Weekly Economic Commentary • Principal Global Investors
Covering the week ended May 30, 2014 — Published on June 6, 2014
Don't Judge a GDP Report by Its Headline
It was one of the best awful reports ever; the headline was awful, but the details were much better. The second estimate of first quarter U.S. GDP revised growth down from 0.1% to -1.0%, suggesting a stagnating economy. This was the first time since 2011 that economic activity declined. The one standout negative was spending on nonresidential structures—this was initially reported to be about flat, but was downwardly revised to a 7.5% contraction. State and local government spending was also revised from -1.3% to -1.8%, a decline out of sync with burgeoning tax receipts and growing state and local government revenues. At year-end 2013, 28 states actually had positive cash balances. We believe that most of the weakness in the first quarter was temporary. Still, the revisions forced our year-end forecast for 2014 down 0.3 percentage points to 2.2%. However, our forecast remains optimistic for the rest of the year, expecting GDP growth to average around 3.4% for the second to fourth quarter.
Around the Rest of the World
China stretches its mini-stimulus: Officials have ruled out any large scale economic stimulus to counteract the slowdown that unfolded over the winter and spring. At the same time, they issued assurances that growth is fine and that whatever develops, Beijing has got it covered. Nevertheless, the list of small measures announced earlier in the year to promote growth has gotten more substantial. In April, reserve requirements were lowered for a select group of rural banks; now, it's for a broader set of "qualified" banks that provide loans to rural borrowers and smaller companies, especially for low-income housing. Railway investment is being enlarged and budget spending is speeding up. Taxes and fees may be reduced for companies.
More Confidence Equals Faster Growth?
We'll soon see. Consumer and business confidence is rising across much of Europe and the United Kingdom. Economic sentiment in the Eurozone hit its highest level in three years which was double the less than 1% growth of last quarter. The European Commission Survey Index rose in Spain, Italy, and Germany and is now above its long-term average. U.K. service companies registered the highest confidence on a Confederation of British Industry (CBI) index this quarter since the survey began in 1998. Purchasing manager indices are holding at or near their cycle highs; the Eurozone composite was 53.9, just a tick lower than the April number. With unemployment still very high and retail sales lackluster, it's not clear the improved confidence will translate into faster growth.
When Do U.S. Rates Move Higher?
Maybe the real question is when does U.S. growth pick up? At the end of 2013, there was an almost universal consensus that U. S. growth would jump to the 3% plus range in 2014 and that yields on 10-year Treasury bonds would move up to the 3.5% range or more by the end of this year. As long ago as May of last year, financial markets began to factor in the end of the Federal Reserve's (the Fed's) bond purchases and impending normalization of Fed policy, which implied higher short-term rates. There was also growing confidence in the growth outlook, so the "smart trade" was for higher rates. Even the temporary government shutdown in October, which postponed the bond-purchase taper, didn't faze the yield and growth bulls too much and Treasury yields marched higher to end the year at 3.03%, the highest since mid -2011. That early year optimism, though, vanished with the winter blizzards and sub-zero temps. As noted, first quarter GDP fell 1.0% annualized from the fourth quarter and yields on 10-year Treasuries plunged over 0.5% in the first five months to May
So, What Happened?
Investors now are grappling with the issue of why rates are so low. The issue can be framed as determining the path of the 10-year Treasury yield, which is heavily impacted by the outlook for Fed- driven short-term rates plus inflation expectations and a term premium that reflects growth prospects as well as uncertainties about the risk of holding long-maturity bonds. So, bond investors began to watch Fed policy closely, especially as influenced by the new Fed Chair Yellen, and wait for growth.
For these reasons, we expect U.S. economic growth to reach 3% to 3.5% for the rest of 2014. The expansion should continue, although at a slightly slower pace, the first half of next year. At some point, the Fed will start to exit its extraordinary monetary policy. Higher rates and slowing liquidity provisions will then become a headwind.
Ultimately, Growth Will Win Out
Investors have grown tired of hearing optimistic growth forecasts. They want to see it actually happen. While today's low Treasury yields are another bond conundrum, if U.S. and global growth does pick up from the modest pace of the first quarter, bond yields should head higher. Also, inflation seems to be bottoming, pulling another leg from the bond bulls' platform. Further strong gains in U.S. jobs would cement the case for growth and higher rates. We previously believed yields on U.S. Treasury bonds would end 2014 in the 3.25% to 3.5% range, but from the vantage point of 2.48% current yields, our estimate should likely come dow
The growth outlook is still reasonable as noted above. U.S. data is picking up. The Eurozone recovery is ongoing, fragile though it may be. Japan seems to be weathering its tax hike. With plenty of slack available, there are few imbalances to note in developed economies. China and emerging economies are stabilizing. There still are excesses and financial stress in developing countries that emanated from the long boom driven by the industrialization of China; but those problems shouldn't deteriorate markedly until central banks begin to reverse their extraordinary policy initiatives sometime next year. Profits are still quite good and margins are near record levels. Faster wage growth would cut into profits, but revenues are leveraged to the increased consumer spending that would develop in response, raising total profits even as margins declined a bit.
Stick with Stocks
To summarize, the technical divergences, weak breadth, meager momentum, and long consolidation (even with an upward bias) caused some nervousness. But the fundamental backdrop, mid-cycle rather than late, still seems positive for risk assets, i.e., stocks, credit, and real estate. For equities, we still like overweights in the U.S. and perhaps domestic Europe. In fixed income, we'd suggest investors prefer credit risk over maturity risk, i.e., intermediate maturity bonds with better yields. Real estate still offers a reasonable yield pickup and the opportunity for limited capital gains..
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