Richard Kisthardt

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Richard Kisthardt
520-298-1800
Tucson, AZ
 
Friday, July 25, 2014

Our economic outlook

An editorial opinion 
by Troy Frerichs, CFA
® 
Director - Wealth Management

July 16, 2014

What an ideal first half of 2014! What does “ideal” mean? It means positive stock and bond market returns with very low price volatility. That is an environment most risk-averse investors would deem desirable. What is even more ideal? The positive returns and low volatility came during a first quarter, which saw the U.S. economy contract almost 3 percent from the end of 2013. Even if the National Bureau of Economic Research won’t officially label it a “recession,” the U.S. at least had the feelings of a mini-recession during the first quarter of 2014.

The S&P 500 Index had a total return of 7.1% over the first half of the year. While there have been two instances so far in 2014 of 4 to 5% declines, price volatility remained historically low.

Small-cap stocks, as measured by the Russell 2000 Index, have underperformed their large-cap peers, returning a modest 3.2% by comparison. Meanwhile, high-flying internet and biotechnology stocks, which enjoyed outstanding results in 2013, came back to earth during the first half of the year, with each sector declining ~ 20% at one point. Still, the broad U.S. stock market, as measured by the S&P 500, is on pace for an “average” result (historically ~10%) with full-year returns in the high single digits or low double digits if current trends hold.

Bond yields increased dramatically during 2013 primarily due to the U.S. Federal Reserve’s “tapering” of its long-term asset purchase program known as Quantitative Easing (QE). With expectations for the Fed to end this program completely during 2014 and foreseeing stronger U.S. economic growth, we thought pressure would be on interest rates to continue moving higher. In fact, rates have reversed course and fallen so far this year. The yield on the 10-Year U.S. Treasury note has fallen from 3.0% on December 31 to just 2.5% as of the end of the second quarter. Falling interest rates and corporate credit spread tightening have propelled the Barclay’s Aggregate Bond Index up 3.9% so far this year.

While our outlook for Fed tapering and stronger growth remains intact, other market forces have overwhelmed these factors and pushed rates lower. Most importantly, falling yields in other developed countries around the world and strength of demand for fixed income securities relative to their supply have kept a lid on interest rates.

Heading into 2014, the U.S. economy seemed to be gaining momentum with both  private sector and government spending showing signs of improvement. Economic growth in the neighborhood of 2.5% to 3.0% finally seemed within reach after averaging just 2.2% since the recovery commenced in 2009. While many of these positive improvements are still in place, economic growth in the first half was disrupted when the worst winter in 20 years hit the U.S. hard. Real Gross Domestic product (GDP) declined 2.9% in the first quarter. Because of the weak first quarter, recent estimates are now projecting the economy to grow slightly below 2.0% in 2014, a far cry from the 2.5% - 3.0% expectation to start the year.  We still think this lackluster start to the year will prove to be a temporary stall, and most of the lost economic activity will be recovered in the quarters to come. Recent economic reports have come in better than expected, and consensus estimates call for second quarter GDP growth of 3.5%.

There are still several positives that point to the U.S. private sector’s continued momentum. For one, the U.S. labor market is gaining strength. With average monthly payroll gains of 231,000 over the first six months of the year, the unemployment rate now stands at 6.1%. The economy has recovered all 8.7 million jobs lost during the recession.

Second, business spending should accelerate over the second half of the year as well. Corporate balance sheets are flush with cash. CEO and small business optimism is rising, and there has been an increase in mergers and acquisition activity. All of this bodes well for domestic economic activity.

We believe the current economic backdrop is still accommodative for equities. Low interest rates, low inflation and improving economic growth should continue to support share price increases. While stock valuations may not be as attractive as earlier in the recovery, they are still reasonable, and a continued abundance of global central bank activity has lowered interest rates, risk premiums and market volatility. This should continue even as the Fed exits from its long-term asset purchase program.

Declining interest rates during the first half of 2014 have buoyed bond portfolios. However, lower yields today suggest lower expected future returns for fixed income investments. Despite the somewhat unexpected drop in rates to start the year, we maintain our expectation that rates will gradually rise through the rest of the year and years to come.

The relatively stable outlook for domestic monetary policy and improving economic growth should put upward pressure on interest rates. However, offsetting factors (such as subdued inflation, low interest rates in international markets and continued strong demand for high-quality fixed income investments relative to new issuance) should keep rates from rising dramatically. Our expectation is for low single-digit returns from bond investments during the rest of this year and in the years to come. Despite the low-return expectation, investment-grade bonds have historically exhibited less price volatility when compared to stocks.

People who achieve financial security rarely do so alone

With all of the current economic uncertainty, this is a perfect time to contact your financial representative for an in-depth review of your situation. Backed by a team of experts, your financial representative is equipped to give you the guidance you need. 

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