The Independent Market Observer

7/16/13 – Slowdown, Tapering, and Interest Rates

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jul 16, 2013 10:42:57 AM

and tagged Market Updates

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Many of the economic stats coming out now are pretty weak. Over the past couple of days, headlines announced that economic growth had fallen short of expectations, with growth for the second quarter quite possibly below 1 percent.

This news is consistent with many of my recent discussions with economists and investment pros. I had a fascinating call the other day in preparation for a chief investment officer panel I’m sitting on at a Financial Advisor magazine conference next week. One of the prominent CIOs who will also be on the panel laid out, chapter and verse, why our current recovery is a mirage.

Yet, when charged with being a bear, he denied it, saying he was just trying to spark a discussion. I get it—I do the same thing myself—but the cogency of what seemed to be his bear argument made me think about my own position.

Does a slow second quarter mean the recovery is in danger? If so, what should we do?

The first question we have to ask when considering this is, why has second-quarter growth slowed? Second, will this reason persist? Third, even if growth has slowed, is it still at positive levels? Finally, what can we reasonably see changing, for better or worse, in the near future?

For the first question, we have a good answer: the government. Tax increases at the start of the year, which cut take-home income for many households, finally seem to have affected consumer spending. Consumers represent two-thirds of the economy, and when they cut back, it hurts. The sequester spending cuts have finally taken hold and are close to their worst levels. Again, government spending is a material part of the economy, and those cuts hurt. Both of these factors have significantly reduced demand and slowed the economy.

As to whether this will persist, we have to remember that growth is a change over time. The tax hikes and spending cuts were one-time events, which hurt as people adjust. Since they phased in over time, the impact was phased as well, but we’re nearing the end of the adjustment period, suggesting that growth going forward will not be impacted. The answer to the second question, then, appears to be close to no.

The third question looks at the effects of these shocks on the absolute, rather than relative, growth level. Think about it: with a big tax hike for a big part of the population, combined with large government spending cuts, the economy still grew. Not fast, admittedly, but we’ll probably still see growth. That’s actually a positive sign for when the headwinds let up.

All of these arguments lead up to the final question: what can we expect going forward—continued slowing or a resumption of faster growth?

Looking at the most recent data, we see a number of positive signs. First, same-store sales are up for many retailers, per today’s Wall Street Journal. Consumer confidence remains high. Inflation remains low. Industrial production, which took a hit from the weakness in the world economy, is ticking back up again. Housing continues to perform well, and auto sales remain a bright spot even in the current slowdown.

As a final point of support, remember that the Fed’s tapering of bond purchases, which we’ve heard so much of lately, depends on continued strong performance in the economy. If the economy fails to show more robust growth, we can expect continued Fed support.

We still face many risks ahead—another reason the Fed may delay tapering—and it’s important to be conscious of them. At this point, though, the slowdown looks like exactly that, not a reversal of the recovery.

Anxious to avoid pulling the stimulus prematurely, the Fed will be watching the data closely, as will the markets. Interest rates have been slowly drifting down again in recent weeks as the slowdown became more apparent and reduced the likelihood of tapering any time soon. This leaves us, potentially, in a very good place, with growth picking up while interest rates remain low—not a recipe for recession.

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