The U.S. economy is on the mend. Finally, the global economic crisis of 2008 and recession appear to be in the rearview mirror.
The Federal Reserve’s latest policy meeting revealed that Chair Janet Yellen and team remain on track to begin interest rate hikes this year. The Fed’s ultra-loose monetary policy stance, with near-zero percent interest rates, has served its purpose, and the central bank is signaling the economy is strong enough to handle a gradual move higher in interest rates.
There are several economic trends the Fed is monitoring in regards to the timing of the first interest rate hike, which many economists expect to come at the September 16-17 Fed policy meeting.
1. GDP growth rate.
Overall total gross domestic product growth for 2015 will likely be 2.5 percent, according to The Haverford Trust Co., a Philadelphia-based wealth and advisory firm. The 2.5 percent forecast follows a 2.4 percent GDP rate in 2014, but it still remains below a more historically normal 3.5 percent growth rate. A key driver of this year’s growth is the consumer – after all, consumer spending accounts for roughly 70 percent of U.S. economic growth.
“The second half [of the year] should be decidedly stronger than the first half. We expect the consumer to begin spending more as job and wage gains continue,” says Hank Smith, chief investment officer at Haverford Trust. Car and truck sales have been strong, with 2015 sales forecast near 18 million units, the highest level since the early 2000s, Smith notes.
Lower gas prices this year have also been a boon to consumers. The national average price for a gallon of gasoline stood at $2.81 a gallon in mid-June, 86 cents per gallon lower than a year ago, which saves motorists $335 million each day, according to data from GasBuddy, a website that monitors retail gasoline prices. But not all of consumers’ savings have gone toward new purchases.
“A lot of the gas savings has been used by consumers to retire debt,” says Curtis Holden, senior investment officer at Houston-based financial planning firm Tanglewood Wealth Management. “This does not help the economy a lot today but will be beneficial in the future, as consumers will be better able to spend and borrow in the future since they have a healthier balance sheet.”
While low prices may sound good to consumers, they reveal a lack of demand in the overall economy. It’s Economics 101: Higher demand drives up prices and generally reflects strong underlying economic activity. This matters to the policymakers at the Federal Reserve because the central bank has been tasked by Congress with a so-called “dual mandate” of promoting maximum economic growth along with stable prices. In the past 12 months through May, the core consumer price index climbed 1.7 percent, which is below the Fed’s 2 percent target rate for inflation.
Experts expect inflation to remain subdued. “It might pick up a fraction of a percent. There are two secular forces that are very disinflationary: technology and an oversupply of labor worldwide,” Smith says.
The muted inflation levels are not expected to stop the Fed from raising interest rates this year, but could keep the number of rate increases to a minimum. “The Fed will be very slow in its interest rate increase. We think they will still hike rates, but it will probably be slow – to the tune of one hike every other meeting,” says Jason Pride, director of investment strategy at The Glenmede Trust Co., a Philadelphia-based investment and wealth management firm.
3. Labor market.
The employment picture has been improving in 2015, and most economists expect hiring to remain relatively strong. In May, the economy added 280,000 new nonfarm jobs, which followed 221,000 new jobs in April. The civilian unemployment rate stood at 5.5 percent in May, down from 5.7 percent in January.
“We’ve made great strides in improvement of the employment picture,” Pride says. “The most important thing is that we’re getting close to a key inflection point where the labor market is getting tight enough that businesses will have a hard time filling jobs. Therefore, they’re going to have to start compensating more, which will cause wages to rise.”
So what do these economic trends mean for investors?
The Federal Reserve has been broadcasting its intention to raise its key policy rate, the federal funds rate, this year, which will not be a surprise to the stock market. The central bank will be hiking interest rates in reaction to a stronger economy, and overall increases are likely to be minimal. The federal funds rate currently stands at zero to 0.25 percent, and analysts expect one or two 0.25 basis-point interest-rate hikes this year, at most.
“While we expect the Fed to modestly increase interest rates in late 2015, we do not believe this will have any meaningful negative impact on the economy or U.S. equity prices,” says Ernie Cecilia, chief investment officer at Bryn Mawr Trust, a Bryn Mawr, Pennsylvania-based wealth management firm.
He expects any interest rate hikes to move at a slow and deliberate pace. “In this environment, domestic equities can generate positive returns, albeit far less than what has been experienced over the recent past. Any increase in domestic equity prices is likely to be a function of increased corporate earnings,” Cecilia says.
Pride says stock investors should remain in equities but be selective. “Find individual values where you can take them, and tilt toward the international spectrum because that’s where the valuation opportunity is with economic improvement,” Pride says.
For long-term investors, asset allocation and diversification remain important.
“Today, bonds serve only one purpose, and that is to reduce near-term volatility. You can get more income from stocks than you can from bonds. Because bonds continue to be overvalued relative to stocks, investors should be at their maximum exposure to equities,” Smith says.
Written by Kira Brecht of U.S. News & World Report
(Source: U.S. News & World Report)