Economist Nick Perna -- 2014: No Major Stock Market Gains, 10-Year Treasury Rates Rise

Includes: DIA, IEF, IEI, PST, QQQ, SPY
by: Harlan Levy

Economist Nicholas Perna is the economic adviser to Webster Financial Corp. and managing director of consulting firm Perna Associates. He has also been a longtime visiting lecturer at Yale University.

Harlan Levy: What do you see for the U.S. economy in 2014?

Nick Perna: We start the year with better overall economic conditions than we've had in the past several years. But that's subject to change.

For one thing, to contrast with the beginning of last year, we don't face an imminent federal fiscal crisis or an imminent encounter with default when Congress must raise the debt ceiling in March. We still have that to worry about, although it's a couple of months out.

Financial markets seem to be optimistic that that, too, will be resolved, given the recent budget agreement, which should last another year or two. But you never can tell. The hard-liners have been awfully quiet, but that doesn't mean they've rolled over. Specifically, I'm talking about people like Sen. Ted Cruz.

Gross Domestic Product growth in 2014 is more likely to be 3 percent than the 2 percent this year. Still, 3 percent is not all that terrific, but it's a lot better than 2, in terms of helping to get the unemployment rate down further.

People seem to be buying cars. Christmas sales weren't all that shabby. However, we do have a sizeable loss of spending power in the economy as a result of the end of unemployment benefits that will affect 1.3 million people.

HL: Is the job sector going to worsen next year?

NP: GDP growth in a rage of 2 to 3 percent would be fine if you were at full employment. We're not, but it's highly unlikely that the job market will worsen if we get GDP growth of 3 percent. In fact, it will improve. We might even start seeing the unemployment rate decline more slowly because some of the discouraged drop-out workers will reenter the job market, which would be a good thing.

What this says is that you have to keep your eyes not only on the jobless rate but also the job formation rate.

HL: What do you see as full employment?

NP: What I think is not important, but what the Federal Reserve's leadership thinks is terribly important. They said in their longer-term projections that the unemployment rate will eventually be in the range of 5 to 6 percent, which I take is their view of full employment.

The interesting thing about that is that it's well above the 4 percent that we actually had before the Great Recession.

Jobless claims have been all over the place. After a while, when you're in this not-so-great recovery, you wonder how meaningful cyclical indicators are. The not-so-great recovery started in mid-2009, so do changes in initial claims have as much meaning as they did in past cycles? Initial claims are a cyclical measure, and we're in one of the weirdest cycles on record. So you have to be careful in using the traditional benchmarks.

What I come back to is that if the data gods only allowed you to look at one number, you should keep your eye on total jobs. The reason is that not only is that important, but it correlates with so many other important economic indicators. When jobs go up, incomes go up. When jobs go up, consumer confidence goes up, and you can keep going down the line.

We look at initial claims because traders need to trade, and they can't just trade once a month when the jobs numbers come out, while initial claims come out once a week. So what they have to rely on are volatile weekly indicators to give them a clue as to where jobs are going.

HL: What's your prediction for stocks?

NP: I look at the conditions that affect stocks. If you look out there, you have forces pulling in opposite directions. So it's going to be a tug-of-war between faster GDP growth

I think there's more upward room for rates to rise on the 10-year, both as a result of faster economic growth and smaller monthly purchases by the Fed under its new tapering announcement, dropping them $10 billion to $75 billion a month.

The tapering and signs of faster economic growth explain how we got to 3 percent. At a minimum, what ends up happening is when the economy strengthens there's more demand for credit, including mortgages. The higher yields available on bonds make stocks less attractive.

The way to understand this is that if you look at stock prices, in a simplistic way, they can be decomposed to earnings per share and the price-to-earnings ratio. Economic growth lifts the earnings-per-share ratio, but the higher bond yields reduce the price investors are willing to pay for a dollar of earnings.

Investors tend to focus on one of the two, but now they really need to focus on both.

Also, if the last few years were the perfect example of a rising tide lifting almost all equity boats, in the coming years you're going to have to be much more selective, because you won't have so much wind to your back. It's hard to see any significant overall market gains in the face of rising interest rates in the next year.

There are a couple of really big questions. If interest rates go high enough, and "high" could be 5 to 5.5 percent for the 10-year, what that would do would diminish the value of bond-holding for those who bought longer-maturity bonds, whether Treasuries or corporate bonds or municipal bonds. It's not a question of whether the borrower pays you back. It's the question of what your bond is worth if you try to sell it in a higher-rate environment.

That's referred to as the possibility of a bond bubble. I don't like the term "bubble" for this, only because it tends to bring back memories of what happened during the dot-com craze when the number of dot-com stocks went from the stratosphere to zero. The difference with a Treasury or decent corporate or municipal bond is that you're going to get the face value back when they mature.

HL: Any last thoughts on 2013?

NP: Yes. Happy New Year, everyone, and coming from an economist that's not a season's greeting. It's a prediction - which is good for stocks, because it pulls earnings up - and a very likely increase in interest rates, especially long-term interest rates like the 10-year Treasury note, which exceeded 3 percent last week That was almost double where it was back in early spring when it dipped down to 1.6 percent.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.