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Weekly Economic Commentary

 
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The year’s first half included some big surprises

July 19, 2013

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  • The year’s first half included some big surprises
  • U.S. wage and salary growth sets the stage for stronger consumption
  • Don’t be discouraged by the most recent housing report

Time flies when you have good duty. Last week marked the close of my first year with Northern Trust, and my sense that the months have rushed by certainly reflects the pleasure I’ve taken from the work. It has been a treat to visit with so many partners and clients to discuss economic issues; I’ve learned a great deal from the exchanges, and hope you have, too.

My anniversary also corresponds with the traditional mid-year lull in market activity, borne of the vacation season and the paucity of meaningful events on the summer calendar. This provides a bit of space to reflect on the first half, and set the stage for the second.

As usual, we proved prescient on some things, current on others, and ignorant of a few. Following is a list of themes that have surprised us most so far in 2013.

  • China’s Great Moderation. Few thought that China could sustain double-digit rates of real growth indefinitely, but this year’s softening of business conditions has caught many analysts by surprise. It now appears that Chinese real GDP could expand by less than 7.5% this year, well below past targets.

    Softer conditions in China’s main export markets have certainly played a role. But the new regime, installed last fall, has been unwilling to make up for the shortfall as its predecessors had. With signals of a housing bubble and urbanization programs working through growing pains, headlong investment in infrastructure no longer seems as attractive.

    Further, the financing of past stimulus programs has left Chinese financial institutions with important amounts of questionable loans. Authorities seem intent on curbing credit excesses in both the official and shadow banking sectors; one hopes this can be done in an orderly way.



    While China’s recent success has created important amounts of wealth and income for its citizens, domestic consumption has not compensated for softer export growth.

    China’s experience has cast a long shadow. Softer demand for commodities has reduced prices for minerals and metals and taken some steam out of countries that produce them. And the moderating fortunes of Brazil, India and Russia reflect the challenges faced by emerging markets when more mature markets struggle.

  • U.S. Fiscal Policy Falls out of the Headlines. Coming into the year, we were quite concerned that debate over the American federal budget represented a significant source of uncertainty and a real threat to markets and growth. Yet while fiscal issues have not gone away, they have essentially been a non-factor so far in 2013.

    Strong tax revenue growth, born of higher marginal rates and strong markets, and windfall profits contributed by Freddie Mac, Fannie Mae, and the Federal Reserve have filled the Treasury’s coffers. The next breach of the debt ceiling has been deferred until late this year.



    The good news is that projections of this year’s deficit are now less than half of last year’s level (as a percent of GDP). The bad news is that fiscal restraint has hindered economic growth. Outright declines in government spending have subtracted from national output over the last four quarters; the Federal Reserve has estimated that real growth would have been more than 1% higher had it not been for this tight fiscal policy.

    While elements of fiscal restraint will linger in the second half of this year, they are expected to be less pressing. So the economy should benefit from that. But the two political parties have yet to agree on an outline for spending in fiscal 2014 (which begins in October), setting the stage for a potential battle late this year. So budget issues are still out there, but markets and businesspeople seem untroubled by it.

  • The U.S. Bond Market Becomes Unmoored. We’ve been pretty consistent in expecting the Federal Reserve to taper its asset purchases this year, and the market seems to have come around to sharing this point of view. But we certainly did not anticipate the rapid rise in long-term yields, and the volatile manner in which this occurred.

    The media has laid much of the blame for the bad reaction at the feet of the Federal Reserve. But in the past several weeks, the communication has gotten tighter, with officials stressing that a lower level of bond buying is not tantamount to monetary restraint. And the decisions made around quantitative easing are quite separate from those regarding short-term interest rates, which are still expected to remain very low for quite a while.

    As the weeks have passed and the shock has worn off, long-term U.S. yields have settled back down. While this is encouraging, it seems clear that contemplating, announcing and executing a change in quantitative easing is going to present ongoing challenges for the Fed and for the markets.

These situations bear close watching in the year’s second half, along with Europe’s attempts at recovery, the next phase of Abenomics in Japan, and the derby to succeed Ben Bernanke at the head of the Federal Reserve. We’ll look forward to keeping you posted on all of this.

I’ll soon be off to drop my son at college … that will no doubt generate a whole new class of surprises for me, on which I’ll also keep you posted. Watch this space.

Ingredients Are in Place to Lift Personal Income Growth

Consumer spending is the life blood of the U.S. economy. Of its underpinnings, the recent upward trend of equity and home prices has given a lift to consumer spending through the wealth effect. Support from personal income, the larger determinant of consumer spending, is heading in the same direction.

Payroll employment has risen nicely in recent months. Hourly earnings rose 0.4% in June, the largest monthly increase in the current recovery. Without doubt, this combination of hourly earnings and employment gains augurs positively for income growth in the balance of this year.

The composition gains in employment and wages illustrate the underpinning of earnings growth.



Of the top five categories in terms of the share of private sector employment (health care, professional and business services, retail trade, leisure and hospitality, and manufacturing), payrolls in the leisure and hospitality industry posted the largest gain in the second quarter, followed by professional and business services.

From the narrow perspective of a change in earnings from a year ago, the less than 1.0% growth in the leisure and hospitality industry validates news stories that strong job creation has occurred in the lowest-paying job sector in the second quarter. Less noticed is that job growth is impressive in the high-paying sector of professional and business services also. These numbers suggest that one has to be careful in drawing conclusions about jobs and compensation growth. Aggregate compensation from the employment report tracks closely with income numbers from the GDP report. Accordingly, we should expect real disposable income (real personal income after taxes) to match the escalation we have seen from the wage report.

The question then becomes how much of this income improvement will make its way into the spending stream. The answer should be quite a bit; savings rates have been rising over the past few months (now standing above 3%), and strong wealth creation reduces the amount that households have to save out of current income. Debt levels appear to be well under control for most households, and recent readings on consumer credit do not reflect a drive to re-leverage.

And as we discuss below, the solid performance of the housing sector typically generates carryover spending on building materials, furnishings, and appliances. So the stage should be set for solid consumption growth in the second half of the year. It will be supported the old-fashioned way … through earnings.

Home Construction Takes a Brief Vacation

The housing sector was late in joining the recovery party but it has since made persistent and noticeable contributions to real GDP. The nearly 10% drop in June housing starts appears to have tainted this rosy picture, but we view this as a temporary pause.

The weakness in new home construction in June was largely concentrated in the multi-family sector, while single-family starts have held nearly steady for the past three two months. The demand for rental homes has spurred activity in the multi-family sector during the six months ended March, with a little payback visible in the second quarter. With all of the frenzy surrounding apartment construction, a bit of a pause was not unexpected.

A couple of things should prove reassuring. Research indicates that single-family housing starts have a strong positive correlation with the Housing Market Index (HMI), drawn from a survey of home builders. The July HMI at 57 is the best reading since November 2005. The HMI has posted gains in each of the last three months, implying that home builders are optimistic about future activity. Consistent with signals from the HMI, permit extensions for new single-family homes have shown sustained gains.

Anecdotal reports indicate that bottlenecks in supply of building materials and availability of suitable labor after the sharp drop in housing sector activity since the peak of 2005 has held back new home construction and should turn around soon.

 

Secondly, household formations continue to accelerate. This reflects improved employment conditions and the expanded availability of rental property (both apartments and single-family homes). Household formations slumped sharply during the recession, and analysts have been expecting them to make up lost ground as conditions improve.

The swift run-up in mortgage rates following the Fed’s message of an impending tapering of asset purchases is a temporary hiccup as rates have reversed a part of the gain in recent days. Applications for mortgages to purchase homes have not diminished noticeably in the two months since long-term interest rates began their upward march.

Positive economic fundamentals could lead to higher mortgage rates, but a steep and rapid climb is unlikely as the Fed has emphatically stated that it plans to hold on to mortgage securities in its balance sheet, primarily to support the housing sector.

We expect residential investment to continue be a leading component of GDP growth well into next year. The bloom is not off the housing recovery just yet.

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The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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