July 2016 – Monthly Commentary
Summer finally caught up with the bond market in July with the 10-year Treasury note virtually unchanged for the month. The benign backdrop was beneficial for the S&P 500, as the index finally broke to a new all time high, closing the month at 2,174. That rally came amid confounding economic data. Favorably, the employment report registered 287,000 new jobs in June assuaging concerns that job growth was stalling. Recall that the April and May reports initially showed job growth of 38,000 and 11,000, well below the 228,000 average monthly gain registered in 2015. Those reports have since been revised to 144,000 and 24,000, respectively. Moreover, the report for July further drove home the point that economy is on sound footing with a gain of 255,000 new jobs and another 2.6% year-over-year rise in average hourly earnings.
On the other hand, investors were not prepared for the first look at Q2 GDP. Forecasters had expected the broad measure of economic activity to show an annualized quarterly gain of 2.5%, bouncing back from the previous two quarters, both of which registered sub 1.0% growth. Indeed, anecdotal evidence, including retail sales, home sales and unemployment insurance seemed to indicate that 2.5% was a safe bet. However, the first estimate of activity registered well below that number, coming in at 1.2%. Digging into the number revealed that growth was not nearly as anemic as the headline number suggested. In fact, consumer consumption grew at a quite healthy annualized pace of 4.2%. Roughly two thirds of the U.S. economy is driven by consumer consumption, so if one judged economic activity on that measure alone, the conclusion would be that growth is robust. The drag on the overall number came from inventory liquidation and a decline in residential construction, with each subtracting 1.16% and 0.52% from the total, respectively. When producers use inventory without replacing it, that amount subtracts from economic growth, as it did last quarter. While it initially subtracts from the calculation, as that inventory is replaced back to sustainable levels, it becomes additive GDP. We’re expecting that to be the case in the current quarter.
Fearful that Great Britain and their impending exit from the European Union would be a negative shock to the economy, the Bank of England took extraordinary steps to stimulate economic activity within the country. The action was a trifecta of accommodation; the overnight lending rate was reduced from 0.50% to 0.25%, bond buying in the secondary market was expanded by GBP70 billion, including GBP10 billion in corporate debt, and a term lending scheme designed to encourage banks to expand lending will be implemented. In the post-meeting press conference, BOE Chairman Mark Carney explained that the committee believed that the growth outlook had deteriorated materially since the vote and that uncertainty was likely to weigh on investment and consumer spending until clarity is reached with the European Union. The committee left their forecast for GDP growth this year unchanged, which didn’t seem to comport with their assessment that activity has already slowed, and they cut their 2017 GDP forecast from 2.3% to 0.80%. To further drive home the BOE’s conviction to protect the English economy from the downside, Carney said that he expects the overnight lending rate to be cut to 0.00% by the end of this year.
Given the return to robust growth in the hiring sector and the strength of the equity market, we believe investors will begin again to debate the timing of the next rate. However, with the uncertainty surrounding BREXIT and the coming U.S. presidential election, we expect the FOMC will likely continue to delay a rate hike. We are looking to Chair Yellen’s speech at the monetary policy gathering in Jackson Hole, Wyoming later this month for clues.