Market Commentary November 2013

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Market Commentary

ECONOMIC OUTLOOK The Outlook in Brief

Improved Financial Conditions; Fiscal Mess
The Feds decision to forego the start to tapering at the September policy meeting brought a welcome improvement in nancial conditions, which had been tightening since early May. This led us to revise up our forecast for 2014, but did not help enough to overcome a bit of weakening in near-term momentum. Incoming data for the third quarter suggested a somewhat weaker expansion of final sales (1.8% vs. 2.3%) and more inventory building than in last months forecast, leaving our projection of GDP growth unchanged at 1.8%.1 Thus, despite signs of strengthening momentum in some indicators of manufacturing production (ISMs) that we expect will contribute to a firming in GDP growth in the fourth quarter, we now expect more of a slowing in inventory accumulation will offset the expected firming in final sales. On balance, we have marked down projected fourth-quarter GDP growth to 2.1% from 2.6% last month. A rather sharp and beneficial reversal of financial conditions higher stock prices, firmer home prices, a lower dollar, and lower public and private borrowing costs as well as lower oil prices, compared to last months forecast, are expected to persist into 2014 and lift growth then by roughly percentage point, to 3.2%, versus 2.7% in last months forecast. The faster growth next year in this forecast pulls ahead some growth from 2015 and 2016, reflected in a slight downward revision in our forecast for those years to 3.2% and 3.4%, respectively. Receding fiscal drag, the waning effects of increases in yields, and continued improvement in credit terms all contribute to rming growth. Failure of Congress to agree on a funding bill for the government resulted in a shutdown and furloughing of non-essential personal. We estimate that a two-week shutdown trims fourth-quarter GDP growth relative to this forecast by 0.2 percentage point, but boosts first-quarter growth by 0.1 to 0.2 percentage point. The unemployment rate is expected to edge lower, balancing modest, but firming employment gains and a steady labor force participation rate through 2016. We expect employment gains through year-end 2013 to average roughly 160,000, rising to 225 thousand next year. The unemployment rate is projected to decline to 6.7% and 6.2% by the fourth quarters of 2014 and 2015, respectively. Core consumer price inflation (PCE) appears to have bottomed at 0.6% in the second quarter, lower than we expected. We project core PCE inflation at just 1.2% over 2013, rising to 1.6% in 2014, 1.8% in 2015, and 2.0% in 2016. We assume that the Fed will end QE3 in the second half of 2014, and that there will be no funds rate hikes until the third quarter of 2015. By the time QE3 is done, we expect the Fed to have purchased about $1 trillion of assets under this program. Our funds rate view is broadly consistent with the FOMCs rate guidance, which calls for no rate hikes at least as long as the unemployment rate remains above 6%.2

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The Outlook in Full

Financial conditions improved sharply following the Feds decision at its September meeting to forego the start to tapering. This partially reversed the sharp worsening in nancial conditions since early May. This led us to revise up our forecast of GDP growth for 2014, but did not help enough to overcome a bit of weakening in near-term momentum. The beneficial reversal of financial conditions higher stock prices, firmer home prices, a lower dollar, and lower public and private borrowing costs as well as lower oil prices, compared to last months forecast, are expected to persist into 2014 and lift growth then by roughly percentage point, to 3.2%, versus 2.7% in last months forecast. The faster growth next year in this forecast pulls ahead some growth from 2015 and 2016, reflected in a slight downward revision in our forecast for those years to 3.2% and 3.4%, respectively. Receding fiscal drag, the waning effects of increases in yields, and continued improvement in credit terms all contribute to firming growth over the next couple of years.
3 Percentage point

Contributions to Q4/Q4 GDP Growth

90 80

Household Balance Sheet Improving

Trillions of dollars

H
Total ne t w orth

PCE Change in inve ntorie s Nonre s. inv.

70 60

Re s. inv.

50 40 30 Equitie s ne t w orth

Othe r ne t w orth

20

Ne t e xports -1 2010

10

Re al e state ne t w orth

Gov't. C&GI 2012 2013 2014 2015 2016

2011

0 1991

1994

1997

2000

2003

2006

2009

2012

2015

Forecast published on October 2, 2013

Source: Federal Reserv e, Macroeconomic Adv isers; Forecast published on October 2, 2013

On the other hand, failure of Congress to agree on a funding bill for the government resulted in a shutdown and furloughing of roughly 800,000 non-essential personal. This, of course, only exacerbates the weakening near-term momentum. We had estimated that a two-week shutdown would trim fourth-quarter GDP growth relative to this forecast by 0.3 percentage point (pp), but first-quarter growth would be higher by 0.3 pp. A ruling that some 400,000 defense department workers were essential allowed them to return to work this week, sharply reducing the direct impact of the shutdown. As a result, with the shutdown now approaching the two-week mark, we reduced our tracking estimate of fourth-quarter GDP growth by two-tenths, to 1.9%. Spillovers to the rest of the economy so far appear to be muted, but could build the longer the shutdown continues. Customs inspectors are deemed essential and are on the job, allowing goods to move through ports. However, other government agencies (e.g., Consumer Product Safety Commission, The Food and Drug Administration, The Environmental Protection Agency, FAA) that normally need to issue approvals or releases for goods to enter commerce are significantly impacted by the shutdown, and anecdotal evidence suggests that normal trade is being disrupted. Ripple effects would be expected to build as well, the longer the shutdown continues. The 900-pound Gorilla in the room, however, is the potential to exhaust the so-called extraordinary measures (essentially borrowing from various government retirement funds) that have allowed the government to pay its bills since the debt ceiling was hit this summer. Current estimates place this in the range of October 22 to November 1. While it is mathematically possible to meet payments on interest and principle, it is not clear this is feasible given systems currently in place. Nevertheless, the cuts in spending required to allow incoming tax receipts to be prioritized for debt service would be so draconian that a sharp, brief recession would ensue, and, of course, the cuts would be highly disruptive to the economy through a myriad of microeconomic channels. As importantly, the approach to a potential default had already begun to rattle financial markets. One need look no further than the 300-point rally in the DJ Industrials Index on October 10 as news spread that a potential deal was in

Market Commentary

the works to permit a six-week delay in the point where the Treasury would effectively run out of cash. We will issue two reports next week on the adverse economic effects of this crisis-driven approach to fiscal policy.
Growth of Personal Consumption Expenditures
16 12 8 4 0 -4 -8 -12 -16 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Bureau of Economic Analysis, Macroeconomic Adv isers, LLC; Forecast published on October 2, 2013

4-quarter percent change Durable s

H F

20 19 18 17

Percent

Households Reducing Financial Obligations

Percent

5.0 4.5 4.0 3.5

Hous e hold financial obligation ratio* (le ft)

Se rvice s Nondurables

16 15

Cons um e r loan de linque ncy rate ** (right)

3.0 2.5

2.0 14 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
* The ratio of debt-service pmts. to disposable personal income, where debt-service includes estimated req'd. pmts. on outstanding mortgage and consumer debt, plus auto lease pmts., rental pmts. on tenant-occupied property, homeowners' insurance and property tax pmts. ** Nonaccrual loans and loans past due 30 days or more and still accruing interest. Source: Federal Reserve Board; Last data plotted for Q1-2013 (financial obligation ratio) and Q2-2013 (consumer loan delinquency rate).

Turning to the less sensational but still important issue of just how was the economy doing before these fiscal follies came to occupy our attention, incoming data for the third quarter suggested a somewhat weaker expansion of final sales (1.8% vs. 2.3%) and more inventory building than in last months forecast, leaving our projection of GDP growth unchanged at 1.8%. As a result, we now expect more of a slowing in inventory accumulation in the fourth quarter to damp slightly the expected firming in manufacturing production. This is despite signs of strengthening momentum in some indicators such as the ISMs. We have also scaled back somewhat the expected firming in final sales. On balance, we have marked down projected fourth-quarter GDP growth to 2.1% from 2.6% last month. As noted above the two-week shutdown (assuming it does not go much longer) will likely trim that to 1.9%. The arguments for expecting growth to firm over the next couple of years remain pretty much unchanged. We continue to expect that waning fiscal drag will contribute to a gradual strengthening of GDP growth over the next few quarters, as we move further beyond the hit to the level of government outlays and the rise in the levels of personal and payroll taxes. The tightening of financial conditions generally since May does delay the expected firming in growth, and as noted above, some of that tightening has been reversed. The lessening of drag from recent rise in the dollar (which tends to be front loaded) will also contribute to stronger growth after 2014. To be sure, increases in interest rates since May have weakened the outlook for interest-sensitive spending for equipment, nonresidential structures, and homes and are expected to exert drag on GDP growth for some time. However, those increases have merely pulled forward in time the increases we have long since expected, so in a very broad sense, they have merely delayed the firming in GDP growth we expected without fundamentally altering our expectation that growth will indeed improve over time.
2200 2000 1800 1600 1400 1200 1000 800 600 400 1987 1991 1995 1999 2003 2007 2011 2015 Re side ntial inve s tm e nt (right) Private hous ing s tarts (le ft) SAAR, thous. units

Housing Starts and Residential Investment

H F

4-quarter percent change

50 40 30 20 10 0 -10 -20 -30 -40

20 15 10 5 0 -5 -10 -15

4-quarter percent change

Home Prices Begin a Solid Recovery

Nom inal H F 20 15 10 5 0 -5 -10 -15 -20

Re al

-20 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
Source: FRB, Macroeconomic Adv isers, LLC; Forecast published on October 2, 2013.

Source: U.S. Bureau of the Census; U.S. Department of Commerce; Macroeconomic Adv isers, LLC; Forecast published on October 2, 2013.

ZACKS INVESTMENT MANAGEMENT

Firming PCE growth, from an average of 2.0% in the first half of 2013 to 2.3% in the second half, followed by 3% or higher from 2014 to 2016, helps account for our forecast of a gradual firming in GDP growth, especially in late 2013 and in 2014. Recent, past, and prospective sharp increases in household net worth contribute to our forecast of solid PCE growth. Over the last four quarters, household net worth has jumped 11.5%, with a little less than one-half of the increase due to equities, about one-third tied to real estate, and the remainder accounted for by other components, such as increases in the stocks of consumer durables. Sharp increases in house prices have been a signicant contributor to improving household balance sheets: the CoreLogic HPI has risen nearly 18% since the end of 2011 and over the 12 months ending in July is up 12.4%. Rising demand for housing, reinforced by the inevitable push from demographics, has put upward pressure on prices as the stock of vacant homes available for sale has shrunk in an environment where home construction continues to run well below long-run trends in household formation. Looking ahead, we expect the rate of growth in house prices to moderate but remain an important contributor to increases in net worth: from the fourth quarter of 2013 through 2016, we assume house prices will rise between 3% and 5% at annual rates. Over the entire forecast period, we assume household net worth will expand by more than $11 trillion, with a little over 50% from housing, approximately 30% from equities, and the remainder from other components such as increases in stocks of consumer durables. Large increases in housing wealth are particularly important, because we nd that increases in housing wealth translate into consumer spending with a much shorter lag (largely within two quarters) than do increases in equity wealth (whose wealth effects on consumption take several years to be fully realized). Home construction has a long way to go to catch up the pace of building needed to house the nations growing number of families. Housing starts which have recently risen to around 900,000 units (annual rate) will need to average roughly 1.59 million over the next decade. That is a 76% rise! This assumes declines in vacancy rates to their historical average, and middle-range population projections. The associated boost to construction employment and the manufacture of housing materials will make housing construction a healthy contributor to GDP growth for the next several years. If immigration reform is realized, and immigration rises to rates widely anticipated, the pace of housing starts may need to rise by another 400,000 per year on average during the rst decade following reform. Downside risks associated with the euro zone continue to fade as the recovery there appears to gain traction. Concerns over a hard-landing in China are also receding, as are fears of wider conflict in the Mideast associated with the civil war in Syria. Waning uncertainty will permit a return of the kind of risk-taking activity that drives economic growth, such as decisions to hire, invest, and make long-term purchase decisions. We place considerable importance on the reduction of uncertainty as a force that will allow growth to rm.
Exports, Imports, and Net Exports
400 Billions of chain-type (2005) dollars Exports (right) Im ports (right) 4-quarter percent change H F 20

200

10

-200

-10

-400 Ne t e xports (le ft)

-20

-600

-30

-800 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

-40

Source: Bureau of Economic Analysis, Macroeconomic Adv isers, LLC; Forecast published on October 2, 2013

Market Commentary

IMPROVED FINANCIAL CONDITIONS THIS ROUND LIFT GROWTH IN 2014-2015 Half empty or half full? While 2% growth (our average since the end of the recession) is weak, one cant help but think the U.S. has fared reasonably well considering the fiscal drag (including the big tax increases at the start of the year as the payroll tax holiday expired and the high-income tax rates were increased), waves of uncertainty out of Europe and elsewhere, the hangover of the massive hit to household wealth occasioned by the nancial crisis and a host of other forces of restraint. Add to that a partial government shutdown and the possibility of an encounter with the federal debt ceiling! Despite these challenges, GDP advanced at a 2.5% annual rate in the second quarter, up from 0.6% annualized growth over the prior two quarters, and is forecast to increase at a 2.0% annual rate over the second half of this year. The near-term resilience is due largely to solid gains in home and equity values last year and so far this year. These developments have bolstered consumer spending, even as real disposable income took a large hit this year from higher taxes. Following 1.9% growth over the four quarters of this year, we look for 3.2% growth next year and 3.3% growth averaged over 2015 and 2016. Contributing to firming GDP growth is a quickening pace of consumer spending growth. Several factors account for the expected improvement in consumer spending. First, household net worth (nominal) is rising strongly. After rising 9.2% last year, it is projected to rise 10.9% this year and 5% next year, driven mainly by gains in house prices and equity values. (See nearby chart.) Our model of consumer spending suggests a long-run marginal propensity to consume of roughly $0.05 per dollar of wealth. Thus, continued strong gains in real wealth lend considerable support to PCE growth. Second, consumer spending is and will continue to benet from the release of pent-up demand in the auto sector. Since taking a hit during the recession, the stock of consumer motor vehicles and parts remains below our estimate of the desired stock. This will contribute to rising light vehicle sales through the end of the short-term forecast.
Growth of Nonresidential Fixed Investment
40 30 20 10 0 -10 -20 -30 -40 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Bureau of Economic Analysis, Macroeconomic Adv isers, LLC; Forecast published on October 2, 2013

4-quarter percent change

H F

Commercial Real Estate: Not Tight, But Tightening

20.0 17.5 15.0 12.5 Percent National office vacancy rate : m e tropolitan areas
H F

4.4 4.0 3.6 3.2 2.8 2.4 2.0 2016

Com pute rs and inte lle ctual prope rty products

Non-com pute r e quipm e nt

10.0

Structure s

7.5 5.0 1988 National indus trial availability rate 1992 1996

Nom inal nonre s ide ntial inve s tm e nt in structure s as a % of nom inal GDP 2000 2004 2008 2012

Source: CB Richard Ellis, last data plotted for Q2-2013; Macroeconomic Adv isers, LLC, Forecast published on October 2, 2013

Third, household debt relative to income is shrinking. Credit market debt as a share of disposable income has declined from a pre-recession peak of 129% to 104% as of the second quarter of this year. This was accomplished through the solid but temporary rise in the saving rate during the recession and in the immediate aftermath. The personal saving rate briefly exceeded 7% then fell back to roughly 5% averaged over 2012 and 4% by the second quarter of this year. To some extent, debt forgiveness also contributed to the decline in household debt, and of course, disposable income has continued to trend higher, reducing the relative burden of any given amount of debt. The debt ratio has returned to levels seen in 2002, suggesting that household balance sheet deleveraging has come a long way. No one can say where this process will end, but we suspect it has nearly run its course. Where the debt ratio troughs in this cycle will depend in large measure on how quickly lenders of all sorts ease credit terms. Relatedly, the burden of household debt is falling. As a share of disposable personal income, household payments to service various types of debt and for various other commitments (e.g., leases, insurance, taxes) have dropped sharply since the end of the recession. While some of the decline in this financial obligations ratio reflects declines in debt from debt forgiveness, some also reflects the pay down of debt, record-low interest rates, and rising employment and income.

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Fourth, delinquency rates on consumer loans have declined to effectively record-low levels. This suggests the prospect of continued easing of credit terms, increased bank willingness to make consumer loans and further expansion of consumer debt that will provide additional support to consumer spending. Finally, labor income is expected to benefit from an eventual firming of growth of payroll employment. Following gains that averaged 195 thousand per month over the first half of this year, payroll employment is expected to decelerate to gains averaging 144 thousand during the third quarter and 159 thousand during the fourth quarter. This deceleration can be thought of as a delayed response to the slowing of GDP growth late last year and early this year. As GDP growth firms, though, payroll gains are expected to move up, averaging 226 thousand per month next year and 235 thousand per month in 2015. The associated improvement in growth of labor income will provide a boost to PCE. The housing sector continues to power along, fueled by strong investor interest, a continued release of pent-up demand by current and potential home owners, modest loosening of mortgage credit terms, and renewed builder optimism. We look for housing starts of 920 thousand this year, 1,227 thousand next year, 1,549 thousand in 2015, and 1,654 thousand in 2016 the trend in starts is firming. Over the last several years, housing starts had been held down by elevated vacancies, tight lending conditions, and declining home prices. These sources of drag are giving way to more favorable conditions, allowing housing starts to move up. Our analysis of the long-term prospects for housing, based upon a careful analysis of demographic trends and a return to normal vacancy, demolition, and conversion rates, suggests that the level of housing starts during the 20112020 period should average about 1.55 million units per year. Given that we built homes through the first half of this year at just over a 900 thousand pace, housing starts clearly have a long way to rise, and there will likely be some over-shooting of the 1.55 million pace at some point over the next decade. Key to a sustained and strong recovery is the upturn in home prices. The CoreLogic house price index rose 8.8% last year (December to December). Similar indexes from FHFA and S&P/Case-Shiller rose 5.7% and 6.9%, respectively. Home prices have accelerated this year. The CoreLogic index increased through August at a 13.6% annual rate, while the FHFA and S&P/Case-Shiller indexes increased through July at annual rates of 10.7% and 15.1%, respectively. We assume house prices will continue to move higher, albeit at a markedly slower rate. We look for the CoreLogic index to rise 10.9% this year, 4.7% over 2014, 3.6% in 2015, and 3.5% in 2016. Falling/rising home prices create a vicious/virtuous cycle. Potential buyers, typically asked to put down 20% or more, risked seeing their equity wiped out in a year or two when home prices were declining at a 10% to 20% rate. With home prices now rising from exceptionally affordable levels, buyers are enticed into the market, both because prices are low and because they are rising! Rising housing equity supports an increase in demand for housing and leads to more strength in home sales, which supports additional increases in home prices and further stokes an improvement in demand. Sounds like a familiar story. The expectation of rising prices reduces the user cost of owning a home and boosts the demand for housing while also improving the environment in which decisions for mortgage nance are undertaken. This dynamic is a welcome development in a sector with plenty of room for recovery.
1800 Index, 1941-43=10

S&P 500 and 10-Year Treasury

Percent

3.0

1700
10-year Treasury note (right)

2.5

1600
S&P 500 (left)

2.0

1500

Sept. 18 FOM C M eeting

1.5

1400 Dec 31 2012

Feb 25 2013

Apr 22 2013

Jun 17 2013

Aug 12 2013

1.0

Source: WSJ, FRB, Hav er Analytics; Last data plotted for Oct. 2, 2013

Market Commentary

The broad, nominal dollar has unexpectedly softened over the last several weeks, suggesting more support from the trade sector in this months forecast than in last months forecast. From early September to early October, the broad, nominal, trade-weighted value of the dollar declined about 2%. This was a decrease we had not anticipated. The dollar in this months forecast, therefore, begins roughly 2% below last months forecast. This gap persists and even widens somewhat throughout the short-term forecast and helps to explain why we expect more of a contribution to GDP growth from net exports in 2014 (three-tenths more), 2015 (one-tenth more), and 2016 (two-tenths more) than in last months forecast.
104 Index (Jan 1997 = 100)

Broad, Nominal, Trade-Weighted Dollar

103

102

101

100
Sept. 18 FOM C M eeting

99

98 Dec 31 2012 Feb 25 2013

Apr 22 2013 Jun 17 2013 Aug 12 2013

Oct 7 2013

Source: Federal Reserv e Board of Gov ernors; Last data plotted for October 4, 2013

Leaving aside the comparison to last months forecast, both exports and imports are expected to accelerate in 2014. After rising 2.4% last year, real exports of goods and services are forecast to rise 3.7% this year and 7.0% in 2014. This occurs as our trade-weighted measure of foreign GDP growth rises from 2.2% last year to 2.5% this year and 3.0% next year. Real imports of goods and services also accelerate from growth of 0.1% last year to 3.0% this year and 7.6% next year. Accelerating imports reflect firming domestic demand. While net exports are expected to be roughly neutral for GDP growth this year (after contributing three-tenths to growth last year), imports rise more than exports (in absolute terms) and real net exports decline enough next year to shave three-tenths from GDP growth. After that, the balance turns, as real exports rise at an average annual rate of 7.2% over 2015 and 2016 and real imports rise at an average annual rate of 4.1%. Real net exports rise enough to add two-tenths to GDP growth in 2015 and five-tenths in 2016.
10 Percent

1st Policy Rate Hike in 2015, but Long Rates Begin to Rise
Conve ntional m ortgage rate

10-ye ar T-note yie ld

4 Fed funds rate 2

0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Federal Reserv e Board, Macroeconomic Adv isers, LLC; Forecast published on October 2, 2013

The pace of inventory-building is expected to moderate this year and next before turning up in 2015 and 2016. The moderation this year and next reflects a couple of factors. First, a deceleration of final sales from 2.5% last year to 1.7% this year contributes to the moderation in nonfarm inventory investment this year and next. Second, as farm output recovers from last years drought, farm inventories build rapidly this year, propping up total inventory investment. But in 2014, the pace of farm inventory investment drops markedly, contributing to the slowing in total inventory-building.

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Beginning in 2015, when the dynamic in farm inventories has largely run its course, total inventory investment rises to reflect firming growth of final sales. Spending on business equipment and intellectual property products combined (EQ&IPP) is expected to moderate this year, but then firm over the balance of the short-term forecast. Following 3.9% growth over the four quarters of last year, EQ&IPP is forecast to slow to grow of 2.5% this year. The moderation in growth reflects rising borrowing costs and fiscal uncertainty. In 2014, growth of EQ&IPP firms to 3.6%, as the positive effects of firming growth of output outweigh the negative effects of the expiration of bonus expensing provisions at the end of this year. For 2015 and 2016, growth of EQ&IPP is forecast to rise to 4.6% and 5.1%, respectively. This improvement reflects continued firming growth of output, narrowing risk spreads, and the absence of drag from the special factors (noted here) holding down growth this year and next. Commercial real estate markets are improving slowly, and structures investment is responding. But because of the small share in GDP, structures investment is not expected to contribute much to GDP growth over the next few years. Commercial vacancy rates, both office and industrial, have been trending down since mid-2010. After languishing near cyclical lows from 2010 through early 2011, real spending on business structures has rebounded sharply. This is due at least in part to the tightening of commercial real estate markets. But it also reflects the fracking revolution that has given rise to booming spending on mining and exploration. As this process continues, and as commercial real estate markets continue to tighten, we expect real spending on business structures to rise at a moderate rate. From the second quarter of this year to the end of 2016, business spending on structures is forecast to rise at a 2.3% average annual rate, 0.8 percentage point below the rate of growth of GDP. Given a rising relative price of business structures (relative to the GDP price index), this just offsets the slower real growth and keeps nominal spending on business structures, as a share of nominal GDP, roughly unchanged at 2% over the short-term forecast. FISCAL POLICY: SHUTDOWN SIDESHOW, DEBT THREAT This forecast was completed before, and so does not reflect, the shutdown of the federal government that began October 1 and that is now in its second week. Elsewhere we have estimated that the direct effect (the lost value of services produced by federal workers, measured by their compensation) of a two-week shutdown is to shave 0.3 percentage point from fourth-quarter GDP growth, and add the same amount back in the first quarter of next. However, a recent legal ruling allowed the Department of Defense to classify as essential almost all the 400,000 civilian defense workers furloughed October 1, thereby reducing the direct impact of a two-week shutdown to about 0.2 percentage point of fourth-quarter growth. Because the shutdown started early in the quarter, we believe any spillovers to the private sector will be largely reversed within the quarter. Hence, unless it lasts longer, the shutdown is more an overall inconvenience than an economic catastrophe. The forecast also assumes the debt ceiling is raised without incident. However, the failure of Congress and the Administration to resolve their political impasse has raised the chances that the debt ceiling will become binding within the next couple of weeks, constituting a potentially significant downside risk to the forecast. Of course the result of exhausting the extraordinary measures that allow the Treasury to continue to pay the governments bills is so catastrophic we can only assume the probability is really quite small. They wont really let that happen, will they? The drag on growth from that risk would not necessarily be eliminated by a last-minute deal to raise the debt ceiling. Any such deal might be short-term, providing just a brief respite from near-term policy uncertainty. Furthermore, in August of 2011 much of the damage to nancial markets occurred when rating agencies downgraded Treasury debt in the week after the President enacted the Budget Control Actthe legislation that, by lifting the debt ceiling, averted the immediate crisis. We do not expect a debt default, but we do believe that hitting the debt ceiling even briefly could cause the next recession. In a forthcoming piece slated for publication next week, we describe two such scenarios. Apart from the shutdown and the threat of default, the diminution of fiscal restraint will provide the economy a muchneeded boost in 2014. This year (2013) has been a year of considerable fiscal drag. There were three tax increases: (a) the expiration of the Payroll Tax Holiday; (b) the implementation of a new, higher top marginal personal tax rate; (c) and new income and social insurance taxes associated with the Affordable Care Act. Together these tax hikes amount to roughly $200 billion at an annual rate. In addition, we estimate that by the fourth quarter of this year the sequestration will have reduced the level of federal spending by about $85 billion relative to the spending caps set under the Budget

Market Commentary

Control Act of 2011. All this will subtract between 1 and 1 percentage points from GDP growth this year. In the MA forecast there are three sources of new fiscal drag in 2014: (a) an additional but modest $12 billion in spending cuts along the ramp-up towards the full run rate of the sequester; (b) the expiration of extended and emergency unemployment benefits, the effect of which is small given the dwindling numbers receiving these benefits; (c) and the wind-down of provisions of previous stimulus, the most important of which is the final expiration of bonus expensing. We estimate that the impact will be to reduce GDP growth in 2014 by between and percentage point. Hence, the diminution of fiscal drag between 2013 and 2014 should boost GDP growth in 2014 by approximately 1 percentage point. LARGER EMPLOYMENT GAINS IN THE FORECAST FOR 2014 AND 2015 Relative to last months forecast, we revised up our forecast of employment gains in 2014 and 2015, but in most respects, forecasts of labor market conditions are broadly similar to last month. We continue to anticipate that nonfarm payroll employment will rise by an average of about 160 thousand per month from September to December. Furthermore, we expect that as real growth strengthens, employment gains will improve to average about 225 thousand in 2014 and approximately 235 thousand in both 2015 and 2016. Relative to last months predictions, the average for 2014 is about 35 thousand higher, the forecast for 2015 is about 20 thousand higher, and the forecast for 2016 is about 10 thousand lower. We continue to expect that the unemployment rate will drift down gradually, from 7.3% as of the last published figure (in August) to 6.7% as of the fourth quarter of 2014, 6.2% in the fourth quarter of 2015, and 5.7% in the fourth quarter of 2016. With larger employment gains in the forecast, the unemployment rate falls slightly faster than before. In the forecast, it falls to 6.5% (an important level for monetary policy) in the second quarter of 2015, one quarter earlier than in last months forecast. Underlying our forecast for gradually increasing employment gains is a rming in productivity growth that is more gradual than the increase in output growth, along with a very slight increase in the average workweek. Productivity growth in the nonfarm business sector is projected to rise from about 1.0% in the second half of 2013, to 1.6% in 2014, 1.8% in 2015, and 1.9% in 2016. On average, productivity growth in the forecast is slightly lower than last month. We assume that the average workweek will drift up slightly, from 32.4 hours in the third quarter, to just round up to 32.6 hours in the fourth quarter of 2016; the path of the workweek is similar to before. The labor force participation rate is subject to competing forces in the forecast. Structural factors, including populationaging, increasing educational involvement, and an increasing share of working-age adults receiving disability benets, are expected to continue to exert downward pressure on the participation rate. In the forecast, these forces are roughly offset by the reversal of temporary factors high unemployment and record high duration of unemployment that have previously pushed down the participation rate. On balance, we assume that the participation rate will edge up from 63.2% in August to average 63.3% in the fourth quarter, remain at either 63.2% or 63.3% through mid-2015, then increase slightly, reaching 63.5% in the second half of 2016. HAS CORE INFLATION BOTTOMED OUT? The steady decline in core PCE inflation that began last year appears to have ended. The twelve-month core PCE inflation rate, which was as high as 2.0% early last year, remained at just 1.2% for four of the last five months. This is broadly consistent with the twelve-month change in the market-based core PCE price index excluding imputed components such as financial services furnished without payment which also has remained nearly flat over the past five months. Although 12-month changes have been steady of late, the annualized three-month core PCE inflation rate rose to 1.7% in August, the highest in a year. The three-month market-based core inflation rate stands at 1.6%. Signs that core inflation may have bottomed out are consistent with our model-based forecast that the trend in core inflation will rise gradually. Elevated slack (high unemployment) and a strengthening dollar, which contributes to soft import prices, both combine to restrain inflation, while stable inflation expectations (at 2.0%) gradually pull inflation up toward that pace. With diminishing slack in our forecast and inflation expectations assumed to remain anchored at 2%, we expect the core PCE price index to rise at a 1.5% rate in the second half of 2013, followed by steadily larger increases in 2014, 2015, and 2016 of 1.6%, 1.8%, and 2.0%, respectively.

ZACKS INVESTMENT MANAGEMENT

Annualized % chg.

Core PCE Inflation: Alternative Horizons

4

12-m onth

3 3-m onth 2

1 6-m onth

-1 2007

-1 2008 2009 2010 2011 2012 2013

Source: Bureau of Economic Analysis; Last data plotted for August 2013.

After no change over 2012 (0.0%), nonpetroleum import prices are expected to be restrained in 2013 (declining 1.0%) and 2014 (increasing 0.5%) to reflect a strengthening of the broad, nominal, trade-weighted index of the dollar. The broad, nominal dollar is projected to rise 1.8% this year and 2.4% in 2014, followed by much smaller changes in 2015 (-0.1%) and 2016 ( 0.3%). As gains in the broad, nominal dollar shrinks after 2014, nonpetroleum import prices are projected to strengthen, with increases in 2015 and 2016 of 2.0% and 2.6%, respectively. DELAY OF FED TAPER CONTRIBUTES TO IMPROVEMENT IN FINANCIAL CONDITIONS Financial markets cheered the FOMCs announcement on September 18 that it would delay the start to tapering asset purchases, with rallies in both bond and equity markets. On that day, the S&P500 rose 1.2% to 1,726 and the 10-year Treasury yield fell 17 basis points to 2.69%. Over the next couple of weeks, broad stock indices gave back some of their previous games, while on balance term Treasury yields eased a bit further. On the whole since the time of our previous forecast, the S&P 500 gained 2.4% to close at 1,695 on October 1, the 10-year yield fell 32 basis points to 2.66%, the Baa corporate bond yield fell 6 basis points, the conventional mortgage rate fell percentage point, and the broad, nominal trade-weighted index of the dollar declined 1.7%.3 Improvements in financial conditions were not limited solely to the US: a variety of benchmark foreign equity indices also posted gains between September 5 and October 1, from approximately 1% to more than 4%. The Feds announcement was a major factor in the recent improvement in financial conditions, but it was not the only factor. Most of the recent decline in the broad, nominal dollar occurred prior to the FOMCs announcement, as it fell from 103.3 on September 5 to 101.7 as of September 16, before easing a bit further to 101.4 as of September 27 (the most recent available at the time of this forecast). Signs that foreign economies are improving, including an improved outlook for near-term GDP growth in the euro zone, contributed to the recent softening in the broad, nominal dollar following its earlier run-up. In addition, both domestic and overseas equity indices had been climbing even before the Feds announcement. In fact, the S&P500 rose about 3.0% between September 5 and September 17, the day before the Feds announcement. The recent improvement in nancial conditions contributed importantly to downward revisions to forecast assumptions for Treasury yields, private long-term interest rates, and the broad, nominal dollar; and in an upwardly revised assumption for equity wealth. Relative to our previous forecast, the 10-year Treasury yield is on average 37 basis points lower, the Baa corporate bond yield is 25 basis points lower, and the conventional mortgage rate is 44 basis points lower. (Comparisons are for forecasts through 2016.) Some of these reductions, particularly after the first few quarters of the forecast, stem from our analysis pointing to slower underlying trend growth, which implies lower long-run targets for real interest rates. In this months forecast, we lowered our long-run target for the real funds rate to 2% from 2%, and we lowered our long-run forecasts for long-term yields by similar amounts. We also lowered the path of the broad, nominal dollar in the forecast to reflect its recent softening: on average, it is about 2.3% lower than in last months forecast.

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Market Commentary

Based on broad stock indices such as the Wilshire 5000, we estimate that household equity wealth rose about 6% over the third quarter (about $1.6 trillion), extending the recovery in equity wealth that began in 2009. We estimate that as of the end of the third quarter, household equity wealth was about 12% higher than at the previous peak, in the third quarter of 2007. We estimate that the third-quarter gain in equity wealth was about $1 trillion larger than anticipated in our September 6 base forecast, implying considerably larger wealth effects that boost consumption going forward. Larger wealth effects were reinforced by recent declines in energy prices, and by large gains in house prices. We estimate that overall household net worth rose $2.5 trillion during the third quarter, with about $0.8 trillion of that accounted for by housing wealth. Looking ahead, we expect overall household net worth to rise some $9 trillion from the end of the third quarter to the end of 2016, with more than one-half from housing, about one-fourth from equities, and the remainder from consumer durables and other net worth. The cumulative change in net worth over the forecast horizon is about the same as in last months forecast, but because the jump-off at the end of the third quarter is higher, the entire path of net worth is higher than before. MONETARY POLICY: HIGHLY ACCOMMODATIVE We assume that the Fed will extend its ongoing asset-purchase program (QE3) until the second half of 2014, when the unemployment rate will be close to 7%. By the time QE3 is done, we expect the Fed to have purchased about $1 trillion of assets under this program. We anticipate no funds rate hikes until the third quarter of 2015. Our funds rate view is broadly consistent with the FOMCs rate guidance, which calls for no rate hikes at least as long as the unemployment rate remains above 6%. In our forecast, the unemployment rate reaches 6%the threshold embedded in the rate guidanceclose to the middle of 2015, when we expect core PCE inflation to be running around 1.8%.

Unless otherwise noted, all quarterly growth rates are expressed as compound annual rates, all expenditure components of GDP are chained 2005 dollars, and all annual growth rates are stated as fourth-quarter over fourth-quarter.
1

The Federal Open Market Committee (FOMC) is the Feds main policy-making body comprised of the seven governors of the Federal Reserve and presidents of 8 of the 12 Federal District banks on a rotating basis.
2

Changes are measured based on financial data from September 5 and October 1, representing closing values that were available at the time of our previous forecast and the one covered by this report.
3

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Market Commentary

History Real GDP & Components GDP Personal Consumption Expenditures Business Fixed Investment Real Activity Private Housing Starts (thous units) Light Vehicle Sales (mil units) Industrial Production (% ch, a.r.) Manuf. Capacity Util. (%) Unemployment Rate (%) Prices, Productivity, & Costs CPI (all urban) Core CPI (all urban) PPI (finished goods) Compensation Per Hour Output Per Hour Price of WTI Crude Oil ($/barrel) Selected Interest Rates Federal Funds Rate 10-Year Treasury Bond Yield Baa Corporate Bond Yield Incomes & Related Measures Corporate Profits HH Net Worth, Equities (qrtrly rate) Federal Surplus (FY, Uni, bils $)
Source: Macroeconomic Advisers, LLCSM 2013.2

2.5 1.8 4.7 869 15.5 0.7 76.0 7.5 0.0 1.4 -1.2 2.3 1.8 94.2 0.12 2.00 4.84 13.9 1.6 363

% change annual rate 1.8 2.1 2.8 3.2 3.3 3.3 1.5 3.0 2.8 3.4 3.5 3.4 2.5 3.4 2.4 2.9 4.0 4.2 quarterly averages, unless noted 901 954 1074 1172 1275 1388 15.7 15.8 15.8 16.1 16.4 16.6 1.9 2.1 -0.7 3.6 4.6 4.8 76.0 76.0 76.1 76.5 76.9 77.4 7.3 7.3 7.2 7.0 6.9 6.7 % change annual rate, unless noted 2.7 1.4 1.5 1.4 1.5 1.6 1.8 1.7 1.6 1.7 1.8 1.9 3.9 0.5 -0.3 0.0 0.3 0.5 1.3 1.6 2.4 3.0 2.9 3.2 0.8 1.1 1.4 1.7 1.6 1.7 106.1 103.2 100.1 97.1 94.8 92.9 quarterly average (%) 0.15 0.15 0.15 0.15 0.16 0.18 2.69 2.65 2.70 2.72 2.80 2.91 5.40 5.35 5.38 5.35 5.43 5.52 % change annual rate, unless noted -4.1 -4.2 2.7 4.2 4.4 4.9 6.7 1.8 3.3 1.9 1.5 1.1 -357 -861 -1011 -443 -651 -715

2013.3 2013.4 2014.1 2014.2 2014.3 2014.4

2012

2013

2.0 2.0 5.0 783 14.4 2.8 75.8 8.1 1.9 1.9 1.7 5.3 0.9 94.2 0.14 1.80 4.93 2.7 13.9 -1089

q4/q4 1.9 3.2 3.2 3.4 2.1 3.3 2.9 2.9 1.4 3.4 3.9 4.6 annual avg. 920 1227 1549 1654 15.5 16.2 16.7 16.7 2.2 3.1 4.7 4.7 76.1 76.7 78.5 79.8 7.5 6.9 6.4 5.9 q4/q4 1.4 1.5 1.8 2.0 1.7 1.8 2.0 2.2 0.9 0.1 0.8 1.3 0.0 2.9 3.2 3.4 0.5 1.6 1.8 1.9 99.5 96.2 89.0 85.0 annual avg. 0.14 0.16 0.34 1.73 2.32 2.78 3.31 4.05 5.10 5.42 5.81 6.29 q4/q4 -0.2 4.1 5.3 7.4 20.4 8.0 0.0 -0.8 -599 -741 -620 -551

2014

2015

2016

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This article is provided for informational purposes only and does not constitute legal or tax advice. Zacks Investment Management, Inc. is not engaged in rendering legal, tax, accounting or other professional services. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. The original content of this document was modified to more accurately reflect the expectations of Zacks Investment Management.

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