By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
The Great Depression of the 1930s was the severest economic event in modern times. As a result of consumer spending, business investment and employment all collapsing for an extensive period of time, it took years for the economy to recover. While the Great Recession of 2007-2009 didn’t rank anywhere near the Great Depression in terms of its devastating impact on the economy, individuals and businesses, the U.S. economy has been unable to consistently demonstrate the kind of growth necessary to completely recover from the recession.
Now, one month into the fourth quarter, it feels like the U.S. economy is finally gaining traction in the wake of the global financial crisis and the Great Recession. While the outcome of the upcoming election, the fiscal cliff (which we discussed last month) and many other events could derail this nascent movement towards full economic recovery, the signs are positive.
A number of factors provide reason for optimism. Underpinning the recovery is the Federal Reserve Board’s long-term policy of low interest rates, which has been in effect since 2007 and will last until 2015, an unprecedented eight years. These lower interest rates, which have been implemented through three rounds of Quantitative Easing and one round of Operation Twist, have enabled consumers, businesses and the government to lower the amount of money they’ve spent on debt service and put that money to work in the economy or save it. Lower rates coupled with lower commodity prices equal lower inflation and more money in the pockets of consumers. As a result, consumers seem confident enough to begin spending consistently for the first time since the Great Recession began more than five years ago.
The housing market, which has dragged on the economy since its collapse in 2006, is showing a durable turnaround. The unemployment rate fell significantly in September, and retail sales are growing. Overall, this confluence of positive events is lessening the potential for a U.S. recession. In addition, the European situation has stabilized, meaning an exit from the eurozone by Greece or another country is becoming less likely. All of these events have been reflected with recent stock market gains, as both retail and institutional investors gain confidence. Of course, the election, a lack of resolution of the fiscal cliff, a new European crisis or some other unforeseen event could throw the recovery off course, but this is seeming less likely as time goes by.
In this month’s commentary, we’ll take a look at these positive trends, discuss briefly what might derail the economy and look at the implications for markets and investors.
Underpinning the recovery is the Fed’s extended policy of keeping interest rates at rock bottom lows through 2015. Altogether, this interest rate policy is expected to continue for eight years. Since consumers and businesses can borrow at low rates to finance capital expenditures such as homes, cars and equipment, both are more likely to do so. This type of spending tends to help job creation because more workers are needed to produce such goods and the services that go along with them.
Due to this policy and consumer efforts to deleverage following high debt levels incurred before the financial crisis, consumer debt service sits at a five year low. This has been aided by record low interest rates. Currently, mortgage rates are at or near all-time lows with 30-year fixed rates at 3.4 percent and 15-year fixed rates at 2.8 percent, enabling consumers who are entering or reentering the housing market to lock in very low rates for an extended period of time.
One of the Fed’s stated purposes in continuing its low interest rate policy via the third round of Quantitative Easing is to lower the unemployment rate. While the rate is still higher than the Fed would like – its stated goal is to drive the rate down to between 5 percent and 6 percent – that rate has been declining more rapidly than earlier in the recovery. While keeping interest rates low for a sustained period of time will not directly affect the unemployment rate – it would take another round of fiscal stimulus rather than monetary policy stimulus to do that – it can indirectly affect that rate by encouraging investment and driving investors into risk assets such as stocks and corporate bonds.
As positive economic data piles up, the risk of recession here and abroad lessens. Economic data on several fronts looks good, particularly the housing market, which is moving from strength to strength via a number of indicators, including housing starts, builder confidence, the return of private mortgage securitization and home inventory.
Consumer confidence, an important gauge of current and future consumer behavior, is rising steadily. In October, consumer confidence, as measured by the Thomson Reuters University of Michigan, rose to its highest level since before the Great Recession. The report exceeded expectations of analysts, who predicted a reading of 77.9. The highest expectation was 81. The actual number came in at 83.1. This pattern is similar to what occurred in the fourth quarter of last year, when strategist and economist sentiment was so pessimistic that actual results surprised on the upside.
This rise in consumer confidence is translating into more spending, as retail and restaurant sales rose on a seasonally adjusted basis 1.1 percent in September from August. The Commerce Department has also revised estimates upward from the summer months. In a very encouraging sign, the three-month moving average – which tends to smooth out the volatile month-to-month numbers – rose 1 percent in September, the second consecutive monthly increase. While retail sales have had short periods of increases only to fall back later, these numbers seem more sustainable for several reasons, including the increased consumer confidence, improved household finances and lower unemployment.
Unemployment has been an ongoing sore spot in the economy, with an agonizingly slow downtick. Without sustained growth in employment, the economy can’t gain traction – it’s that simple, and one of the major reasons that the Fed has been so accommodative in regard to low interest rates in an attempt to restart the employment engine. But finally, in early October, the Bureau of Labor Statistics reported that the unemployment rate fell from 8.1 percent in August to 7.8 percent in September as 873,000 more Americans became employed over the previous month. This rate marks the lowest the unemployment rate has been since January 2009 when President Obama was inaugurated. The drop in the unemployment rate is mostly due to the sharp decline in the labor participation rate.
In Europe, a difficult situation still remains, but signs are good that European leaders are coming to grips with it. In a boost to its confidence and approach, the European Union received the Nobel Peace Prize for the stabilizing role it has played in unifying Europe and helping it heal from “a continent of war to a continent of peace.” Exports rose sharply in August and inflation is unchanged. In addition, bond prices are stable in the peripheral countries and there is hope that Spain won’t need additional bailout funds following the bailout of large banks that occurred earlier this summer.
The housing market plays an important role in economic growth. The prolonged aftermath of the housing bust and the subsequent foreclosure crisis has hobbled economic growth for the past six years. This is due to consumers driving the U.S. economy, accounting for two-thirds of economic growth. Their main source of wealth is their homes. It is now beginning to look like the housing market recovery that has been predicted for years is actually taking hold, and it’s a bright spot for the U.S. economy.
In mid-October, the Commerce Department reported that housing starts increased 15 percent from a month earlier. The year-over-year comparison surged by 34.8 percent. This is the highest level in over four years, and it’s highly significant for the housing market and the overall economy. Housing starts are important because home builders need to employ more skilled workers when housing starts are rising. Families that purchase new homes tend to buy more big ticket items such as furniture and appliances, which greases employment in the manufacturing sector. Housing starts occurred across the country. The Commerce Department report noted that new construction rose in three out of four U.S. regions. The only region where activity fell was the Northwest. In a further sign for future new construction, the number of new building permits rose by 11.6 percent.
Recently, the National Association of Home Builders reported that its Market Index, a gauge of builder sentiment, has increased for five straight months. The index level currently stands at 3.5 standard deviations higher than the five year average. Another positive sign for the housing market is that inventory of homes is tight. The number of homes for sale during September fell by 2.2 percent from August and is down 17.8 percent from the same time last year and 34.3 percent from 2010, according to Realtor.com. This is good news for the housing market overall, and very good news for sellers, though not so good for potential homebuyers who have less to choose from, especially among entry-level homes. Median level asking prices are rising – there was a .8 percent gain from August to September. In addition, median prices were up from a year ago in 86 of the 146 markets, as tracked by Realtor.com.
There are signs that many consumers who lost their homes to foreclosure are starting to return to the housing market, bringing more buyers into the market. Those numbers are virtually impossible to quantify, but real estate agents, homebuilders and mortgage brokers all report increasing numbers of such buyers in search of new homes. Generally, borrowers who default on a mortgage must wait a minimum of three years before becoming eligible for a new mortgage backed by the Federal Housing Administration.
Another positive sign is the potential reemergence of the private market for mortgage bonds, which had virtually disappeared since the beginning of the Great Recession in 2007. Private firms are starting to file paperwork with the Securities and Exchange Commission to launch private securitization programs. These programs have the potential to fill the eventual gap, which would be seen if the federal government, as planned, cuts back on the role of federal mortgage securitization currently filled by Fannie Mae and Freddie Mac.
To be sure, there are some issues that could derail the recovery even as it gains steam. The upcoming election is a factor, but that will resolve itself in the next week. Depending on the outcome of the election, the fiscal cliff issues that focus on increased tax rates and budget cuts could also be resolved if there is better cooperation between the White House and Congress.
Europe, while still an uncertainty, seems less volatile as of now, both in the financial markets and in broader levels of social unrest, although that could always unravel. The economies on the periphery of Europe that have the worst performing economies and needed the bailouts – Greece, Spain, Portugal, Ireland and Italy – could need more help in the future, raising the eurozone’s liabilities and potentially causing conflicts among the more stable countries that need to provide the bailout funds. But right now the situation seems fairly stable.
The International Monetary Fund (IMF) released a report in early October noting that the recession risks for the global economy are elevated over its previous report, stating, “Risks for a serious global slowdown are alarmingly high.” Indeed, the IMF pegs the global economy to expand at just a rate of 3.3 percent this year and 3.6 percent next year as many major developed and emerging economies experience slowdowns. Despite this seemingly pessimistic forecast, the IMF’s projections are actually somewhat more optimistic than some private forecasts. In addition, the global economy has so far avoided another downturn despite the difficulties it has encountered, which argues for its overall resilience in the face of economic setbacks.
Without a doubt, the election is the biggest piece of news coming in the month of November, and it will be telling in terms of whether the management of the economy focuses on tax cuts and budget cutbacks or staying the course. Whichever party controls the White House and Congress, resolution of the fiscal cliff will be front and center on the agenda. How that resolves will tell us a lot about whether the economy continues to grow in 2013 at a sustainable rate, or falls back into a low growth mode or enters a recession.
Events in Europe and further economic data also bear watching. More bailouts and unrest in Europe would have a negative impact, as would an increase in the unemployment rate or a fallback in consumer sentiment.
Historically, fourth quarter equity market performance fares better when consumer confidence is rising. This factor may favor investors with an equity component in their portfolios as the fourth quarter still has two months to run, and consumer confidence is rising and looks like it will continue to do so.
The big question on the minds of investors has to do with the election and following repercussions that it will have on the impending fiscal cliff. As of now, the election is too close to call, and while we don’t know the exact deal that will be made in Congress regarding the fiscal cliff, we do believe that some type of resolution to the large cloud of uncertainty will be a positive one for businesses. While many companies likely have their own personal desired outcomes for the election and dealing with the fiscal cliff, clarity in one way or another trumps uncertainty. As uncertainty subsides, look for companies to begin investing the large amounts of cash currently resting on their balance sheets. This, we believe, will be a positive outcome no matter who is inaugurated this upcoming January.
Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The Federal Reserve Board is the governing body of the Federal Reserve System.
The International Monetary Fund (IMF) is an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.
The Consumer Confidence Index (CCI) is an indicator that measures the degree of optimism on the state of the economy as it relates to consumer activities of saving and spending.
The University of Michigan Consumer Sentiment Index Thomson Reuters / University of Michigan Surveys of Consumers is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters that indicates how consumers feel about their own financial situation, the short-term general economy and the long-term general economy.
The European Union (EU) is an economic and political union of 27 member states which are located primarily in Europe.
The National Association of Home Builders Market Index gauges builder perceptions of current single-family home sales, sales expectations and prospective buyers. Any number over 50 on the seasonally adjusted index indicates that more builders view conditions as good than poor.