Second quarter annualized U.S. GDP increased by 4.0%, which is a sharp reversal from the -2.1% (revised up from -2.9%) experienced in the first quarter and shows the U.S. economy bounced back from dismal winter weather. Our thesis of accelerating growth being driven by certain "economic pillars" was evident in Q2, with consumer spending up 2.5%, increased capital expenditures (structure up 5.3% vs 1.6% in Q1 and equipment up 7.0% vs -1.0% Q1), housing related growth (affordability continues to decline but overall a rise in new housing starts contributed positively to residential investment and growth) and, after dragging down growth over many quarters, government spending was 1.6% higher. The one area of the report that some pundits are concerned with is rising inventory levels and the potential for this to falsely bump up reported growth. While inventories did rise more than expected, we believe businesses are becoming more risk-tolerant as consumer confidence increases (measured by the U of M Survey of Consumer Confidence, up to 81.8 from 80.0 at the end of Q1). Finally, net exports subtracted 0.06% from GPD. Net exports could be a component of GDP that surprises in the quarters ahead, as oil exports begin to flow. The U.S. has been prohibited from exporting crude oil since the 1970s; however, lightly refined products called distillates are now being exported. In all, the Q2 GDP report indicated that U.S. growth continued at a modest to moderate pace from the second half of 2013.
Employment and Inflation
The U.S. economy added 209,000 jobs in July, and the unemployment rate rose 0.1% to 6.2% on a slight uptick in the participation rate. The last time the economy added more than 200,000 jobs for six straight months was 1997. If there is a robust indicator of economic growth and higher interest rates, this streak of job creation is it. A factor appearing to hold down long-term rates is inflation, which printed last Friday at 1.6% year-over-year, below the Federal Reserve’s target rate of 2.0%. Evolving inflation will likely be driven in large part by wages. JP Morgan points to the Employment Cost Index (ECI), which grew by 2.0% year-over-year, as having an extremely high correlation to future inflation. Benefit costs, mainly retirement plans, are up 2.5% as the population ages, and wages grew by 1.8%. As we push through the back half of 2014, wage growth (or lack thereof) will likely be the biggest indicator of labor market slack and whether inflation eventually moves higher. The Fed is watching developments on these fronts closely.
Federal Reserve Meeting
The Federal Reserve concluded a two-day meeting last week by announcing a continued reduction in its bond purchase program, which was widely expected and affirms its confidence in the strengthening recovery. In its post-meeting statement, the Fed pointed to the improving economy (see first paragraph above) and strong job creation (see second paragraph), but expressed concern about excess slack in the labor markets and the effect that slack is continuing to have on wages and inflation. Interesting to note, however, is that certain FOMC members have become more outspoken in recent weeks on the need to normalize monetary policy (i.e., raise interest rates) more quickly than is expected. Charles Plosser, President of the Philadelphia Fed, went so far as to dissent from the statement based on this thesis. The financial markets currently anticipate the first rate hike coming in mid-2015. Should the "hawks" on the Fed such as Plosser turn out to be correct and the Fed raises rates sooner than that, bond investors, particularly those reaching for yield by having long durations and low credit quality portfolios, could suffer. We’ve positioned portfolios to protect against such risks, and are confident that when other investors are selling, we’ll be ready to buy at attractive prices.