Growth with Consequences

October, 214
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

Some of you will remember an old TV game show called “Truth or Consequences.” On this show, contestants had to answer an off-the-wall trivia question correctly or else be subjected to participate in some zany stunt. The show was hosted primarily by Bob Barker and ran from 1950 until the late ‘70s. In addition to wacky antics, the show often featured a heartwarming reunion story. I heard an economic analyst recently ascribe a twist on the show’s title to our current economic situation: “Growth with Consequences.”

This 3rd Quarter newsletter will take a look at the growth our economy is seeing as well as some of the consequences, if you will, of that growth.

During the recovery from our latest recession, the average GDP (Gross Domestic Product) growth has been plodding along at an average of 2.2% - this compares to a historical average growth rate of 3%. In the past year, growth has increased to 2.6%, giving hope that the economy will be able to resume its historical trend and remain at that level for a while.

There are obviously many data points that make up a country’s GDP, the largest portion belonging to consumers. We find that keeping an eye on the 2 biggest purchases that consumers make – cars and homes – gives us a good overview of what is happening. In this quarter, automobile sales reached their highest level since 2006 (many recalls not withstanding). Housing starts continued their trend upward, but they still have room to grow to return to their historical average number.

Source: BEA, FactSet, J.P. Morgan Asset Management, Census Bureau

Companies seem to expect that rising consumer demand will continue to accelerate as evidenced, albeit anecdotally, by both FedEx and UPS planning to hire significantly more seasonal workers this year as they anticipate record volumes.

On the jobs front, the most recent report showed that the average number of jobs created during each of the past 12 months is now at 219,000, a significant improvement from the 198,200 level we were experiencing this time last year. Another encouraging element of this report is that the Public Sector is now consistently showing job gains, which was not the case for the first several years of the recovery.

The unemployment rate has now dropped to 5.9% - the first time this number has started with a 5 since July 2008. Most people would be surprised to learn that the current unemployment rate is now below the 50 year average unemployment rate of 6.1%.

While new jobs were gained and the overall unemployment number went down, the only part of the latest report that came in lower than expected was the Average Hourly Earnings growth. This metric is one the FOMC (Federal Open Market Committee) has paid particular attention to and provides fuel for the camp who would like the FOMC to not raise interest rates anytime soon. Though taken as a whole, the data shows an employment situation that has reached the point where prior FOMC’s have felt it appropriate to start raising rates.

This leads us to the first consequence of economic growth – higher interest rates. The Fed looks like they will wind up their asset purchase program this quarter and has thus far stated that they will keep the Fed Funds rate near zero for a “considerable time.” Conventional wisdom tells us, however, that as growth continues to normalize, the interest rate environment must eventually do the same. The 10 year Treasury bond yield finished the quarter almost exactly where it started, yielding 2.52% after reaching an August low of 2.34% (for perspective, the average yield since 1958 is 6.32%). The projections of the FOMC members show an expectation of 5 quarter-point rate increases in 2015 and 6 more such increases in 2016.

Rising rates will be a headwind for fixed income investing; as market rates rise, the value of current bonds will decrease. So far this year, 30 year Treasury Bonds have been the best performing fixed income class; this will not be the case if/when rates do rise. For this reason, we value exposure to a variety of fixed income classes including Municipals, Floating Rate securities, Mortgages, High Yield bonds, and International bonds.

Here are some things we would not expect rising rates to do:

  • Hurt consumer spending – Debt Service is low
  • Cripple the housing market – Banks continue to raise the credit score required to get a mortgage
  • Explode the Federal deficit – CBO (Congressional Budget Office) forecasts have built in a doubling of the 10 year Treasury Rate
  • Crash the stock market – History doesn’t support the idea that rising rates equal bad stock markets

Another consequence of stronger U.S. growth, combined with the prospect of higher interest rates is that of a stronger U.S. Dollar. The Dollar increased in value about 7% this past quarter. This is positive if you are using Dollars to buy something being sold in a different currency, however, if you are a United States company that sells products to other countries, it is a different story. These companies face the challenging decision of either allowing their products to become more expensive and risk lowering demand or lowering their prices which will cause their profits to decline. It also is a headwind for investing in foreign stocks as the profits made in other currencies get converted into fewer Dollars.

Source: BEA, Federal Reserve, FactSet, J.P. Morgan Asset Management

A rising Dollar also helps keep inflation in check as it lowers the prices on items we import as well as lowering the prices of commodities. This is one of the reasons we are currently seeing gas prices lower than they have been in a while. Inflation has remained contained, with the most recent report showing a rate of 1.7%

With the economy growing, companies have been able to increase earnings this quarter by about 11% year over year. Going forward, a rising Dollar and rising interest rates may stymie this trend. Here in early Q4, the stock market has increased its volatility, while waiting to hear from companies just how much difficulty they expect in the near term. Valuations would seem historically fair and there is certainly a significant amount of cash in low yielding vehicles that institutions could deploy elsewhere if the right opportunities present themselves.

The stock market has rewarded these rising profits by sending the S&P 500 to 33 record high closes this year, though managing only a 1% gain for the quarter. Here’s a market recap for Q3 2014:

Index 3rd Qtr
2014
Return
1 Year Return 3 Year
Annualized Return
5 Year
Annualized Return
S&P 500 1.1% 19.7% 23% 15.7%
Dow Jones Industrial Average 1.9% 15.3% 19% 14.9%
Nasdaq Composite 2.2% 20.6% 24.6% 17.5%
Russell 2000 – Smaller Companies -7.4% 3.9% 21.3% 14.3%
MSCI EAFE – International -5.9% 4.3% 13.7% 6.6%
Barclays US Aggregate Bond 0.2% 4% 2.4% 4.1%

Other quarter highlights:

  • The record high for the Dow Jones Industrial Average was set on September 19 at 17,279.74
  • Alibaba, a Chinese e-commerce company, debuted on the New York Stock Exchange also on September 19 in what was the largest IPO ever
  • Healthcare is the only industry to post positive returns in each quarter so far this year, while no industry has had negative performance in each quarter
  • This was the 7th consecutive quarterly gain for the S&P 500
  • Apple released new iPhones and the Apple Pay digital payments system
  • Shares of energy companies declined as commodity prices sank
  • Famous bond manager Bill Gross announced he was leaving PIMCO to join Janus

So we find ourselves enjoying the results of a growing economy – a stock market going up, unemployment going down while preparing ourselves for the consequences – rising interest rates, along with a rising Dollar and the ramifications they present. While some of these ramifications are predictable, others will most certainly come around that were not. As a result, we think it’s in the best interest of our clients to stay diversified in our investment portfolios and retain the flexibility to make adjustments as conditions warrant.

As always, we thank you for your time and your trust. Included in this newsletter you will find an updated Privacy Notice. Enjoy your fall, and as Bob Barker used to say, “Hoping all your consequences are happy ones.”

Sincerely,
The Castle Investment Advisors®, LLC Investment Team

                    
 
Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
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