Orlando's Outlook: Stay the course


Bottom Line The bar was clearly low when the government was set to release its flash report for second-quarter Gross Domestic Product (GDP). But the surprisingly strong 4.0% bounce—in conjunction with benchmark revisions that were generally positive for the first quarter and all of 2013—served as an economic wake-up call for bearish investors. Sure, we would be a lot happier if housing was stronger. But the labor market, autos and the consumer appear to be in pretty good shape, and manufacturing is improving. All in all, we continue to believe that these point to above-trend GDP growth in this year’s second half that should drive both Treasury yields and stock prices higher into year end.

Stay the course on GDP The fixed-income and equity-investment professionals who comprise Federated’s Macroeconomic Policy Committee met recently to discuss a wide-range of economic, financial-market and central-bank developments in the U.S. and abroad.

  • In its recent benchmark revisions, the Bureau of Economic Analysis (BEA) revised first-quarter GDP from a negative 2.9% to a negative 2.1%. While better, it’s still the single-worst quarter in the current recovery from the Great Recession. The BEA also revised full-year 2013 higher, from 1.9% to 2.2%.
  • The Commerce Department recently flashed second-quarter 2014 GDP at 4.0%, right in line with our estimate here at Federated, but well above the consensus estimate of 3.0%.
  • With a new inventory restocking cycle in place, a strengthening labor market, a solid consumer and an improving manufacturing sector, we’re keeping our third-quarter GDP estimate unchanged at 3.5%, while the Blue Chip consensus is raising its 3.0% estimate to 3.2% (within a range of 2.6% to 4.0%).
  • We also are keeping our fourth-quarter estimate unchanged at 3.5%, and the consensus estimate remains unchanged at 3.1% (within a range of 2.4% to 3.7%).
  • The government’s upward revisions for the first quarter of 2014 and for all of calendar 2013 prompt us to revise our full-year 2014 GDP estimate up from 1.8% to 2.2%, while the Blue Chip consensus recently lowered its full-year estimate to 1.6% (within a new 1.4%-1.9% range). But we believe that the Blue Chip data is stale, and that after our competitors evaluate the benchmark revisions and second-quarter GDP surprise, the consensus similarly will move its estimate closer to our forecast.
  • Federated is holding its full-year GDP estimate for calendar 2015 at 3.3%, as is the Blue Chip consensus at 3.0% (within a range of 2.6% to 3.4%).

Federated’s Macroeconomic Policy Committee also made the following investment observations: 

Fed stays on pace The Federal Reserve has tapered its original $85 billion monthly Quantitative Easing (QE) program six times since December. Purchases are now down to a monthly pace of $25 billion. We expect Fed Chair Janet Yellen to chop another $10 billion in September and the last $15 billion in late October, at which point QE will be wound down to zero. We continue to expect the Fed to begin to raise the federal funds rate from its current zero- to 25-basis-point range during the second quarter of next year, but the timing and pace of this decision will be data dependent.

Core inflation firming Core inflation, which strips out the nominal increase from volatile food and energy prices, has risen over the first half of this year. On a year-over-year basis through May, the wholesale Producer Price Index (PPI) is running at a core level of 2.0% (up from a gain of 1.1% in February), although it eased back to 1.8% in June. The retail Consumer Price Index (CPI) also hit 2.0% in May (versus an increase of 1.6% in February), but it slipped back to 1.9% in June. The core Personal Consumption Expenditure (PCE) index—the Federal Reserve’s preferred measure of inflation—is now at 1.5% year-over-year through June (versus a tepid gain of 1.1% in both January and February). That places it the middle of the Fed’s 1.0% to 2.0% target range and still below its 2.0% inflation trigger to reverse its current Zero Interest-Rate Policy (ZIRP). The employment cost index hit a nearly 6-year high in the second quarter, with a gain of 0.7%.

Second-quarter corporate results pretty good thus far We’re about 80% done, and the second-quarter corporate reporting season is progressing better than the consensus had expected. Revenues (ex-financials) are up by about 6% year-over-year, which is 1.5% better than consensus expectations, with more than half of the companies surprising to the upside. EPS (also ex-financials, because of the huge one-off write-downs this quarter) are up by a solid 10-11% year-over-year. That is 4% above consensus expectations, with nearly 70% of these companies surprising to the upside. So we’re still feeling very confident with our above-consensus $120.00 forecast for S&P 500 profits this year.

Employment gains press on With the winter now behind us, nonfarm payrolls have risen by an average of 244,000 new jobs over the past six months through July (versus a weather-impaired trough of 84,000 jobs in December), marking the first time that jobs have exceeded 200,000 per month for six consecutive months in 17 years. We believe that this positive trend will continue, as initial weekly jobless claims—an important leading indicator—hit a 15-year low at 279,000 last month. Meanwhile, the ADP report (an important leading indicator of private payroll growth) has averaged 218,000 jobs per month over the past six months, with 80% of their jobs coming from small- and mid-sized companies.

Consumer strengthening Due to the aforementioned improvements in the labor market, the Conference Board’s consumer confidence index surged to a 7-year high of 90.9 in June, consumer spending in June hit a 3-month high, and the personal saving rate last quarter hit a 2-year high at 5.3%. So after posting the weakest 3-month Christmas retail season since 2009 because of the bad weather, Easter sales bounced nicely, as March and April combined rose by 4.3% in a strong year-over-year beat. With a better labor market and elevated confidence and savings, we expect a solid Back-to-School (BTS) season in July, August and September. Because consumer spending accounts for 70% of GDP, that solid BTS season could help to set the table for a good third-quarter GDP.

Manufacturing bounces back The national ISM manufacturing index surged to a 3-year high 57.1 in June, substantially better than the “contraction” reading of 49.0 in May 2013. That helped to drive a powerful inventory restocking cycle in the second quarter, as businesses nearly tripled their inventories on hand to $93.4 billion. Industrial production enjoyed its strongest second quarter in four years, and capacity utilization has been running at roughly a six-year cycle high for the past four months. Capital goods shipments (non-defense, ex-air), which feed directly into GDP, rose by 1.4% in June.

Autos strong, housing soft Auto sales soared to an 8-year high of 16.92 million annualized units in June from 15.16 million in a weather-impaired January. Autos remain one of the economy’s true bright spots, with overall sales now up by 88% from the cycle trough of 9.0 million total units in February 2009.

Housing, however, has been a mixed bag. The difficult winter weather held back building activity, as did higher prices and mortgage rates, lower inventories, tighter bank credit and student-loan debt. While the housing-market index has risen from 45 to 53 in recent months, existing-home sales have improved the past three months. Delinquencies and foreclosures have continued to experience declines, and new-home sales, starts and permits and pricing have all fallen.