Residential Recovery Redux February 25, 2014

Several key reports on the state of the housing market are due out this week (February 24 – 28, 2014), most of which will likely be negatively impacted by the colder and snowier-than-usual weather in much of the nation over December 2013 and January 2014. The data due this week include:

• Case-Shiller Home Price Index for December 2013;
• New Home Sales for January 2014;
• Pending Home Sales for January 2014; and
• Housing Contribution to gross domestic product (GDP) for Q4 2013.

The weather will eventually return to normal, but market participants are likely to be asking: Once the weather improves, will the housing data continue to feel the pinch of higher mortgage rates over the rest of 2014?

Solid Supports

The recent rise in mortgage rates — from just under 3.50% (for a conventional 30-year loan) in May 2013 to a recent reading of just over 4.25% — has led to widespread fears that the housing recovery will come to a grinding halt. Those fears appear to be overdone, in our view, as almost all of the factors supporting an ongoing recovery in housing remain in place. However, the rise in rates will likely slow the pace of the recovery somewhat.

In general, the housing market hit bottom in early 2009, and moved sideways between early 2009 and late 2011 before picking up momentum at the start of 2012 (please see “Location, Location, Location”). Until housing added 0.3 percentage points to overall GDP in 2012, housing construction (the most direct way housing impacts economic growth as measured by GDP) had not been a significant, sustained contributor to economic growth since 2005. The lack of participation from housing has been one of the main reasons for the sluggish economic recovery, along with the severe cutbacks in state and local governments.

When we last wrote in depth on the housing market in mid-2013, we forecast that “despite the recent rapid rise in rates, we still see housing making another significant (0.3 – 0.5 percentage points) contribution to GDP growth in 2013, as the positives driving the residential recovery more than outweigh the negatives.” Indeed, although the data are not final, housing contributed 0.3 percentage points to overall GDP growth in 2013. We expect housing to add between 0.2 and 0.3 percentage points to overall GDP growth in 2014.

At this stage of the recovery, satisfying pent-up demand for housing rather than mortgage rates will likely be the bigger driver of housing. Later on, when the pent-up demand is sated, interest rates (and affordability) should be key drivers, along with housing supply and demand, the willingness of banks and financial institutions to make mortgage loans, the health of the labor market, and the housing PE (median sales price/disposable median income per capita).

Although we continue to hear and read comments from housing market “bears” that the housing market is already back in a “bubble,” housing (represented by residential investment) currently accounts for just 3% of GDP. This is half of what it was at the peak of the housing market in 2005 – 06, when housing accounted for more than 6% of GDP. Since 1980, housing, on average, has accounted for 5% of GDP. At just 3% today, housing’s share of GDP is not only half of the recent peak, but also well below the long-term average of 5%. But what about the other housing indicators?

Key Housing Indicators

Many, if not all, of the other housing indicators we watch (see below) also suggest ongoing recovery in the housing market in the quarters and years to come.

To be sure, while the sharp increase in mortgage rates since mid-May 2013 may have slowed the pace of gains in the U.S. housing market, our view remains that the housing market is still in the early stages of recovering from the 2006 – 09 bust that followed the decade-and-a-half (early 1990s through mid-2000s) housing boom that began to show severe cracks in 2007 and collapsed in 2008. The collapse in housing, in turn, was a major contributor to the financial crisis and the Great Recession of 2007 – 09. The housing market, along with many financial markets and global economies, is still feeling the after-effects of the housing collapse.

The health of the housing market can be measured in many direct ways (e.g., housing starts, housing sales, construction spending, home prices) and indirect ways (e.g., homebuilder sentiment, mortgage applications, foreclosures, inventories of unsold homes, mortgage rates, housing vacancies, lumber prices, prices of publicly traded homebuilders). The U.S. government and private sources collect and disseminate these data. A quick recap of some of these indicators is below.

Taking the Pulse of the Residential Recovery

• Near-record housing affordability. Housing affordability, the ability of a household with the median income to afford the payments on a median priced house at prevailing mortgage rates, hit an all-time high in early 2013 before the big run-up in mortgage rates that began in mid-May 2013. The latest data point (December 2013) saw a 21% drop in affordability from the peak in January 2013. Despite the drop, affordability remains well above the long-term average, and it is some 70% higher than at the peak of the housing market in late 2005/early 2006. Rising incomes and the aftermath of the 20 – 30% drop in home prices nationwide between 2005 and 2009 will continue to support an elevated level of affordability. At this point in the housing recovery, pent-up demand will likely outweigh affordability as the main driver of housing demand.
• The housing PE. Although not a perfect measure of the frothiness (or lack thereof) in the housing market, the ratio of the median sales price of an existing home ($197,700 in December 2013) to disposable personal income per capita ($39,726 as of December 2013) is one way to gauge the health of the market. Our infographic shows that while the housing PE”has moved higher in recent months, it remains well below average. Indeed, aside from the housing bust era (2007 – 11), the housing PE is the lowest it has been in more than four decades. This also suggests that the housing recovery remains in its early stages and is not in a bubble.
• Inventories of unsold homes are tight. Although the inventory of unsold new and existing homes has moved up from a 32-year low since the start of 2013, inventories of unsold homes remain well below average. The official count of the inventory of unsold single-family existing homes (from the National Association of Realtors), along with the record-low inventory of new homes for sale, tells us 1.8 million homes are for sale. Depending on the data source cited (there is no “official” number for shadow inventory), the shadow inventory is in the 1.0 – 1.5 million range. The low inventory of unsold homes, particularly in areas where housing demand is the highest, supports ongoing improvement in housing construction and housing sales.
• Supply of home mortgages. From the mid-1990s through late 2006, bank lending standards (down payment required, credit scores, work history, etc.) for residential mortgages were relatively easy. Coupled with low rates and rapid innovation in financial products backing residential mortgages, this easy credit helped to fuel the housing boom. The banking industry began tightening lending standards in early 2007, and continued to tighten for more than two years. Lending standards eased in 2009 and 2010, but remained more restrictive than they were in the peak boom years from 2004 to 2006. The latest survey (February 2014) reveals that bank lending standards for home mortgages are now back to “normal,” as defined by the 10 years between 1995 and 2005. It’s too soon to tell whether or not the tightening of standards in the latest period (February 2014) is the start of a new trend, or just a wiggle in the data. Either way, relatively normal mortgage lending standards are supportive of more gains in housing in the coming quarters. The Federal Reserve (Fed) compiles these data in the quarterly Senior Loan Officer Survey.
• Demand for home mortgages. Consumer demand for mortgages remained muted during the first two-and-a-half years (early 2009 through late 2011) of the housing recovery, as consumers remained uncertain about prospects for home price appreciation and their own financial and labor market status. Between mid-2011 and mid-2013, an improving labor market, Fed actions to lower mortgage rates, and rising home prices drove consumer demand for mortgages to levels not seen since the early 2000s. But the rise in mortgage rates since mid-2013 has had a meaningful impact on demand for mortgage loans in recent quarters, and a further pullback in consumer demand for mortgages would be a threat to the sustainability of the recovery. The housing recovery is dependent upon low interest rates, but not necessarily the lowest interest rates. History shows us that if job and income growth can rise along with mortgage rates, the growth in housing can continue. The Fed compiles these data in the quarterly Senior Loan Officer Survey.
• Demand for housing. Net household formation boomed in the mid- 2000s (2004, 2005, and 2006) but began to slow just prior to the start of the Great Recession in 2007. Unemployed new graduates were living with their parents or renting in large groups rather than moving into homes of their own for years after the 2007 – 09 recession. But that is ending. Over the past five years, (2009 – 13) household formations have stabilized, partially due to the better labor market, but also thanks to the echo boomers reaching their mid-to-late 20s. Although new household formation has slowed from its pre-Great Recession pace, it is still running at almost 1.0% per year. By early 2011, the gap between new household formation and new housing starts had never been wider. Soon thereafter, housing starts began to recover, and the healing in the housing market began to accelerate. However, there are still more than 18 million vacant homes — down from the peak of more than 19 million, but still well above the pre-Great Recession level of 14 – 15 million. This indicator continues to suggest that the housing recovery is still in its early stages. The U.S. Census Bureau collects the data on household formation and housing vacancies.

On balance, the sharp rise in mortgage rates that commenced in mid- May 2013 will likely slow the pace of housing activity that had accelerated noticeably between mid-2011 and mid-2013. Despite the rise in rates, most of the indicators we watch suggest that the housing recovery remains firmly entrenched. The pace (and sustainability) of the housing recovery will help to determine the pace of the overall economic recovery. We expect housing — as measured by the residential investment component of GDP — to make a positive contribution to overall GDP growth in 2014, as it did in both 2012 and 2013. However, it will likely take several more years before the national housing market is back to normal.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

The Infation Conversation: Part 2 February 18, 2014

Exploring the Disconnect

What are the reasons for the apparent disconnect between reported inflation and what consumers and businesses see at gas stations, the mall, the grocery store, and elsewhere? The Consumer Price Index (CPI), the Personal Consumption Expenditures deflator (PCE), and other inflation indices tell one story, whereas consumers and businesses tell another. We will explore this question in today’s commentary.

We began this discussion last week, when we wrote about how the conversations most consumers and small businesses are having about higher prices for food, energy, and other items like education and medical services, are at odds with policymakers’ and the markets’ views on inflation.

Although there are likely many reasons for the disconnect in the inflation conversation, we believe most of it can be explained by the following factors:

• Definitions;
• Quality;
• Frequency;
• Weighting;
• Age;
• Geography; and
• Substitutability.

Of course, not all of the differences in what consumers and businesses see and hear about higher prices can be attributed to the above factors. We examine the quality and definitional issues in depth in this week’s report, and will return to the other factors at a later date.

Definitions Disconnect

By definition, inflation is a sustained, broad-based increase in the general level of prices, but we often hear from policymakers that “there is no inflation.” According to the CPI, the general price level has increased by 26% over the past 10 years, 60% over the past 20 years, and 93% over the past 25 years. To put it another way, the general price level has nearly doubled in the past 25 years (since 1989). When policymakers say there is “no inflation” or that inflation is “well contained,” they are generally talking about the rate of increase of inflation.

Over the past 10 years, the 26% increase in the general price level works out to a 2.4% annualized increase in inflation per year. The 60% increase in the general price level over the past 20 years is also equivalent to a 2.4% annualized increase in inflation per year. The 93% gain in the general price level over the past 25 years (1989 – 2013) works out to a 2.7% gain per year in inflation in each of those 25 years.

So, in general, when policymakers say there is no inflation, they do not mean that prices are not going up. Prices almost always go up. What they mean is that the rate of change in the general price level, or the inflation rate, is moderate. By comparison, in the 25 years ending in 1988, the general price level increased by 290%, and the average annual rate of change in the CPI was 5.6% per year, more than double the rate observed over the 1989 – 2013 period [Figure 1].

Quality Disconnect

In 1990, the best-selling car in America was the Honda Accord. It had power brakes, power steering, and a five-speed manual transmission. Air conditioning and AM/FM cassette stereo system were optional, and it got 21 miles per gallon (MPG) around town and 27 MPG on the highway. The manufacturer’s suggested retail price (MSRP) was $12,145.

The top-selling car in 2013 was the Toyota Camry. It also had power brakes and power steering. But air conditioning and the AM/FM stereo came standard, and it had an automatic transmission and got 25 MPG around town and 35 MPG on the highway. The 2013 Camry also came standard with:

• A trip computer;
• Cruise control;
• Free maintenance for two years or 250,000 miles;
• Free roadside assistance for two years or 25,000 miles;
• A USB connection;
• CD/MP3 player;
• Bluetooth wireless;
• Four-wheel anti-lock brakes;
• Dual front and dual rear side-mounted airbags;
• Traction control;
• Daytime running lights;
• Stability control;
• Rear door safety locks;
• Passenger airbag occupant sensing deactivation;
• Intermittent wipers; and
• VIP security system.

The MSRP for this car was $22,325, nearly double the price of the best-selling car in 1990 (the Honda Accord).

According to the New Vehicle Index within the CPI, new car prices increased by only 20% between 1990 and 2013. As noted above, the price of the top-selling car in 2013 was 84% higher than (nearly double) the price of the top-selling car in 1990. Why the disconnect [Figure 2]?

The disconnect comes in the quality adjustment that the Bureau of Labor Statistics (BLS) uses to make an “apples-to-apples” comparison of the 1990 Accord and the 2013 Camry. The quality adjustment attempts to account for the fact that the 2013 Camry had many more “bells and whistles” than the 1990 Accord. The quality adjustment does not only apply to cars. A large portion of the components of the CPI have some form of quality adjustment applied to the raw prices, and the level of quality adjustment applied varies from item to item. In many cases, it’s not possible to attribute how much of the change in the CPI for a particular component is due to the quality adjustment and how much is due to the increase in the raw price. However, it is clear that this process of quality adjustment adds to the disconnect in the inflation conversation.

On balance, many factors contribute to the disconnect between what policymakers and economists say about inflation, and what consumers and businesses see and hear when they make purchases. We discussed two of the drivers of the disconnect here, but many others warrant further discussion. For policymakers like the Federal Reserve (Fed), the low rate of increase in the inflation rate expected by its policymaking arm, the Federal Open Market Committee (FOMC), this year (1.5%) and next year (1.75%) suggests that inflation is in fact “well contained.” Further, this low rate suggests the Fed can be patient as it begins to remove the monetary stimulus put into place over the past six years.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

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INDEX DESCRIPTIONS

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

Personal Consumption Expenditures is a measure of price changes in consumer goods and services. Personal consumption expenditures consist of the actual and imputed expenditures of households; the measure includes data pertaining to durables, non-durables and services. It is essentially a measure of goods and services targeted toward individuals and consumed by individuals.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

 

Add More Bond – James Bond – to Your Portfolio February 11, 2014

It was 1964, 50 years ago, that the film Goldfinger debuted. It is the quintessential James Bond film and the first one to win an Academy Award. In Goldfinger, Q — the head of the gadget-making “Q-Branch” — presents Bond an alternative to the traditional car. It can emit an oil slick and has a battering ram, a pop-up rear bulletproof screen, and even an ejector seat. These gadgets helped Bond make the best of some risky situations. Now, 50 years later, bonds are facing a risky situation — and alternative investments may help to make the best of it.

Although not part of the overall bond market measured by the Barclays Capital Aggregate Bond Index, the high-yield and municipal bonds we favor for 2014 are considered traditional investments. As your “Q-Branch,” LPL Financial Research would like to present you with some alternatives to traditional investments that may be helpful in 2014 as faster growth may lead to higher interest rates and flat returns for the bond market: bank loans, business development companies (BDCs), real estate investment trusts (REITs), and master limited partnerships (MLPs).

• Bank loans. Bank loans are an alternative that seeks to offer an attractive yield and less interest rate risk for 2014. The interest rates on these loans made to businesses float higher with short-term interest rates. While bank loans can suffer losses when economic growth deteriorates and negatively impacts the ability of companies to repay their borrowings, we expect solid economic growth in 2014. Finally, they behaved well in last year’s interest rate run-up from May to July, as you can see in Figure 2.

• BDCs. Business development companies function like banks by lending money to businesses. BDCs have flexibility to go beyond the most senior structured loans, so they can have more credit risk if the economy deteriorates, resulting in companies being unable to repay their debts. Illustrating this heightened leverage and credit exposure, the Wells Fargo BDC Index has behaved like 2.25 times the Barclays Capital High Yield Bond Index, as you can see in Figure 3. It is a good idea to keep the 2.25 factor in mind when considering weighting and overall portfolio credit exposure. \

• REITs. Looking back over the past 20 years, REITs (measured by the NAREIT Index) have generally provided solid yields and strong total returns with the exception of poor relative returns in 1998 – 99, 2007 – 08, and 2013. In 2013, REIT returns were similar in magnitude to 2002 and 1994, when they outperformed stocks and bonds, but in 2013 the S&P 500 Index outperformed REITs by a margin of about 30 percentage points. In 2007 – 08, credit conditions and the bursting of a real estate bubble were the problems contributing to REIT losses — something we do not expect to see in 2014. However, in 1998 – 99 and in 2013, we saw rising interest rates and a move by the Federal Reserve to become less bond market friendly. We expect that to be the case in 2014 as well. In 2013, interest rates went up in the late spring and early summer without being accompanied by better economic growth and that led to poor returns for REITs and remains a risk for 2014. However, in 2014 we expect better growth to accompany the rise in rates — making a better environment for REITs as occupancy and rents rise. From a valuation perspective, REITs are fairly valued on historical metrics like discount to net asset value, price to funds from operations, and spreads to BBB bonds. While they may fare better in 2014 than in 2013, REITs still face headwinds from rising interest rates, making REITs likely to underperform stocks, but outperform bonds.
• MLPs. In comparison to REITs, rising U.S. liquid fuel transportation needs may make MLPs that operate pipelines able to re-price rents and keep up with rising rates in 2014. A key beneficiary of the American energy renaissance, pipelines are seeing strong volume growth. In 2013, MLPs provided solid mid-single digit yields and posted double-digit total returns that nearly kept up with the soaring stock market (the Alerian MLP Index produced a total return of 27.6% in 2013, less than 5% below the 32.4% for the S&P 500). The U.S. Energy Information Agency forecasts transportation of U.S. crude oil production will continue to grow in 2014 near last year’s growth rate of 16%. Rising transportation demand may help to support another year of solid performance for MLPs in 2014 despite the risk posed by higher interest rates and some degree of commodity price sensitivity.

The alternative features installed in his car that helped to make Bond safer were not safety equipment. But used in the right way, they did help to protect him and provided an advantage when facing certain risky situations. The alternative investments featured here are not safer investments. But, used the right way, they may provide some protection from the risks and the potential to capitalize on the opportunities we believe investors face in 2014.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock and mutual fund investing involves risk including loss of principal.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

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INDEX DESCRIPTIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The S&P/LSTA U.S. Leveraged Loan 100 Index is designed to reflect the largest facilities in the leveraged loan market. It mirrors the market-weighted performance of the largest institutional leveraged loans based upon market weightings, spreads, and interest payments. The index consists of 100 loan facilities drawn from a larger benchmark, the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Wells Fargo BDC Index is a float adjusted, capitalization-weighted Index that is intended to measure the performance of all Business Development Companies that are listed on the New York Stock Exchange or NASDAQ and satisfy specified market capitalization and other eligibility requirements. To qualify as a BDC, the company must be registered with the Securities and Exchange Commission and have elected to be regulated as a BDC under the Investment Company Act of 1940.

The Barclays Capital High Yield Index covers the universe of publicly issued debt obligations rated below investment grade. Bonds must be rated below investment-grade or high-yield (Ba1/BB+ or lower), by at least two of the following ratings agencies: Moody’s, S&P, and Fitch. Bonds must also have at least one year to maturity, have at least $150 million in par value outstanding, and must be US dollar denominated and non-convertible. Bonds issued by countries designated as emerging markets are excluded.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

The Employment Situation: Slow Climb Back February 4, 2014

This Friday, February 7, 2014, the U.S. Department of Labor will release its monthly Employment Situation report. Though a lagging indicator of the economy, the report will likely garner plenty of attention from market participants, policymakers, politicians, pundits, the news media, and the public.

In December 2007 and January 2008, U.S. private sector jobs peaked at 115.7 million. The Great Recession and its aftermath saw the private sector economy shed 8.9 million jobs, and by February 2010, the private sector economy was down to 106.8 million jobs. Since then, the private sector economy has created 8.2 million jobs, and as 2013 ended, needed just under 700,000 net new jobs to get back to the pre-recession peak. We expect that to occur sometime in the first six months of 2014 [Figure 1].

Prior to the disappointing December 2013 employment report (released in early January 2014), which revealed that the private sector economy had created only 87,000 net new jobs in the weather-impacted month of December 2013, the economy had consistently been creating between 175,000 and 200,000 net new jobs per month [Figure 2]. We expect this pace of job creation to continue in 2014, with some variation around the trend due to fundamentals and weather. (See below for a discussion of weather’s impact on the January 2014 report.)

Weather and Revisions:  Sources of Uncertainty

The consensus of economists as surveyed by Bloomberg News is looking for a 190,000 gain in private sector payrolls in January 2014, after the 87,000 gain in December 2013. The range of estimates — the difference between the high and low estimate — is unusually wide for the January report. In recent years, the range of estimates has been around 120,000; for January’s report it is 200,000. The unusually wide range reflects the uncertainty around the impact of the weather on both the December 2013 and January 2014 reports, and also the revisions to the employment data made each year at this time.

While not all of the weakness in the December 2013 employment report was due to an unusually cold and snowy December, a sizable portion was. In January 2014, the population-adjusted average temperature was two degrees above normal. In December 2013, the same metric was two degrees colder than usual. The anomaly was even worse during the survey week (the week containing the 12th of the month) for the December 2013 employment report. It was six degrees colder than usual during the survey week in December 2013, and two degrees warmer than usual during the survey week in January 2014. In addition, the Department of Labor said that 273,000 people were “unable to work because of bad weather” in December 2013, the most for any December since 1977. This metric will be very closely watched again in January.

Another source of uncertainty surrounding the January 2014 employment report is revisions. In February of each year, the Labor Department releases revised data on the number of employees on payrolls. The revisions are based on new information gathered from businesses records and tax returns. Because of these revisions, the monthly changes in the payroll job count over the past year will be adjusted, but the pattern of employment is unlikely to change very much.

As noted in our Outlook 2014: The Investor’s Almanac, our view for this year is that U.S. economic growth will accelerate to 3.0% from the 2.0% pace seen in 2013. We expect both the federal government’s lifting of fiscal drags and increased state and local government spending to boost economic growth this year. In all of 2013, state and local government spending subtracted a small amount (0.02 percentage points) from gross domestic product (GDP) growth, but all of that drag occurred in the first quarter of 2013. By contrast, state and local governments added 54,000 jobs in 2013, marking the first year since 2008 that the sector added jobs. This sector added jobs in eight of the final 11 months of 2013, and we expect that trend to persist well into 2014 and beyond.

Fedlines and Labor Market Health Points

Of course, financial markets pay so much attention to this report because policymakers at the Federal Reserve (Fed) have tied the pace of quantitative easing (QE), and indeed the Fed’s guidance on rates, to the health of the labor market. “Maximum employment” in the context of price stability is the Fed’s goal, and the new Fed chairwoman, Janet Yellen, has cited several labor market metrics in public appearances over the past several years. Next week, Tuesday, February 11, 2014, Yellen will deliver the Fed’s semiannual Monetary Policy testimony (also known as the Humphrey-Hawkins testimony) to Congress, providing the market with her views on policy, the economy, and the labor market for the first time as Fed chairwoman.

In its most recent (January 29, 2014) statement, the Federal Open Market Committee (FOMC), the Fed’s policy making arm, reaffirmed that:

The current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

In addition, in his final press conference as chairman in December 2013, Ben Bernanke discussed the unemployment rate, saying:

And so we were comfortable setting a 6.5 percent unemployment rate as the point at which we would begin to look at a more broad set of labor market indicators. However, precisely because we don’t want to look just at the unemployment rate, we want to — once we get to 6½ — we want to look at hiring, quits, vacancies, participation, long-term unemployment, et cetera, wages. We couldn’t put it in terms of another unemployment rate level, specifically. So, I expect there will be some time past the 6½ percent before all of the other variables that we’ll be looking at will line up in a way that will give us confidence that the labor market is strong enough to withstand the beginning of increases in rates.

The metrics Bernanke noted, including hiring, quits, vacancies, and participation, have been cited by Yellen in the past as indicators she was watching to gauge the health of the labor market. This week’s employment report for January 2014 will provide updates of several of these metrics (the participation rate, long-term unemployment, wages, hiring), and market participants will closely watch these as they gauge the pace of tapering and the Fed’s guidance on rates.

On the other hand, the data on “quits” and “vacancies” are found in the monthly Job Openings and Labor Turnover Survey (JOLTS). The JOLTS report (for December 2013) is due out on the same day (and at the same time) that Janet Yellen delivers her first Humphrey-Hawkins testimony to Congress, next Tuesday, February 11, 2014. Figure 3 shows that the “quit rate” — the percentage of job leavers who leave their jobs voluntarily (presumably because they have better prospects elsewhere) — climbed to near-record highs in late 2013. However, some of the other labor market metrics noted recently by Bernanke and Yellen are still at depressed levels.

On balance, the January 2014 employment report will garner plenty of attention from market participants, the media, and the public as the labor market continues its slow climb back to its pre-recession peak.

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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System, is charged under the United States law with overseeing the nation’s open market operations (i.e., the Fed’s buying and selling of U.S. Treasury securities).

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.  quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Job Openings and Labor Turnover Survey (JOLTS) is a survey done by the United States Bureau of Labor Statistics to help measure job vacancies. It collects data from employers including retailers, manufacturers and different offices each month. Respondents to the survey answer quantitative and qualitative questions about their businesses’ employment, job openings, recruitment, hires and separations. The JOLTS data is published monthly and by region and industry.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually  calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

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