Market Analysis by Financial Institutions

Market Outlook

THIRD QUARTER 2013

U.S. EconomySigns of improvement but still subpar recovery with headwinds Subpar Recovery: Our base case (most likely) scenario continues to call for a subpar recovery (low growth compared with prior recession recovery periods), producing near-term economic growth rates of approximately 1.0% to 3.0%. Still Substantial Headwinds: Headwinds to recovery include high U.S. unemployment, consumer deleveraging (instead of spending), fiscal spending cuts, higher taxes, recessionary conditions in Europe and Japan, and slower growth in China. Signs of Improvement: The economy seems to have achieved sustainable growth, but not strong growth. The housing market is gaining traction, tax revenues are growing, corporate default rates remain relatively low, the stock market has rallied this year, and unemployment is trending lower.
U.S. InflationContained in 2013 but most likely on upward path thereafter Contained in 2013: A 1.5% to 3.0% increase over 12 months in the overall Consumer Price Index (CPI, a government index derived from detailed consumer spending information) appears most likely this year. That’s largely because of modest global economic growth this year, which is expected to help contain near-term inflation pressures. Long-Term Concerns: We believe higher inflation (a 12-month CPI change over 3.0%) could occur in the coming three- to five-year time frame. That’s because of the unprecedented monetary and fiscal policies enacted in response to the 2008 Financial Crisis and the present global economic slowdown. Don’t Be Complacent: We believe strongly that some level of inflation protection be incorporated into investor portfolios.
U.S. Monetary PolicyAggressive stimulus continues but tapering talk roiled the markets Aggressive Stimulus Continues: The Federal Reserve’s (the Fed’s) statements indicate that its overnight rate target should remain historically low for the foreseeable future, anchoring short-maturity U.S. Treasury yields. This should continue to create risk-taking incentives. Also, the Fed’s “tapering talk” seems more focused on possibly reducing the volume of its monthly bond purchases than on ending that program soon. Talk of Tapering QE: The Fed’s monthly bond purchase program (aka quantitative easing, or QE) presently totals $85 billion per month. In May, the Fed began suggesting how and when QE might be tapered if economic conditions appear supportive. We think this essentially represents a policy change for the Fed. The markets responded to it that way, perhaps more than the Fed anticipated. No Near-Term Change in Rate Target: With no near-term threat from inflation (deflation became more of a concern in the second quarter) and the economy still vulnerable to possible shocks, we think it’s unlikely that the Fed would raise its historically low overnight rate target any time soon.
U.S. Interest RatesStill range-bound but at a higher level; “Taper Tantrum” started normalization “Taper Tantrum” Started Normalization: The Fed’s tapering talk triggered a violent market reaction— the 10-year U.S. Treasury yield jumped from 1.63% on May 1 to 2.61% on June 25. From a broader perspective, this was the start of a normalization of rate levels after years of “artificially” low long-term interest rates caused in part by QE. Data-Driven Volatility: With the Fed having announced its intention to taper QE, with economic data as a guiding mechanism, we think the strength or weakness of economic reports will generate even more scrutiny and reaction than usual. Example: the Treasury market sell-off in response to the employment data released July 5. Range-Bound But Higher: Given continued economic headwinds, we expect interest rates to remain in trading ranges rather than shooting straight higher. For the rest of this year, we expect the 10-year U.S. Treasury yield to trade between 2.0% and 2.85%. We think the long-term trend will be higher, assuming the economy strengthens.
GlobalSlow growth with widespread stimulative policies and low inflation Slow Global Growth: Overall economic activity slowed in the first half of 2013 in both developed and emerging economies. Western Europe experienced the sharpest downturn, with many countries in recession. Widespread Stimulative Policies: Central banks have responded aggressively to this economic weakness, reducing interest rates and buying government securities. We expect this trend to continue for the rest of this year. Low Inflation: Under these conditions, we believe inflation is unlikely to be a near-term threat. However, the amount of monetary and fiscal stimulation that has been prescribed could create longer-term inflationary pressures.

Source: American Century