Outlook and Market Review - Third Quarter 2013

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Real GDP grew 3.6% in the third quarter of 2013 according to the second estimate from the Bureau of Economic Analysis. Second quarter growth was 2.5%. Both quarters had higher growth than expected but the economy continues to expand at a rate well below potential. The primary drags on third quarter GDP growth were federal government spending and imports. Inventory buildup added about 1.7% to GDP, raising the possibility that fourth quarter GDP growth will be slowed if inventories do not move as expected. Consumers played an important role by providing 1.8% and 1.5% to growth in the second and third quarters, respectively. Personal spending increased 3.7% in the third quarter while real disposable income grew only 2.5%. Consumers are likely to ratchet back on spending to keep pace with income growth.

Consumer confidence has been declining since July but increased slightly in November. The Conference Board’s Index of Leading Economic Indicators grew 4.4% on a year-over-year basis, consistent with modest growth. Surveys suggest that present conditions are poor but prospects for the future are better. This is a fragile balance. Job growth is not strong enough to boost wages and salaries very much while, consumers will be facing higher taxes and insurance costs. These factors may dampen consumer enthusiasm for spending going into 2014. It is unlikely that government spending will grow outside of entitlement spending and global economies are not likely to improve enough to provide much boost for U.S. exports.

The unemployment rate dipped to 7.0% in December aided by a shrinking workforce. The civilian labor force, which declined by 720,000 in October, rebounded 455,000 in November and the labor force participation rate dropped 0.2% to 63.0% in that two month period. The U6 unemployment rate, which adjusts for marginally attached and part-time workers, is just over 13%. Labor costs continue to show very modest growth due to a combination of improved productivity and a labor market that is too weak for significant wage increases.

Inflation is low in the U.S. and most other countries. Both the CPI and PCE indexes are growing less than 2%, suggesting that deflation may become more of a concern than inflation. Interest rates remain low across the maturity spectrum. Most analysts expect the Fed to pull back from the $85 billion a month bond purchase program sometime in the early part of 2014. Much of this expectation is already being priced and interest rates are not expected to take the full 100 basis point surge seen earlier this year in response to the suggestion of tapering. The Fed should keep short term rates low to maintain bank liquidity and allow upward creep in longer term rates.

The outlook calls for low growth of about 2% for the fourth quarter of 2013 with slightly higher rates of 2.5% to 2.7% in the first two quarters of 2014. The unemployment rate should break below 7% late in 2014 with job growth averaging about 180,000 per month. Inflation will remain at or below 2% with little movement in short term rates and intermediate term rates creeping up to just over 3% by the end of 2014.