August 2012 Economic Outlook

This is a monthly newsletter by Greg Sweeney, CFA, Chief Investment Officer, at Bell State Bank & Trust. Sweeney holds a bachelor’s degree in business from the University of North Dakota, is a CFA charter holder, and is a 26-year veteran of the Investment Management team.

 

Federal Reserve Monetary Policy

  • At the next Federal Reserve meeting on September 13, we expect the Fed to leave rates unchanged between zero and 0.25%. The Fed indicated rates would remain near these lows until late 2014.

Inflation

  • The year-over-year consumer price index (CPI) released in July shows inflation remaining at 1.7% as expected. There is a chance the release this month will show 1.6% inflation over the last 12 months. Rising rents and now rising food costs appear to be dodging capture by the index.

Economic Activity

  • The Federal Reserve is so focused on driving interest rates lower by using manipulative programs (yes, that is legal for the Fed, but private investors would go to jail) that the real culprit for the slow economy is being overlooked. Real personal income per capita has been flat for six years. Gross domestic product (GDP) is the sum of consumer consumption, business investment, government spending and exports minus imports. Consumer consumption is about 70% of that formula. Flat real personal income per capita means that growth from 70% of the driver for GDP is missing, regardless of interest rate levels. Sure, if consumers paid lower interest rates they would have a bit more income to spend – but many consumers are not able to take advantage of the current rate environment.
  • Sometimes the obvious escapes observers, but the other problem is that more debt rarely solves existing debt or spending problems. Where the Federal Reserve leaves off with its monetary programs, the federal government takes over with deficit spending programs. Reversing this trend will be increasingly difficult as countries like Portugal, Greece, Spain and perhaps Italy are currently demonstrating.
  • Proposed European solutions seem to center around reducing national sovereignty and sharing debt burden. The first part of the scheme does not sit well with anyone, and the second part does not sit well with those who would have to pay bills they did not incur. Looks like the stalemate continues.
  • Unemployment remains above 8%, and the horizon suggests it will remain elevated.

Fixed Income

  • The market option price for protecting the popular Barclay’s Aggregate Bond index against loss costs about 4% a year, which is about 70% more than an investor earns in interest on this fund each year. What does this mean? Interest rates are not properly compensating investors for the risk of owning fixed income securities.
  • The negative real return on 10-year U.S. Treasury bonds, mentioned last month in this publication, confirms this also. Why do investors buy them? They are seen as safe, but that is only the case if interest rates remain low during the life of the bond.

Stock Market

  • Last month we felt that the Fed was the biggest force behind stock market advances, and we still see it as the primary driver today. The choice that confronts investors is whether to go along with the Fed and buy stocks, or focus on fundamentals in the economy, sit on the sidelines and look for the foundation to begin firming.
  • This remains a difficult environment for risky assets, and short-term solutions seem out of reach for the macro issues the world faces. Another round of quantitative easing, more action from the European Central Bank or an early deal to address the fiscal cliff could potentially lead to a rebound, but it is also easy to find factors that could send the markets lower. Near term, equity volatility will likely continue to be present, as it is difficult to find much conviction on the short-term direction of markets. However, it is important for long-term investors to stay focused on their goals.

View previous Economic Outlook newsletters.

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