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CNB Economic Commentary:2013 Review and 2014 Preview

December 30, 2013
To: Everyone
From: Gregory S. MacKay, Senior Vice President & Chief Economist
Date: 12/27/2013

“2013 Review and 2014 Preview”

The Year in Review:

“Moderate, “muddle” and “modest” became the three most overused words in my vocabulary in 2013. At this time last year I was looking at the “fiscal cliff” as a probable cork in the consumer spending bottle, slower business spending, falling governmental spending and only slightly better exports. The offset to all the negatives was ongoing Federal Reserve stimulus, my hope for some fiscal advances, and benign inflation. The year 2013 looked like another year of modest expansion that would have few surprises. Neither a masterpiece, nor throw-away spin art.

Consumers seemed to take the fiscal cliff in stride early in the year, but slowed their spending increases as time marched on. While consumer spending rose 2.2% in 2012, final 2013 numbers look to be around 2.0%. Little mention of the social security tax hike was heard after the first quarter, but the ongoing debate of the effect of slow wage and job growth versus better stock and housing prices highlighted consumer spending discussions. Real wage growth in 2013 measured about 1%, or less, depending on the statistics used. The “half-full, half-empty” debate on jobs continued. There have been 2.3+ million jobs created in the past year, and the number of unemployed fell by over 700,000, but the unemployment rate is still above 7%, and the participation rate drags. Enthusiasts on the economy point to the soaring stock markets and home price improvements as the reason for better consumer confidence and increased spending. I thought consumer spending could increase 1.7% in 2013, and that number will be a little low, as both auto and household related spending increased nicely, albeit not at the 2012 rate.

Housing was generally upbeat in 2013. The S&P/Case Shiller Indices for home prices showed strong advances for the latest available 12 month data. Both the 20 city index and the 10 city index showed home prices rising over 13% from September 2012 to September 2013. Nationally, prices are now around late 2008 levels or still about 20% below the bubble top in 2006. New home sales for the past 12 months have risen 16.6% and the median price of $270,900 is 10.6% above year ago levels. Existing home sales showed the effects of interest rate increases and tighter credit. The median price for an existing home was $196,300 in November, up 9.4% from November 2012, yet inventory is 5% higher than a year ago. Annualized sales are slightly below the November 2012 levels, but median time on the market for homes dropped 20%. This seemingly conflicting data shows the average credit worthiness necessary for home buying has advanced substantially since the Great Recession.

Business spending rose about 7.6% in the past 12 months, a bit slower than 2012’s 9.5%. Dramatic increases in inventory levels could bring the full year 2013 level up a bit, and corporate profits have held up pretty well. The ongoing fiscal follies in Washington – everything from tax reform to Obamacare – have held back corporate hiring. Corporate balance sheets are ending 2013 in very good shape, with debt levels down and some cash flow going to retire stock.

And what a year it was in Washington. The “fiscal cliff” gave us increased social security taxation, marginally higher taxes on the super-wealthy, “sequestration”… and a healthy dose of Congressional budget infighting that ended with the first federal shutdown in 17 years. While the net economic effect of the shutdown appeared to be minor, total government spending for the past year fell about 1%, and is just starting to turn positive.

The export-import deficit improved slightly, as imported energy fell and exports improved slightly. Inflation remained tame (C.P.I. around 1.2% for the past 12 months), as energy costs fell at both the wholesale and consumer levels.

The year of 2013 produced the usual amount of over-the-shoulder analysis of the various business and economic releases. The “blame game” over the lack of pace in economic growth got a little murky. Business got blamed for a lack of hiring… who then blamed Congress for a lack of jobs programs and the uncertain cost and effectiveness of Obamacare…then Congress blamed the bankers for a lack of lending…then the banks blamed Congress for the Volcker Rule, Dodd-Frank, and Basel III, all programs intended to legislate against poor lending practices, but with the side effect of increasing loan costs… and Congress carried on with its usual fingerpointing across the isle of social spending and tax hikes versus defense spending and tax cuts. And everyone watched the Fed… trying to guess what it was doing.

Just this month the Federal Open Market Committee signaled a better economy by cutting bond purchases, and Washington passed a federal budget. The “tapering” of bond purchases had been anticipated for months, the budget was hoped for for as long. Mr. Bernanke and the Fed sent us a message that the economy had healed enough to begin the decoupling process of easy money. Congress reacted to public denunciation by passing a two year budget that doesn’t cut much spending and has yet to deal with the debt ceiling… but it’s the first real budget in 14 years.

The U.S. equity markets became the flavor-of-the-month, as excess business cash, and a public seeking higher returns than bond offerings pushed stock levels to new highs.

So What’s New For 2014?

GDP growth will be slightly better than in 2013, as ongoing monetary stimulus and some fiscal responsibility will ratchet into the system. The Fed’s message is that the expansion is now strong enough to begin to withdraw its unusual support. Congress appears willing to try to play nice. The ongoing quandary is a lot like your first seventh grade dance. Who to dance with? Who to talk to? Don’t want to look dumb – or be rejected. Do I lead or follow? Better go slow and see what happens… so will consumers or businesses lead?

My belief is that consumers are about to get their second wind. Job growth of over 200,000 in 3 of the last 4 months equals the best run since late 2011 into 2012. Consumer spending outpaced personal income in late 2013, and consumer confidence numbers continue to grow. While durable goods purchases led the 2013 spending list, I think non-durables will gather strength in 2014, adding to an ongoing better consumer spending climate. Faster job growth will bring fresh capital to the economy. Look for consumer spending to increase to something above a 2% increase over 2013.

Of course, caution will still reign. The knee-jerk reaction of housing sales to the sudden increase in mortgage rates this year is evidence of a lack of depth in buying power. Consumers are still tip-toeing toward spending, like the seventh graders moving toward the dance floor… but they continue to move.

I think housing will rally later in the year as the reality of 4% mortgages sinks in. Yup - the 3% era is gone, and at 4.5%, a $180,000 mortgage will cost about $100 a month more than last year. That’s not a deal stopper, and a stronger jobs market will increase demand again.

Business already seems to have bet on more consumer demand in 2014. As mentioned, inventory build-ups in late 2013 pushed GDP growth above 4%, as companies have plowed some profits back into goods and services to restock the shelves. I look for 2014 levels of business spending to increase at double digit rates again. Equipment spending, which lagged horribly in 2013, will rebound to near double digit rates again. While non-residential structures may cool a bit, residential building will continue at double digit levels.

With all of the turmoil surrounding governmental issues in 2013 (Obamacare, the shutdown, the fiscal cliff), somebody might suggest that 2014 has to be better. I’m in that camp. I don’t see the terrible headwinds of 2013 happening again, but we’ll all get to see how Congress wants to play early in the year as the debt ceiling is addressed. I do believe that there will be sufficient drama as both parties look for defensible positions to be used at election time. I don’t’ see another shutdown, but remember that the recent budget accord – that was so highly touted – only dealt with 1/3 of the total amount of federal government spending. That’s right – 2/3 of the federal budget is “non-discretionary” – and takes legislative action to fix. Having said that, it should be noted that the improving economy and some fiscal restraint lowered the budget deficit in 2013 to 4% of GDP from 10%. That’s great improvement which should continue into 2014. I just don’t see government spending adding or reducing GDP by more than 1% either way.

The global picture looks to be slightly better in 2014. It appears that the European Union is climbing out of its recession, but some political decisions remain as to how to better assimilate Fed like actions in Europe. China should remain the world GDP growth leader, but at a lesser pace. Emerging economies should have near normal growth. All of this suggests that U.S. exports could grow a bit next year, and with energy prices down, and U.S. production up, import levels may slow their gain. That all translates into an import imbalance that could shrink to under 2% from well over 3%.

Inflation will again be a non-event, but necessarily so. Without completely tame inflation, the Fed would have to ponder an increase in short term interest rates. At this point, that prospect is considered to be no closer than sometime in 2016, so any inflationary spikes would upset the apple cart. With energy prices remaining under control, I just don’t see inflation anywhere near 2% in 2014.

So for the record, here’s how I see 2014:

GDP (total year) +2.1% to +2.3%
CPI (total year) +1.6% to +1.8%
Unemployment Rate (12/14) 6.6% to 6.8%
Federal Funds Rate (12/14) .25%
3 Year Certificate of Deposit (12/14) .95% - 1.05%

Financial Markets:

Can we possibly have another great year in stock prices? As measured by the S&P 500, prices rose 14% in 2012, are up 23% thus far in 2013. Why not a triple-double? With some kind of accord in Washington, more jobs, better consumer attitudes and spending, businesses back to spending and a reasonable global advance, there’s no reason to suggest any kind of retrenchment. The only serious headwinds could come from bond investors that start to move back toward fixed income as the Fed continues to taper its bond purchases. With all the green lights mentioned above, corporate earnings will expand at a reasonable pace, forestalling any discussions about asset bubbles. Short of some social/political trouble, it looks like 2014 should be a positive year with stock prices rising 10% or so.