Pundits and - to a lesser extent - markets are getting the "rate hike jitters" again in the wake of relatively good GDP numbers in the second quarter. Some suggest that we are now heading to 4% real GDP growth and that this means that the Fed will raise interest rates sooner than expected. Job creation has also been strong although it is curious that the unemployment rate actually increased last month (more on that later).
1. GDP Growth < 1% - I am still skeptical of the recovery and I still find myself in the sluggish growth camp at this time. First of all, it is important to view the second quarter GDP numbers in the context of the first quarter GDP numbers. The table below provides seasonally adjusted GDP (in billions of 2009 dollars) for the designated quarters. The source of the data is the Federal Reserve Bank of St. Louis.
|4th Q 2013||$15,916|
|1st Q 2014||$15,832|
|2nd Q 2014||$15,986|
GDP declined about 1/2% in the first quarter of 2014 and then increased roughly 1% in the second quarter. These increases are released in annual terms (just as a car which traveled 20 miles in 15 minutes would be described as traveling 80 miles per hour) as annual rates of GDP growth of minus two and plus 4. The net effect is that GDP expanded by less than 1/2 percent in the first six months of 2014, which can be stated as an annual rate of expansion, which is less than 1 percent.
I think it is legitimate to look at the last six months because weather reduced GDP in the first quarter and the second quarter probably "stole" some GDP from the first in the form of construction work delayed from the first to the second quarter and other items. At this point, we can look back on the six-month totals as suggesting medium-term trends. From this perspective, GDP growth looks very, very sluggish.
2. Confusing Employment Market - While job creation has been reasonably decent, the unemployment rate recently shot up from 6.1 to 6.2%. It is not really hard to understand why. Up until the 2008 Panic, the Work Force Participation Rate had been hovering around 66%. The Great Recession drove the rate down to the 63% area where it has stayed ever since - recently showing a modest uptick. Based on the size of the work force (156 million), we can see that an increase of the Participation Rate back to 66% would involve roughly 7 million people entering the work force. As the job market improves, we will likely see most of these people return to the work force and this will prevent the emergence of a "tight" labor market (one of my children just reentered the work force this month). At our current rate of job creation the absorption of 7 million additional workers will take a very, very long time.
3. Exchange Rate Issues - Even a hint of an interest rate increase is enough to push the dollar higher. With most central banks following expansive policies, a tighter US monetary policy will mean a stronger dollar and this, in turn, will mean lower exports, higher imports, fewer foreign tourists here, more American tourist abroad and increased deflationary pressure. The recovery is not strong enough to absorb very much of this pressure.
4. The Big Picture - The potential sources of GDP growth are limited. Most of our large trading partners are in trouble so that the potential for increased exports or reduced imports is limited. The gridlock in Washington makes increased federal fiscal stimulus unlikely. The American household is still cautious and living paycheck to paycheck so that an expenditure on a new TV simply displaces other current expenditures such as eating out or travel. The only real sources of growth are business capital expenditures and household purchases which can be financed (houses and cars). The auto market has been strong but it is questionable how much growth from here can be obtained from that direction. The housing market is still sluggish and would certainly not be helped by rising interest rates. Capex has been increasing but, again, would be discouraged by higher interest rates.
5. Conclusion - I stick to the prediction I made in this article in the Fall of 2013 that we will not see a 2 handle on the federal funds rate until 2017. I am not necessarily predicting a 2 handle in 2017 but I am saying it will not appear before 2017. Back in 2011, I predicted that we would have zero rates until 2013 in this article and that turned out to be too conservative.
6. Implications - Investors shouldn't look for any significant yield on money market funds, bank deposits or other cash-like vehicles in the near future. Yield oriented equity strategies - dividend stocks, BDCs, REITs, MLPs, private equity managers, and utilities - still will beat almost anything available in the fixed income universe. Preferred stocks are starting to look good on a relative basis. Investors should hold some cash and look for bargains on dips. It takes a long time to recover from a financial crash and 6 years in we are probably only about halfway home.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.