Jul 5, 2017

Economic Outlook July 2017

Federal Reserve Monetary Policy
  • The next meeting of the Federal Reserve is July 26. The Fed acted in accordance with market expectations last month by raising the Federal funds rate to 1.25 percent. It was the second rate increase this year but is still considered accommodative (designed to stimulate growth), because it is below the inflation rate. We expect no change at the July 26 meeting.

  • The year-over-year inflation rate for May, the latest data available, was 1.9 percent. This was a 0.3 percent drop from the previous month and dipped below the Federal Reserve’s 2 percent rate goal. The drop below 2 percent is a bit of a surprise, since we see actual consumer costs rising faster than this, but it does not change our expectations that inflation will hover around the low 2 percent range for the next couple of months.

Economic Activity
  • Consumers, who account for about two-thirds of gross domestic product in the United States, are often cited as the reason the U.S. economy will continue to grow, since increased employment rates and wages will generate more buying capacity to drive economic growth in the near future. Fair enough. What has gone unnoticed is record-high consumer debt levels, as seen in the following chart from Federal Reserve data. This does not include mortgage debt, which is within a stone’s throw of record highs last seen in June 2008. This chart may suggest consumers have already borrowed against their good fortune, and additional consumer buying could be slower than expected.
    Graph of consumer credit outstanding
  •  Wages per capita have also increased to record levels, so the argument could be made that consumer debt levels as a percentage of income have remained in check. Unfortunately, consumer debt as a percentage of income is also at record highs, as shown in the next chart, which also excludes mortgage debt.
    Graph of consumer credit as a percentage of income

Fixed Income
  • The 10-year U.S. Treasury bond yield started the year at 2.45 percent and drifted up to 2.63 percent by mid-March. Since then, the bond yield dropped to 2.14 percent toward the end of June before a noticeable jump to 2.30 percent during the last four days of June. What caused the sudden reversal? It appears the Bank of Japan and the European Central Bank are considering curtailing their asset purchases. While they don’t aim to purchase U.S. bonds directly, this has the effect of reducing overall demand. Interest rates respond by moving higher if demand is expected to decline.
  • We don’t see 10-year U.S. Treasury bond rates moving beyond our expected upper limit of 2.75 percent for the year if inflation expectations remain in check.

Stock Market
  • The stock market dispersion in the first half of the year was remarkable. As of June 30, the health-care sector (represented by XLV etf) finished up 15.8 percent and the tech sector (represented by XLK etf) finished up 14.05 percent, while the energy sector (represented by XLE etf) fell 12.7 percent. In addition to sector dispersion, there was also style dispersion with the S&P 500 growth index returning 13.3 percent and the S&P 500 value index returning 4.85 percent. It doesn’t stop there. Capitalization dispersion was also present with the S&P Large Cap 500 returning 9.34 percent, the S&P Mid Cap 400 returning 5.99 percent and the S&P Small Cap 600 returning 2.78 percent.
  • The second half of the year will likely be met with investors questioning whether these trends will continue and if the market can continue to reach record highs in the face of elevated price/earnings ratios, earnings growth adjustments and overall political challenges facing prospective federal tax cuts and fiscal spending initiatives.
  • Timing the market to get out before declines and back in before recoveries is risky. The best way to address market volatility is proper portfolio allocation consistent with each investor’s personal profile.

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View previous Economic Outlook newsletters.