage applications. The interest rate sensitivity of refinancings suggests a dramatic drop if rates stay at levels of early July, let alone if they rise further. Assuming that a portion, if not all, of the money that was captured through refinancings at lower rates was spent, the boost to consumer spending provided support to the economy. The absence of new refinancings as a result of higher rates will likely remove that support of economic growth in the second half of 2013 and beyond.
The labor market is another source of economic strength that investors hope will continue to improve. While it has been slow, job growth has at least been enough to gradually reduce the unemployment rate to 7.6%, according to the government’s employment report for June 2013, released July 5.3 The 200,000 per month average increase in non-farm payrolls in 2013 seems to be a level adequate to persuade investors that economic growth will continue, and that a continuation of this level of job creation could be enough to promote self-sustaining growth.
But a breakdown of the types of jobs being created offers less encouragement for the economic optimists. Data from the U.S. Bureau of Labor Statistics show that over the past three months (ended June 2013), restaurants and bars have accounted for more than 25% of all new jobs. Considering that average weekly earnings in the leisure and hospitality industry are $351, less than half the average for all private industry, such jobs may not have the economic impact the 200,000 headline number implies.
Furthermore, many jobs created may be part-time. Data from the June employment report show that 78% of the jobs created since the beginning of 2013 have been part-time. With this picture of employment growth, perhaps market observers shouldn’t have been surprised at the less than robust economic growth of 1.8% in the first quarter. If job creation is to be a key contributor to self-sustaining economic growth in 2013—and an acceleration of growth in 2014—both the quality and volume of jobs will have to improve.
As we mentioned earlier, the economy has overcome many hurdles in 2013. Its resilience offers hope that whether it is higher taxes or reduced government spending via sequestration, growth in the United States will prevail. And this resilience seems to be evident in the surprising progress we seem to have made in reducing our budget deficit.
But as Milton Ezrati, Lord Abbett Partner, Senior Economist and Market Strategist, has noted in commentary about the U.S. deficit, future reality may be starkly different than today’s perceptions. Notions of improvements in the deficit—and an overall resilience in the U.S. economy—have a common transient denominator: a 28% surge in year-over-year tax increases this past April. Fear of higher taxes in 2013 appeared to bring forward bonuses, dividends, and investment gains in late 2012, an event unlikely to be repeated in 2013. The income-enhancing event created a one-time tax windfall for the government, and at the same time supported an increase in consumption.
As a result, the deficit looks better than expected and personal spending, after averaging 1.7% in the third and fourth quarters of 2012, increased to 2.6% in the first quarter of 2013.4 The resilience implied by such spending is not likely to continue through 2013, and is likely to be missing as well from 2014.
Furthermore, the seemingly mild impact of the 2013 sequester may have less to do with economic resilience and more with the size and nature of the “spending” cuts. First, because the sequester was only in effect for part of the fiscal year, the cuts amount to about $45 billion, not the $85 billion annualized figure that is widely recognized. Second, many of the cuts, according to a recent Washington Post article,5 were postponed, including maintenance, work furloughs, and other easy temporary measures. Recognizing that these cuts may have to be more permanent in the next fiscal year could pose the real economic pain that has so far been avoided. The additional $109 billion in spending cuts under the 2014 sequester for the fiscal year beginning October could further test the mettle of the economy.
This is not to say that recent growth will turn to recession, but that substantial economic improvement may be more difficult to accomplish that what is generally assumed. Accordingly, while equities may be capable of a 6–8% earnings improvement in a 2% GDP growth environment, the higher yield aspects of fixed income are also worthy of portfolio consideration. Even as the Treasury and high-quality debt markets shudder in anticipation of tapering and the gradual absence of the Federal Reserve as a major buyer of long-term Treasuries, the bank loan (as represented by the Credit Suisse Leveraged Loan Index) and high-yield (as represented by the BofA Merrill Lynch High Yield Master II Constrained Index) sectors appears to offer relative value at recent yields of about 5.0% and 6.2% respectively, according to Bloomberg. ‘A’ rated and ‘BBB’ rated corporates and municipals also currently offer better than average historical spreads, even after Treasury yield have adjusted to anticipated tapering.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.
Gross domestic product (GDP) is the total value of all the goods and services produced within a country's borders. When that figure is adjusted for inflation, it is called the real gross domestic product, and it's generally used to measure the growth of the country's economy. In the United States, the GDP is calculated and released quarterly by the Department of Commerce.
The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The CS Leveraged Loan Index is an unmanaged, trader-priced index that tracks leveraged loans. The CS Leveraged Loan Index, which includes reinvested dividends, has been taken from published sources.
The BofA Merrill Lynch High Yield Master II Constrained Index is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment–in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BB-/Baa3, but are not in default. The BofA Merrill Lynch U.S. High Yield Master II Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure.
The credit quality ratings of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.