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Financial Industry Insights from Advisors Asset Management
On November 12, 2015
U.S. Economic Picture Improves, But Global Pressures Remain a Concern
Economic data has turned more positive in recent weeks, but crosscurrents remain. The Citi Economic Surprise Index1 improved more than 10 points during October, reflecting economic performance that is moving closer to what economists expect. As expected, markets rallied during the month, with the S&P 500 Index2 rising 8.3% and the spread on the Barclays U.S. Corporate Investment Grade Index3 narrowing 10 bps (basis points).
Initial estimates of third-quarter real GDP came in about as expected at 1.5%4. While we view this level of economic output as short of trend, in our analysis it was mainly due to volatile components such as inventory and net exports. We think real final sales to private domestic purchasers is a better measure of domestic demand, and this remained healthy at 3.18% versus a four-quarter average of 3.25%.5
Congress also surprised to the upside with the expected passage of a two-year bipartisan budget plan that eliminates the near-term possibility of default on U.S. debt, boosts spending on domestic defense, and in our view helps solidify leadership in the House Republican party. While we think long-term-debt sustainability requires changes to deficit spending, this plan “kicks the can” past the presidential election next fall and may provide a small lift to U.S. GDP growth in 2016.
Economic crosscurrents are also at play in U.S. inflation. Core goods inflation remains pressured from the strong dollar, while domestic areas are stronger. We think strength in core services and the dissipating impact of lower energy prices should result in both core and headline inflation converging toward 2% at year-end.
While our base case is that the U.S. Federal Reserve (the Fed) will need to wait until 2016 before moving off its zero-interest-rate policy, its hawkish October 28 press release appeared at odds with our view. Indeed, the implied probability6 of a Fed Funds rate increase was 35% the day before the release but rose sharply to 50% the next day (see Figure 1).
The Fed appears to be giving the business sector more benefit than it may deserve. Our analysis of higher frequency data, such as non-defense capital goods orders excluding aircraft, continues to raise concerns about the business sector. These orders have trended lower all year and have been negative since February on a year-over-year basis. Other data has not countered these negative trends, such as the ISM manufacturing new export orders sub-index (see Figure 2). Plus, hiring in manufacturing has turned negative, raising concerns that the corporate sector weakness may spill over into the services sector. Given the solid demand shown in GDP, we view these headwinds to the manufacturing sector as global in nature for now.
China’s deteriorating economic health depressed global risk markets during the latter part of the third quarter. With pessimism running deep, the modest stabilization in China’s economic data, coupled with rising prospects of further easing by central banks, helped to buoy global risk markets. Although consistent with our expectations, we believe this risk rally should be approached with caution. Economic activity may very well improve in China during the fourth quarter; however, while policymakers have gone to great lengths to support growth in the near term, China’s structural challenges are unlikely to abate anytime soon. We expect markets to remain vulnerable to the tug-of-war between slowing growth and the counter-cyclical efforts deployed to smooth the country’s economic transition.
The prospects of additional monetary easing by major central banks, including the European Central Bank and the Bank of Japan, also likely contributed to the improvement in risk sentiment this quarter. In our view, the market has yet to fully appreciate the global economic implications of further monetary policy divergence among the central banks. Additional strengthening of the U.S. dollar poses a substantial risk should the Fed hike short-term interest rates in December. A stronger dollar would undermine the Fed’s efforts to increase domestic inflation and could damage U.S. export competitiveness.
While we see economic crosscurrents continuing, especially globally, we believe U.S. household consumption should remain strong due to stable consumer confidence, improved household balance sheets and a decent labor environment. Should consumption hold firm, the inventory drag could turn into a positive for U.S. GDP in the fourth quarter, as companies may need to ramp up production in response. However, net exports will likely remain a headwind. Risks to our outlook include a faster-than-expected rise in interest rates, a major shift in European or Asian economic policy, rapid deterioration of corporate earnings, and geopolitical or weather-related events.
Footnotes
1. Citi Economic Surprise Index, Bloomberg, Ticker: CESIUSD Index, October 30, 2015
2. S&P 500 Index, Bloomberg, Ticker: SPX Index, As of October 30, 2015
3. Barclays Capital, U.S. Corporate Investment Grade Index, Option-adjusted spread, October 30, 2015
4. Real Gross Domestic Product, Bureau of Economic Analysis, News Releases, National, September 30, 2015
5. Real Final Sales to Private Domestic Purchasers is the sum of consumer spending and private fixed investment, seasonally adjusted annualized rate, Bureau of Economic Analysis, October 30, 2015
6. Calculated using the Fed Funds futures data, Bloomberg, Ticker: “Fed” “WIRP”
CRN: 2015-1111-5041R
This commentary is provided for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
The forecasts, opinions and estimates expressed in this report constitute the Firm’s judgment as of November 2, 2015 and are subject to change without notice based on market, economic and other conditions. The assumptions underlying these forecasts concern future events over which we have no control. The assumptions may turn out to be materially different from actual experience. There is no guarantee that any forecasts made will come to pass. Sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision. All data contained in this material is from sources deemed to be reliable, but cannot be guaranteed as to accuracy or completeness. All investments are subject to risk, including possible loss of principal. Fixed income investments are subject to credit and interest rate risk. Investments in high yield and foreign securities involve risks beyond those inherent in higher-rated and solely domestic investments. These risks are magnified in emerging markets. Past performance is no guarantee of future results.
Hartford Investment Management Company (HIMCO) is a registered investment adviser subsidiary of The Hartford Financial Services Group, Inc. (SEC registration does not imply a certain level of skill or training; nor does it imply that the SEC has sponsored, recommended, or otherwise approved of HIMCO).
HIMCO is not affiliated with Advisors Asset Management, Inc. (AAM). AAM was not involved in the preparation of this article, and the opinions expressed herein do not necessarily reflect those of AAM.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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