Outlook and Market Review - Second Quarter 2013

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Summary: 

Real GDP growth in the second quarter of 2013 was revised upward to 2.5% from the preliminary announcement of 1.7%. GDP growth in the first quarter was a lackluster 1.1%. The unemployment rate (U-3) fell to 7.3% in August but the key driving force behind the decline was a drop in the labor participation rate as potential workers dropped out of the labor market. The labor force participation rate fell to 63.2% in August, a new post-recession low, and the employment-to-population ratio fell to 58.6%. The broader measure of unemployment that adjusts for part time work and underemployment (U-6) fell to 13.7%.

Inflation remains low with the year-over-year increase in the CPI of 2%. Real wages remain flat suggesting slack in the labor market. Even so, consumer spending is outpacing GDP growth due to wealth effects from higher housing and equity prices. Corporations are in a position to invest if economic and regulatory uncertainty can be lifted. Net profit margins, measured as the ratio of after-tax profits to output, are twice the average level since World War II. Balance sheets are also generally strong, as businesses are flush with cash and debt loads are light.

Housing continues to rebound but at a slower pace due to higher interest rates. The benchmark rate for mortgages, the 10-year Treasury yield, is now 3% compared to less than 2% six months ago. Rates may continue to rise if the Fed begins tapering its $85 billion monthly purchases of securities later this year. The Treasury Department’s estimate of the real rate of return from the TIPS auction is currently about 1.3%. With expected inflation of about 2% we might expect the ten-year Treasury to be 3.3% or higher in the near term. Oil prices are likely to remain high until uncertainty in the Middle East improves. The combined effects from higher oil prices, higher interest rates, flat wages, and mixed levels of confidence will provide headwinds for the remainder of 2013.

Analysts expect growth in the 2.2 to 2.4% range for the remainder of 2013 with momentum toward a 2.6% rate in 2014. This forecast seems optimistic in light of rising oil prices and Middle East tensions that will carry into the next year. Core inflation should remain below 2% with interest rates creeping up over the remainder of the year.