2014 Midyear Update

Bryan Pratt By | On June 26, 2014

Independent Financial Planning

Economic Growth Resuming, Markets Rangebound

The initial outlook for 2014 was based on an improving economy across the board. As we approach the middle of the year, despite a weather-weakened first quarter, those expectations are playing out.

• After a slow first quarter, economic growth should heat back up to between 3 percent and 4 percent for the remainder of the year.

• Continued growth should have the Federal Reserve (Fed) completing the tapering process by the end of the year.

• Employment and wage growth should continue to accelerate.

• Earnings growth will have trouble meeting expectations, as rising wage bills and slowing productivity hit profit margins.

• Equity market growth will be constrained by earnings weakness, with the market trading around current levels for the remainder of the year.

“Snowdown” turns to meltup

We started 2014 in a much better place than we did 2013. Employment, both current and trend, was much better. The housing market was much improved. The consumer was much stronger. The government was much more stable—and in a much better fiscal position. The stock market responded to this ongoing improvement by posting its best year since 1997.Although the first quarter of the year was snowed out (hence the above moniker), the second quarter looks to fare much better, and there is the prospect of economic warming kicking in at the global level for the rest of the year. First-quarter economic growth of 0.1 percent—which is quite likely to be revised to a loss—was driven by record-setting snowstorms, leaving hundreds of thousands more workers than usual stuck at home in January and February. Improving weather in March and April sent those workers back in, along with many others, leading job figures to increase at their highest level in years and driving private employment to an all-time high.

As we look further into 2014, we can expect the underlying economic trends to continue. Growth in jobs has stabilized at around 200,000 per month, bringing unemployment down from 6.7 percent at the end of 2013 to 6.3 percent at the end of April 2014. House prices have continued to appreciate, and although the market appears to have slowed, it continues to improve. Business investment has remained at levels above those of recent years, while government spending and hiring has ceased to be a drag on the economy.

All things considered, I expect to see real economic growth of around 3 percent for the remainder of the year, with the possibility of stronger performance. With consumer spending growing at around 4 percent on a nominal basis, business investment growing at around 8 percent, and government spending essentially flat, 3 percent appears both reasonable and achievable. Combined with inflation of around 1.5 percent for the year, nominal growth should approach 4.5 percent—better than we have seen for some time.

The risks here are largely on the upside. If consumer borrowing were to pick up, spending could grow faster than wage growth. Business investment could finally respond to improving demand and rise more than expected. Local and state governments could increase investment and hiring more than expected.Downside risks are more limited and primarily external, with Europe and China remaining as possible negative actors in the world economy and financial markets. The major domestic downside risk is of slowing employment growth, of which there are few signs. Should employment growth drop, the rest of the economy would also slow. Nonetheless, the most probable case remains continued economic expansion. The stock market, on the other hand, will face larger challenges this year and may struggle. I expect the U.S. equity markets to end 2014 at about the same level as they are now—around 1,875 for the S&P 500. Although earnings will continue to grow, they will do so more slowly than expected, and valuations may be adjusted over the year as investors expect lower future growth—and accordingly pay less for stocks. That willingness to pay less will also come because interest rates will rise somewhat over the year, making bonds more attractive as an investment and lowering the present value of the slowly growing earnings stream even more. The lower valuations will offset the somewhat higher earnings, leaving the market essentially flat for the year.

Unlike the economy, I believe the risks to the market are mostly on the downside. Valuations remain at high levels—higher on some metrics than they were in 2007, for example. Profit margins are at historic highs, and the tailwinds that got them there are disappearing. Stock buybacks, which have been responsible for much of the growth in earnings per share, appear to have peaked—and, in any event, have become less effective for every dollar spent as prices increase. And unlike in the real economy, market-related debt has increased back to 2007 levels and above.

That said, there is also the possibility that retail investors could start to buy in to the market—which could drive prices even higher. This could be considered a “bubble effect” and would drive valuations even farther above historic norms. Although this could certainly happen in 2014, it would only set the stage for a more severe adjustment later on.

In conclusion, despite the weak first quarter, the recovery continues and should strengthen through the remainder of 2014. And as the Fed winds down its stimulus, we may see moderate increases in interest rates toward the end of the year. I expect the financial markets, on the other hand, to close 2014 at around the same level at which they are right now—and the potential for a decline at some point during the year is very real.