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Living Up To Our Potential: Where The Markets And Economy Stand Now

Motivational speaker and corporate consultant Zig Ziglar, a legend in the halls of many Fortune 500 companies, had a unique view on what potential means. "When you catch a glimpse of your potential," Zig said, "that's when passion is born." In other words, thinking about how great you could be can ignite the drive to achieve that greatness. In terms of our country, its level of "greatness" has a far-reaching effect upon the greater good of many. The economy is one measure of such greatness, and of course we all want to see the U.S. economy live up to its potential. But what does that mean - and how will we get there?

In order to get back to its full output, the U.S. economy will have to break free from the frustrating stop-and-go cycle it has been stuck in for some time. While we're still trying to recoup the setback we saw during the first quarter this year, the "spring warm-up" we looked forward to in April is largely coming to fruition. The employment situation is improving, sales of homes and vehicles have picked back up and household wealth is now at its highest level ever. Though challenges remain, overall we feel the tailwinds will outweigh the headwinds, leading to the sustained and robust growth that will return living standards to the levels we know are possible and get our nation living up to its potential once again.


Interested in what's happening, but prefer not to get into the nitty-gritty details? Here's what you need to know about the most recent quarter and where the markets and economy stand now.


Quarter in Review: Broad U.S. equity markets continued their climb past the record highs achieved at the end of 2013, with the S&P 500 (S&P) gaining 5.2 percent and the Dow Jones Industrial Average moving up 2.8 percent.

Small-Cap Struggles: After a great ride in 2013, the small-cap run came to a halt and the small-cap Russell 2000 Index trailed the large-cap S&P throughout the quarter.


Worse Than We Thought ... But Improving: The economy's decline in the first three months of the year appears to be more of a pause in the recovery than a full stop, as second-quarter data reflected improvement in many areas, including job creation, manufacturing and consumer confidence.

Household Net Worth Reaches New Heights: The National Association of Realtors reports that existing home sales rose 4.9 percent in May, an increase that - along with an improving job market and rising home prices - has helped bolster household balance sheets.

Inflation Ticks Up: Food and energy prices are on the rise, but expectations for inflation remain steady due in part to perceived slack in the employment market. As a result, we do not expect the Federal Reserve to adjust monetary policy in response in the near term.

The Output Gap - What is Our Potential?: The gap between real GDP (gross domestic product) and potential GDP has persisted throughout the recovery, but that means there remains room for economic growth without inflation spiraling out of control.


Our Outlook - Closing the Gap: On the economic front, we expect the mix of headwinds and tailwinds to persist, causing growth to remain modest but certainly picking up following the first-quarter contraction. Fortunately, the labor market is improving, foreign demand for U.S. products has rebounded, the housing market has regained its footing and consumer balance sheets are improving as the stock market continues to surge. Overall, we think economic growth will return to solid ground in the second half of 2014, as we have room to run and will continue to work toward closing the gap and returning the nation's output to its full potential.

The following pages provide more information on these topics.



Coming into 2014, our outlook was for modest gains in the broad equity markets, albeit with increased volatility along the way. Well, we were right about the equity gains - as of the end of the second quarter, at least. Through the first six months of the year, broad U.S. equity markets have continued climbing from the record heights achieved at the end of 2013. The S&P 500 (S&P) advanced 5.2 percent during the second quarter and is now up 7.1 percent year-to-date. While the Dow Jones Industrial Average (Dow) is not keeping pace with the S&P, it still gained 2.8 percent during the quarter and has increased 2.7 percent this year.

On the other side of the prediction coin, the Chicago Board Options Exchange Volatility Index (VIX) continues to hover around its all-time low. Such reduced volatility is not just limited to equity markets, as many bond, currency and commodity markets are experiencing similar environments. The low volatility has been noticed by officials at the Federal Reserve (Fed), as Minneapolis Fed President Narayana Kocherlakota recently said investors may be growing more complacent. This complacency could cause investors to feel comfortable enough to move into riskier areas of the market they otherwise would avoid.

One of the bond market's riskier areas to which investors have taken a shine is high yield. Mutual funds in Morningstar's High Yield Bond category have taken in $7.3 billion this year alone, and $84.4 billion since the Fed took its key interest rate to near-zero in late 2008. Given their strong performance over the trailing five-year period, we decided to "ring the register" and reduce our allocation to high-yield bonds in the beginning part of April. The spread between yields on a 10-year U.S. Treasury note and high-yield corporate bonds is now at its lowest level in 30 years, and from a risk-return perspective, the amount investors are currently being compensated is not as rewarding as it once was. The chart below illustrates the consistent monthly inflows and strong performance that high-yield bond funds have seen during the low- interest-rate environment.

High-Yield Bond Asset Flows and Performance

Source: The Mutual Fund Research Center®, Morningstar


Another recent change made to client portfolios was a reduction in the overall allocation to small-cap stocks. We previously highlighted the asset class' long-term outperformance relative to large-cap stocks and their dramatic ascent in 2013. The early-April timing of the move turned out well, as the large-cap Russell 1000 Index outperformed the small- cap Russell 2000 by 3.0 percent during the second quarter.

A market that had favored riskier, high-growth companies for the trailing year suddenly turned on a dime, turning its focus back to value and finding those higher-quality companies with stronger cash flows and balance sheets. This proved to be more of a problem for small-cap indexes rather than large, as there is a higher concentration of lower-quality companies in the small-cap universe. In particular, small caps were held back by the more high-momentum growth stocks as the Russell 2000 Growth Index lost 5.1 percent. At one point in early May, the index had entered correction territory, having fallen 12.0 percent from its March 4 high.

Not only did large-caps outperform small during the quarter, but they did so with a lower level of volatility. As we move further into the market cycle, we expect large-cap stocks will continue to look more favorable than small caps from a risk-return perspective.

Small vs. Large During the 2nd Quarter

Source: The Mutual Fund Research Center®, Russell Investments



As we discussed in last quarter's "Perspectives," the economy sputtered at the beginning of year, affecting everything from automobile sales to manufacturing. At the time, we did not know the extent of the damage, learning only recently that the first three months of 2014 represented the worst quarter of economic growth since the recovery began in 2009. The decline of 2.9 percent in inflation-adjusted gross domestic product (GDP) was largely accounted for by weak (but positive) consumer spending, sharp declines in investment by firms and households, and a drop-off in U.S. exports of goods and services.


Though bad, we still view the first quarter as more of a pause in the recovery than a full stop, and the market agrees - demonstrated by its race to new heights despite the disappointing economic releases. Data released during the second quarter has indicated improvement in many areas, including industrial production, manufacturing, vehicle sales and consumer confidence.

Furthermore, the U.S. economy managed to add 569,000 new jobs during the first quarter, and the latest numbers from the Bureau of Labor Statistics (BLS) indicate the job market continues to improve. The headline unemployment rate declined from 6.3 percent in May to 6.1 percent in June - a rate we have not seen since September 2008. Also in June, 288,000 more Americans joined the ranks of the employed - the fifth-straight month of employment growth exceeding 200,000. This is good news! The five-month average now sits at 248,000 jobs, while the same five-month average in 2013 was less than 200,000.

We've now gained more jobs during the recovery (9.4 million) than were lost during the recession (8.8 million). However, while job creation is improving at a considerable rate, we're still seeing a large amount of part-time, temporary and service-oriented jobs being created. Jobs in the leisure, hospitality and retail sectors - traditionally some of the lowest-paying - accounted for 27.0 percent of June's 288,000 jobs. So despite employment returning to its pre-financial- crisis level, the labor market remains softer than it was prior to the recession.


Recoveries don't exist and persist without healthy participation from the housing sector, which is why it's a sector we watch carefully as a barometer of the economy's strength. The sector has been taking steps in the right direction as home-buying picked up in the spring. The National Association of Realtors reports that existing home sales rose 4.9 percent in May, its highest monthly rise since August 2011, and new-home sales saw their largest month-over-month gains since the early 1990s. Overall, the housing market appears to be benefiting from an improving job market and a slight decline in mortgage rates, and home prices continue to increase.

This rise in home prices, along with a rising stock-market, has buoyed household balance sheets. The Fed recently reported that household net worth - the value of homes, stocks and other assets minus total household debt - has climbed above its pre-recession high, rising $8 trillion, or 11.0 percent, over the last 12 months to $81.8 trillion. Much of these financial gains appear to be tilted toward older, wealthier Americans who tend to save their additional income rather than spend it. Thus, these gains in wealth have not yet translated into stronger consumer demand - leaving room for further growth in this area.


The second quarter of 2014 saw a slight uptick in inflation, as the BLS reported the consumer price index (NYSEARCA:CPI) rose 0.1 percent in February, 0.2 percent in March, 0.3 percent in April and 0.4 percent in May. Notice a pattern? Overall, the CPI has increased 2.1 percent over the last 12 months.

Anyone who has recently purchased a cup of coffee or filled up their gas tank is well aware that some food and energy prices are on the rise. Earlier this year, a drought in Brazil caused the price of some coffee beans to double, and motor-club and leisure-travel organization AAA reports that a gallon of regular gasoline is 20 cents - or 6.0 percent - higher than it was this same time last year. More broadly, the CRB Commodity Price Index, which tracks 19 different commodities, is up 9.5 percent since the beginning of 2014.

Inflation not only affects your wallet at the grocery store and gas pump, it can influence the Fed to raise rates which can impact the bonds in your portfolio. As such, it's an area of the economy that the bond fund managers we utilize are always monitoring. The chart below illustrates market expectations for future inflation using U.S. Treasury notes and Treasury Inflation-Protected Securities. While commodity prices increased and inflation ticked up slightly during the first half of the year, the bond markets largely kept their inflation expectations steady.

We foresee it largely staying in the 1.5- to 2.0-percent range for the time being. But do we think the Fed will adjust monetary policy in response to these latest inflation figures ticking up? In the near term, probably not. One reason is that the Fed's favored measure of prices, the Core PCE Index (which excludes food and energy) is up only 1.5 percent from last year - which is below the Fed's desired inflation target of 2.0 percent. Chair Janet Yellen has also made it clear in recent speeches and press conferences that she believes there is considerable slack in the labor market, which will dampen any inflation pressure coming from wages.

Market-Expected Inflation

Source: The Mutual Fund Research Center®, Federal Reserve Bank of St. Louis


In a March 31 speech in Chicago, Yellen said, "Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill." She went on to state four reasons why the recent declines in the unemployment rate do not necessarily indicate a healthy job market:

  1. There is a large pool of "partly unemployed" workers. Currently, there are 7.5 million people (about 3.0 percent of the population) who are working part time but would like to be working full time. In 2008, prior to the recession, there were less than 5 million (1.8 percent of the population) in this situation. It is reasonable to expect that employers will increase the hours of these part-time workers as the economy expands rather than hire new workers.
  2. There is little opportunity for workers to negotiate for higher wages. This is evidenced by the fact that wages and benefits have increased a paltry 2.0 percent per year since the recession.
  3. There are still twice as many workers who have been unemployed for six months or longer than there were prior to the recession. Recent studies have found that these long-term unemployed had a particularly difficult time finding work.
  4. The share of working-age adults who hold or are seeking a job remains low. At the start of the recession, this share - known as the labor-force participation rate - stood at 66.0 percent. It is currently 63.3 percent, the same level as in the late 1970s when a much smaller share of women were in the workforce. People who are not actively seeking a job are not counted among the unemployed. How many of these people who have dropped out of the labor force will begin seeking work as the economy improves remains an open question.

If Yellen is correct, there are hundreds of thousands of workers available and eager to work who are instead sitting at home. If these workers were employed, the quantity of goods and services produced inside the United States would surely be higher. But by how much?

Economists have devised an estimate of what GDP could be to answer this question. Detailed in the chart on the following page, this hypothetical measure - called potential output - is plotted against actual real-GDP figures according to estimates from the Congressional Budget Office (CBO). Note that prior to 2008, real GDP tends to track potential GDP quite closely. When real GDP is above potential output, it's an indication that labor markets are tight and firms are finding it difficult to fill jobs. Other times, real GDP is below potential output, indicating a slack labor market like the one described by Yellen.

Since 2008, real GDP has been consistently below potential output, and the gap between these two series has narrowed only slightly in past five years. The economy is producing 5.3 percent less than it would if it productively employed all willing and able workers. Even though the recession "officially" began in December 2007 and ended in June 2009, the damage it wrought continues; five years after the recession ended, GDP has still not returned to its potential. However, with such a large output gap, policy makers believe there is considerable room for the economy to grow without inflation spiraling out of control.

The Output Gap

Source: The Mutual Fund Research Center®, Congressional Budget Office, Federal Reserve Bank of St. Louis



As the tongue-in-cheek saying aptly points out, economists have correctly predicted nine of the last five recessions. Over the past few years, the track record for market prognosticators calling for the next correction has been similar - every slight pullback has been met with support and the market continues to climb. Nearly three years removed from the last correction in August 2011, it seems the playbook that helped push equity markets to new heights since then remains intact.

Although a correction of 10.0 percent or more may occur in the second half of the year, we feel the overall economic and market environment will provide support, preventing the market from declining substantially and continuing the long-term bull run we've enjoyed since early 2009. Here's why we've developed a position of cautious optimism:

  • We think the low-interest-rate environment will persist through the rest of the year and into 2015, with the first rate increase not expected until mid-2015 (at the earliest), as the Fed continues to stay on the sidelines until wages and income pick up.
  • Much has been made about the price levels reached by broad indexes, as many fear that valuations are too high as a result of repeated record highs for both the S&P and Dow. However, quarterly profits have kept up by hitting their own records over the last couple of years.
  • While there are several areas of geopolitical unrest in the world - tensions in Ukraine, the escalation of conflict between Israel and Hamas, and the situation in northern Iraq - markets have largely moved past any temporary pullbacks these events have caused. We feel that unless one of these areas was to flare up considerably, the overall geopolitical and economic landscape remains one that should encourage growth

On the economic front, we expect the mix of headwinds and tailwinds to persist, causing growth to remain modest but certainly picking up following the first-quarter contraction. Fortunately, the labor market is improving, foreign demand for U.S. products has rebounded, the housing market has regained its footing and consumer balance sheets are improving as the stock market continues to surge. Overall, we think economic growth will return to solid ground in the second half of 2014, as we have room to run and will continue to work toward closing the gap and returning the nation's output to its full potential.