The U.S. Economy
The effects of a harsh winter were glaringly apparent in the Bureau of Economic Analysis' second estimate of first quarter growth in U.S. GDP. According to their report, the domestic economy contracted at a 1% annualized rate during the first three months of the year. Of the 19 quarters that have passed since the last recession ended in mid-2009, this was the second time economic growth turned negative. A similarly weak period occurred during the first quarter of 2011 when the economy contracted at a 1.3% annualized pace.
Driving the first quarter contraction this year were negative contributions from less investment in private inventories, lower exports, declines in nonresidential and residential fixed investment, as well as reduced spending at the state and local government levels. On the positive side, personal consumption expenditures continued to grow above 3% annualized and helped to offset some of the weakness in other areas. Federal government spending also ticked slightly higher and was a positive growth contributor thanks to an increase in nondefense spending.
Consensus was expecting a downward revision to the advance estimate released last month that showed the economy expanded at a 0.1% annualized pace, but the second estimate was worse than their -0.5% forecast. Despite this, investors appeared willing to look past the bad news, as stocks were little changed immediately after the release. We think growth should snap back during the second quarter and indications through the first two months of the period largely support this notion.
The housing market remains a focal point in the current economic cycle, and after finally gaining some momentum during the past several years activity slowed during 2013 when interest rates began to rise. Home sales always experience seasonal weakness during the winter, but this time conditions were particularly poor. Evidence of stalled activity permeated the first quarter GDP report as a 5% annualized drop in real residential fixed investment was attributable to weakness in the housing market.
Long-term interest rates drifted slightly lower early this year and that has helped breathe life back into various housing related indicators during the past couple of months. For example, the seasonally adjusted annual rate (SAAR) of existing home sales stemmed three consecutive months of declines and rose to 4.65 million units in April. The SAAR for new home sales also broke a similar multi-month trend of slower sales in April. New homes changed hands at a 433,000 unit annual sales pace that month. While sales appear to be accelerating heading into the summer selling season, these recent figures are still below last year's peaks. New building permits are a popular leading indicator of new home sales, and the pace of permit issuance for single family home construction remains depressed relative to last year as well.
Remarking on the importance of housing in the economic growth equation, Federal Reserve Chairwoman Janet Yellen referred to the current economic situation as "solid," but said the recent evidence of softness in the real estate market will require close monitoring. Her statements seem to indicate that she is not totally convinced that the return of warmer weather will reinvigorate housing activity such that sales revisit and ultimately exceed the robust trends we saw last year before interest rates began to rise. Though she stopped short of stating it explicitly, we think the comments were directed at a commonly held view among lawmakers and some investors that the return of an upward trend in selling activity is here to stay. The message is that consensus should be careful if they think reacceleration in growth after the bad winter is a foregone conclusion.
While it is true that housing affordability metrics continue to suggest that buyers have the wherewithal necessary to purchase a home, and indicators such as the Fed's Senior Loan Officer Opinion Survey show lending standards are getting looser at the margin, other data illustrate that the important first time home buyer group remains reticent to spend. The homeownership rate among people younger than 35, a demographic typically associated with first time home buyers, was 36.8% at the end of last year, down from 42% during the third quarter of 2007.
The recent conclusion of important national elections in India could prove to be a critical watershed event for the country and we view it as a distinct positive. Narendra Modi emerged as the overwhelming choice for prime minister and his Bharatiya Janata Party (BJP) also won a majority in parliament. These results should grease the wheels of economic change and are likely to lead to swift implementation of policies geared to promoting business and economic growth. Previously, as governor of the state of Gujarat, Modi built a reputation as a market friendly economic reformer. He successfully attracted entrepreneurs and encouraged investment that brought new businesses to the state, a recipe we now expect will be applied to India as a whole.
By winning 282 seats of India's 543 member parliament the BJP victory became the most decisive in a major Indian election since the early 1980's. Voting offered a glimpse into the population's widespread displeasure with the corruption and lack of progress that often characterized the leadership style of outgoing officials. With a majority in parliament and Modi as the prime minister, we expect the BJP will be able to put forth an ambitious policy agenda with relatively little threat of resistance from opposition parties. Modi's political capital is further enhanced by favorable relationships with allied parties that comprise the National Democratic Alliance (NDA). Collectively, Modi's support totals more than 330 parliamentary seats.
Among areas of the Indian economy we expect policymakers to address in relatively short order is the nation's outdated and ailing infrastructure. We see logistical bottlenecks created by decrepit transportation systems as a major impediment to economic growth and would not be surprised by the announcement of new projects designed to bring those systems up to speed with the modern demands of India's s economy.
Beyond infrastructure we also expect lawmakers to tackle issues in the labor market and draft legislation that makes it easier and less bureaucratic for a company to manage the size of its workforce. Efforts to reduce the influence of government in commercially viable competitive businesses and to promote a more level playing field in the private sector represent other policy pursuits we see as likely in the near-term. Over time we suspect the recent changes to India's political landscape will manifest as an environment more conducive to healthy and sustainable economic growth. While real GDP growth has been decelerating during the past several years, more recent indications suggest that the growth pace is bottoming and inflation is under control.
While valuations in the broad domestic market remain elevated as compared to recent years, we see the risk of a meaningful correction in stock prices as quite low. The economic, sentiment, and valuation indicators we scrutinize continue to show little evidence of the types of extremes that typically lead to large and lasting selloffs. Outside the U.S., equity valuations are mixed. There are pockets of expensive and cheap markets and others that are in-between. In this environment we continue to stress that discernment and flexibility are critical whether the focus is stocks, bonds, or both.
In portfolios geared toward investors that need capital growth, our main focus is on identifying companies that can grow in an otherwise growth-challenged global economy. We are looking for businesses that have control of their own destiny and are taking share in large established markets or are creating new markets on their own. The goal is to identify companies trading at attractive valuations relative to their growth potential. In our view, reinvestment rate risk remains the key challenge facing long-term investors that need capital growth. Investing in companies with good fundamentals and tailwinds at their back should help investors combat this risk.
For fixed income investors and investors with a shorter time horizon or current income needs we continue to focus on opportunities we are seeing in investment-grade corporate bonds. A selective approach to the below investment-grade corporate space is helping us find value there as well, however opportunities are becoming more scarce as investors reach for yield. With regard to government debt, we continue to favor Agencies over Treasuries. In an effort to limit the sensitivity of clients' fixed income investments to a rising rate environment, portfolios are tilted toward shorter duration securities. In our view, short-term and income-oriented investors should also explore equities that display stable fundamentals and are trading at attractive valuations. We believe companies that generate strong, stable cash flows, and pay an attractive dividend could be compelling options for these types of investors in the current environment.