Highlights: 

• US economic output appears to have resumed at a moderate level following a scale back in the first quarter, attributable mostly to extreme weather.  European and Japanese economic growth rates continue to recover although deflationary concerns persist.  China’s output is somewhat less than recent history but remains relatively strong.  All are supported by significant governmental and central bank stimulus which appears likely to persist. 
• Equities generally rose in this environment and although the domestic market reached historical highs, the valuations can be rationalized by firm corporate earnings with multiples still below historical averages as well as a low inflation environment. 
• The Federal Reserve has indicated their quantitative easing program will terminate this fall, but the markets do not seem to imply from this a significant increase in interest rates.  Significant capacity in production and employment may explain this. 
• Geopolitical turmoil in countries such as Ukraine, Syria and Iraq has resulted in only localized impact to markets.

Comments:

Despite a U.S. economy that contracted in the first quarter of the year for the first time since 2011, and by the most in five years, the Fed believes this was mostly due to the harsh winter.  Consumer spending and industrial production have since rebounded and this is expected to persist for the rest of the year.  This has come with a moderate increase in inflation which apparently will not be a major concern for the Fed until economic growth and employment improve robustly.  Most analysts still do not see any increase in interest rates until early 2015, and then, on a tempered basis.
     
The labor market continues to reflect a mixed picture.  On the one hand, the U.S. continues to add jobs in both the public and private sectors.  The unemployment rate continues to fall and is currently at a six-year low of 6.1%.  Furthermore, jobless claims are at their lowest level in seven years, payrolls have returned to pre-recession levels and there finally appears to be upward pressure on wage growth.  On the other hand, adjusting for population growth since 2007 as well as the impact of the long-term unemployed who have stopped actively looking for jobs, the labor market recovery is not translating to levels of economic recovery which historically would have been expected. 

The recent slowdown in the housing sector is another area that the Fed is monitoring closely and that could be tied to the aforementioned labor market conditions.  It is yet to be seen if the recent housing slowdown that became evident in late 2013 is a result of the harsh winter or a sign of more fundamental issues.  Some worrisome signs include a 14 year low in mortgage lending and continued tight lending standards.  On the contrary, with improving consumer balance sheets and employment levels, we have recently seen encouraging statistics for existing and new home sales which hopefully will continue.   

Whereas U.S. policy makers are closely monitoring the pace of inflation, the European Central Bank (ECB) is facing pressure to do more to protect the region’s tenuous economic recovery.  The Euro-zone inflation rate fell to 0.5% in May, well below the ECB’s nearly 2% target and putting it at a level on par with those seen during the 2009 global recession.  In response, the ECB unveiled an unprecedented round of measures aimed at ensuring the record low interest rates bolster an economy threated by deflation.  These measures included becoming the first major central bank to take one of its main rates negative, opening a 400-billion-euro ($542 billion) liquidity program designed to encourage lending, and a plan to enact a Fed-like asset purchase program.  To this point, these measures seem to have convinced investors that a Japan-like stagnation may be avoided in the region.   

The United Kingdom presents a bit of an anomaly to the conditions generally experienced on the continent.  U.K. unemployment has reached a five year low and consumer confidence has hit a record high.  The result has been strong economic growth and an even stronger real estate recovery which has seen housing prices increase at over 10% over the past year.  There is some concern of a bubble condition as bank lending continues to be aggressive and consumer indebtedness continues to expand.  The challenge for the England’s central bank will be the appropriate magnitude and timing of rate increases so as not to constrain GDP growth, but contain the a potential housing bubble.

The challenge which the Bank of England faces is a challenge most other central banks would relish, including that of China.  The Chinese face a housing slump that is affecting other parts of its economy, ranging from construction companies to steel makers.  This is just one symptom of a general slowdown that China’s economy has been experiencing over the last couple of years.  In response, China’s central bank recently unveiled a stimulus plan aimed at letting banks lend more of their deposits to the rural sector and smaller companies that have increasingly turned to foreign investors for financing.  China recently announced that they had opened 80 infrastructure projects to private investment in an effort to spur growth and give private capital a more prominent role in its economy.  China has also been buying U.S. Treasuries in an effort to weaken their currency and boost exports.  Should these efforts be insufficient a more broad based reserve rate cut may be effectuated.  
    
In Japan, first quarter GDP growth was very strong at 6.7% as consumers accelerated spending in anticipation of a VAT (sales) tax increase effective April 1st.  Prime Minister Shinzo Abe announced a second round of broad stimulus measures to assure investors that he remains committed to making structural changes that have stymied the country for the better part of more than two decades.  The new package calls for reductions to the corporate tax rate and deregulation in areas such as employment rules, agriculture and health care.  Recent data does reflect some improvement in consumption and wages along with a positive inflation expectation.   

To summarize, investors continue to heavily weigh global monetary policies that have supported economic recovery and a global equity market rally that began in 2009.  Weaning the global economies off such easy money policies will undoubtedly be a delicate task, but seems to be in process in some areas and should be indicative of a stronger and more self-sustaining global economy that should continue to benefit investors.  How this unfolds is, of course, uncertain.  In this vein, we continue to suggest an investment policy that allocates funds to a diversified equity portfolio only after having objectively established that you will not need access to such funds for several years.  This affords you the ability to avoid trying to time the market, as making subjective determinations is likely to be a value losing proposition over the longer term.

Urban Financial Advisory Corporation - July, 2014