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Dr. Kelly's Commentary: Checking the Speedometer on the U.S. Economy

Dr. Kelly's Monthly Commentary for January 2014.

DOCUMENT | JAN 17, 2014

Dr. David Kelly, CFA
Managing Director
Chief Global Strategist
J.P. Morgan Funds
A combination of mixed economic numbers and strong political bias, in the news media and even the Federal Reserve, has left many confused about the pace of economic growth. However, a careful assessment of the data can help clear up some of this confusion, and the over-riding reality is that any steady pace of economic improvement, be it in second, third or fourth gear, is likely consistent with gradually rising interest rates. An upward trend in interest rates still supports the case for a mild overweight to equities over fixed income, as well as the idea of greater global diversification.

On the economy, the two central questions are (1) how fast is real output growing? and (2) is the pace of output growth strong enough to produce meaningful job gains?

On the first question, the government will release their advanced estimates of fourth quarter GDP at the end of January. In the year ended in the third quarter, real GDP grew by 2.0%. However, it has gradually been accelerating and we believe that it could average 3.0% or more over the course of 2014, representing the strongest gain in output seen since 2005.

The reason for this advance is straight forward. This year, unlike the last few years, all major sectors of demand should contribute to economic growth.

  • Consumer spending should continue to grow, powered in part by huge gains in wealth.
  • Capital spending could accelerate as employment finally pushes through its old peaks, increasing the demand for both office space and equipment.
  • Housing should continue to recover as home-building is still well below normal and financing, even after recent increases in home prices and mortgage rates, remain very affordable.
  • The government sector could actually add to output in 2014 as federal austerity fades and state and local governments slowly expand.
  • Finally, a broad, albeit modest, expansion in the global economy should help our trade sector.
Moreover, this roughly 3% real GDP growth rate should be more than enough to produce solid gains in employment and declines in the unemployment rate. Over the past 10 years, while payroll employment has risen by 0.5% per year, real GDP has risen by 1.7% per year giving an annual growth in output per employee (a rough measure of productivity) of just 1.2%. This is weak by historical standards and partly because of insufficient long-term investment spending. However, presuming this productivity problem isn’t fixed any time soon, a 3% real GDP growth rate over the course of 2014 could imply annual job growth of 1.8% or just over 200,000 jobs per month. While job growth fell far short of this in December, partly due to weather effects, it is likely to reaccelerate towards this pace in the months ahead.
Equally important, largely because of a wave of retirements among baby-boomers, the U.S. labor force has hardly grown at all over the past five years and actually shrank in the year ended in December. Even if it were to grow at a 0.7% pace in the year ahead, a 1.8% growth in total employment would cut the unemployment rate from 6.7% in December 2013 to 5.7% in December 2014. If it were to do so and wages began to rise more quickly in response, long-term interest rates should continue to move higher and markets would begin to price in a first increase in the federal funds rate in early 2015.

Such a scenario should be relatively positive for equity markets and negative for fixed income markets, suggesting a mild over-weight towards stocks over bonds. However, it is also important to recognize the legacy of 2013 when the S&P500 rose by 29.6% and ten-year Treasury rates increased from 1.78% to 3.04%, far above equity gains elsewhere in the world or interest rate rises in other developed countries.

These market movements mean that stocks are not nearly as cheap, nor bonds nearly as expensive, as they were a year ago. For investors, this suggests that 2014 may be a year of less gain in U.S. equities with less pain in U.S. bonds, but also a year in which it makes sense to increase allocations towards other parts of the world which saw less spectacular equity gains in 2013.

Any performance quoted is past performance and is not a guarantee of future results.

Diversification does not guarantee investment returns and does not eliminate risk of loss.

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

J.P. Morgan Funds are distributed by JPMorgan Distribution Services, Inc., member of FINRA/SIPC.

©  JPMorgan Chase & Co., January 2014

Topics: U.S. Recovery