fourth-quarter us economic update january 2014 · fourth-quarter us economic update page 3 january...

Fourth-Quarter US Economic Update January 17, 2014

Fourth-Quarter US Economic Update January 2014

Summary of Recent Economic Developments

Real GDP in the US continues to expand at a moderate pace. Fourth quarter growth was probably above 3%. Despite recent acceleration, private economists forecast 2.6% real GDP growth in 2014. We expect 2.0-2.5%, with odds improving that growth will achieve the upper end of that range. The Federal Reserve is more optimistic, forecasting 2.8-3.2% expansion in 2014. Economic performance by sector was mixed in the fourth quarter. Job growth improved a bit, but progress remains slow despite a sizable drop in the unemployment rate. Wage growth slowed, holding down gains in personal income. Consumption expenditures grew faster than income, driving down the savings rate but making its sustainability unclear. Housing performance was mixed, with higher home prices but slower sales. Business investment appears to be improving, and industrial production jumped by over 5% in Q4. Trade improved sharply, led by rising exports and falling imports of petroleum products. Government consumption probably fell again, but a recently passed budget deal should reduce federal fiscal drag in 2014 and removes a key source of economic uncertainty. Inflation remains subdued. Interest rates rose in the fourth quarter as the Federal Reserve began to taper its securities purchases, but rates have recovered substantially in January. Credit spreads narrowed, reflecting improving credit fundamentals. Preferred securities had mixed performance in Q4 but have stated 2014 on a strong note. We believe economic and financial conditions should be favorable for preferred securities in 2014.

Figure 1: Key Macroeconomic Indicators and Interest Rates

Economic Indicator* 2012:1 2012:2 2012:3 2012:4 2013:1 2013:2 2013:3 2013:4Real GDP, Chg QoQ (%, SA, AR) 3.7 1.2 2.8 0.1 1.1 2.5 4.1 2.6fReal Personal Consump Expnds, Chg QoQ (%, SA, AR) 2.9 1.9 1.7 1.7 2.3 1.8 2.0 N/AReal Business Inv ex Stuctures, Chg QoQ (%, SA, AR) 5.4 3.9 -1.2 7.7 2.3 1.4 2.6 N/AReal Residential Investmt, Chg QoQ (%, SA, AR) 23.0 5.7 14.1 19.8 12.5 14.2 10.3 N/ACorporate Profits, After Tax, Chg YoY (%, SA, AR) 13.3 5.7 2.0 -0.7 4.5 6.4 8.6 6.3fCurrent Account Balance, Annualized (% of GDP, SA) -3.0 -2.7 -2.6 -2.5 -2.5 -2.3 -2.2 N/AFederal Budget, 12-mo Def or Surp (% of GDP) -7.8 -7.6 -6.7 -6.5 -5.5 -4.2 -4.0 -3.3Unemployment Rate (%, SA) 8.2 8.2 7.8 7.9 7.5 7.5 7.2 6.7Household Employment, Chg QoQ (000, SA) 1243 353 515 265 181 682 195 316Nonfarm Payrolls, Chg QoQ (000, SA) 787 324 456 626 622 547 502 515Nonfarm Productivity, Chg QoQ (%, SA, AR) 1.5 1.2 2.5 -1.7 -1.7 1.8 3.0 N/ACapacity Utilization (%, SA) 77.3 77.7 77.2 77.8 78.2 77.9 78.3 79.2GDP Price Index, Chg QoQ (%, SA, AR) 2.0 1.8 2.3 1.1 1.3 0.6 2.0 1.1fConsumer Price Index, Chg YoY (%, AR) 2.7 1.7 2.0 1.7 1.5 1.8 1.2 1.5CPI ex food & energy, Chg YoY (%, AR) 2.3 2.2 2.0 1.9 1.9 1.6 1.7 1.7Nominal Personal Income, Chg YoY (%, AR) 4.1 3.6 3.6 7.9 3.0 3.4 3.9 2.3aPersonal Savings Rate (%, SA) 5.4 5.6 4.8 8.7 4.3 4.6 5.1 4.2a

Rate or Spread (End of Quarter) 2012:1 2012:2 2012:3 2012:4 2013:1 2013:2 2013:3 2013:4Federal Funds Rate Target (%) 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.253-month LIBOR (%) 0.47 0.46 0.36 0.31 0.28 0.27 0.25 0.2510-Yr Treasury Note Yield (%) 2.22 1.66 1.64 1.76 1.85 2.49 2.62 3.0330-Yr Treasury Bond Yield (%) 3.34 2.75 2.82 2.95 3.10 3.50 3.69 3.96Moody's Baa Long Corp Spread (bp) 196 231 190 168 173 185 170 14110-Yr Interest Rate Swap Spread (bp) 8 13 7 6 16 21 16 7

* Figures are either quarterly or, if more frequent, end of period. f = Forecast1; a = Actual through Nov 2013 Source: Reuters EcoWin

Legend for all Figures: AR = Annual Rate; SA = Seasonally Adjusted; MA = Moving Average; C.O.P. = Change over Period


Economic Outlook Before looking back at fourth quarter economic performance, we will start by looking ahead. After accelerating considerably in the second half of 2013, inflation-adjusted gross domestic product (real GDP) growth will probably settle back into a 2.0-2.5% range in 2014, with odds improving that it will achieve the upper end of that range. Underlying private sector growth (real GDP excluding government consumption, net exports and inventories) remains modest at about 2.6%, and we anticipate little acceleration in 2014. Government consumption should again reduce GDP growth in 2014, but by less than it did in 2013. State and local spending has begun to turn up, and federal fiscal drag should gradually diminish throughout 2014. Inventories, which grew rapidly in the second half of 2013, will probably restrain growth in 1H2014 but add to it in the second half, making it about neutral for 2014 overall. Net exports are a tougher call. We had expected the real-goods trade deficit to widen in 2013 (reducing real GDP) given decent economic growth in the US and generally sluggish growth abroad. However, rising domestic energy production probably caused the trade deficit to shrink slightly in 2013, and it might do the same in 2014. We are penciling in no contribution to GDP growth from net exports, but that may be too pessimistic.

Add it up, and our outlook for real GDP growth remains moderate. If government consumption and trade each subtract from growth, then overall GDP growth could be close to 2%. If they are neutral or slightly positive, growth could be 2.5% or a bit more. That forecast compares to economists’ consensus of 2.6%1 and the Federal Open Market Committee’s expectation of 2.8-3.2% growth. We will update our growth views in this publication as the year progresses.

Figure 2: Sluggish Job Growth… Figure 3: …Equals Slow Income and Consumption Summary Statistics (3-month moving averages for Employment Changes)

US Employment Situation

All employees, Employment, Overall, Nonfarm payroll, total [c.o.p val 1 month, ma 3] Employment, By Sector, Overall, Total (civilian, household survey) [c.o.p val 1 month, ma 3] Unemployment, Rate, Total

Source: Reuters EcoWin

Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep09 10 11 12 13

Une

mpl

oym

ent

Ra

te (

Pe

rce

nt)

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

Em

plo

yme

nt C

hg (

Pe

rso

ns)

(tho

usa

nds)

-1000

-750

-500

-250

0

250

500

Personal Income, Consumption and Savings

Personal Income Account, Overall, Total, Current Prices, USD [c.o.p 12 months] Personal Outlays (PCE), Overall, Total, Current Prices, AR, SA, USD [c.o.p 12 months] Personal Saving, Rate


90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Inco

me

& S

pend

ing

Gro

wth

, P

erce

nt

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

Sav

ings

Rat

e, P

erce

nt

0

1

2

3

4

5

6

7

8

9

10

Turning back to 4Q2013, economists forecast that real GDP grew by 2.6%, although recent trade data makes it likely that growth was 3% or more last quarter. In combination with 4.1% growth in Q3, that would mean second half real GDP growth roughly doubled from its 1.8% pace in the first half of 2013. While that’s encouraging, we caution that inventory growth and rapid trade

1 All growth rates are annualized unless otherwise noted. Forecasts in this Update are from The Livingston Survey, Federal Reserve Bank of Philadelphia, December 12, 2013 unless otherwise noted.


improvement account for most of that acceleration, and they are unlikely to repeat such strong performances in 2014.

Turning to an analysis of major economic segments, the labor market improved in the fourth quarter, but progress remains frustratingly slow. Payroll employment rose by 515,000 jobs, slightly faster than in Q3 (Figure 2). The household employment survey added just 316,000 new jobs, although that was better than 195,000 jobs added in Q3. Compared to December 2012, payroll jobs grew by 1.6% and household jobs by 1.0%, not much above population growth of about 1%. Labor participation fell to 62.8%, its lowest rate since 1978. The unemployment rate fell to 6.7% in December from 7.2% in September, mostly due to lower labor participation.

Wage growth remains slow despite a lower unemployment rate. Average hourly earnings were up 1.8% YoY in December, compared to 2.1% a year ago when the unemployment rate was 7.9%. Typically, wages accelerate as unemployment falls. This is another indication a recent drop in the unemployment rate overstates improvement in labor market conditions.

Slow growth in jobs and wages translated into slow growth in personal income. Overall nominal personal income was up just 2.3% YoY in November (latest data available), and wage and salary income increased 2.2% YoY (Figure 3). Disposable (after-tax) income fared even worse at 1.5% YoY due to higher taxes in 2013, though drag from taxes should fade in 2014. Even with very low PCE inflation of about 1%, subtracting inflation from those nominal numbers means real income growth remains very slow.

Personal consumption expenditures (PCE) grew faster than income, up 3.5% YoY in November (Figure 3), and relatively strong retail sales in December could push Q4 consumption up further. With consumption rising faster than income, the personal savings rate fell to 4.2% as of November, and it probably fell further in December. Rising stock and home prices have encouraged faster consumption; that may continue for a time, but we will need to see faster income growth for it to be sustainable. We expect savings should move up gradually, as it did for most of 2013, during which time spending growth necessarily would lag income growth. We expect real PCE to grow about 2.2% in 2014, a little better than its 2% pace in 2013.

Figure 4: Housing: A Pause that Refreshes? Figure 5: Home Prices Still Rising Rapidly New & Existing Home Sales, Inventories and Affordability

New + Existing Home Sales, AR, SA New + Existing Homes for Sale, AR, SA United States, Consumer Surveys, National, Housing Affordability Index, composite, Index


90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Aff

orda

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United States, House Price Indices, YoY%

S&P Case-Shiller, Composite-20, 2000M1=100 [c.o.p 12 months] FHFA, USA (Purchase-Only), 1991M1=100 [c.o.p 12 months]


00 01 02 03 04 05 06 07 08 09 10 11 12 13

Per

cent

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-15

-10

-5

0

5

10

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20


The housing market continues to recover, although its pace appears to be slowing a bit. New and existing home sales are about unchanged compared to a year ago, up 0.1% YoY to 5.36 million units in November after peaking at 5.78 million units (+10.8% YoY) in August (Figure 4). Despite a slower pace of sales, home prices are up 13.6% (Case-Shiller 20-city Index) and 8.2% (Federal Housing Finance Agency Index) YoY in October (Figure 5). Real residential investment was up 10.3% in Q3 and added 0.3% to real GDP growth. Given slower home sales, we anticipate slower growth in residential investment in Q4, though it should still contribute to overall GDP growth. Housing affordability improved slightly in Q4 and remains relatively high historically, but higher home prices and mortgage rates reduced affordability significantly in 2013 (Figure 4). Lower affordability will not derail housing recovery, but it probably will slow future gains in home prices. Looking ahead, we anticipate 8-10% growth in residential investment and home price gains of 5-10% in 2014.

Business investment probably improved in the fourth quarter and should pick up a bit in 2014 as well. Real business investment excluding structures was up 2.6% in Q3, and we expect 3-4% growth in Q4. Capacity utilization rates have moved up in recent months as production has expanded, which should drive higher demand for new investment (Figure 6). So far, increases in capacity utilization are modest, however, so we look for similarly modest gains in business investment excluding structures of about 4% in 2014.

Figure 6: Higher Utilization Driving Investment Figure 7: Production Expanding Capacity Utilization vs Business Investment

United States, Capacity Utilization, Total index, SA [cop val 12 months] . [c.o.p val 12 months] Nonresidential Investment excluding Structures, AR, SA, UAD, 2009 chnd prices [c.o.p 12 months]


99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Bus

ine

ss I

nve

stm

ent

(P

erc

ent,

Yo

Y)

-20

-15

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-5

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5

10

15

Ca

paci

ty U

tiliz

atio

n (1

2-m

o C

hang

e, P

erc

enta

ge P

ts)

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

Industrial Production & ISM Surveys

Production, Manufacturing total ex. motor vehicles and parts, Volume Index, SA [ar ma 3 months] Production, Overall, Total, Volume, 2007=100 [ar ma 3 months] Business Surveys, ISM Manufacturing, PMI total



Pro

duct

ion,

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cent

-25

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65

Five years after the financial crisis caused demand for commercial real estate to fall sharply, investment in business structures may be turning the corner. Industrial production, inventories, and sales are rising and employment is growing (though it remains below its pre-recession peak). Although economic activity has not yet reached a level that significantly strains capacity of current structures, commercial vacancy rates are falling gradually. As a result, investment in business structures began to pick up in 2Q2013, and we expect further growth of perhaps 2% in 2014. Admittedly, this is not a boom, but it helps at the margin.

Industrial production took a roller coaster ride in 2013. Early in the year, production rose rapidly on rebuilding from Superstorm Sandy, slumped around mid-year as those orders were


filled, and gradually accelerated in the second half (Figure 7). Overall industrial production was up 6.8% in the fourth quarter, and manufacturing production excluding vehicles was up 5.3% on the same basis. In addition, the Institute of Supply Management’s manufacturing survey points to continued moderate growth over coming months and is consistent with moderately faster investment spending.

The trade deficit likely narrowed in the fourth quarter as export growth improved and energy imports fell (Figure 8). Net exports added about 0.1% to real GDP in Q1 and subtracted an average of about 0.1% over the first three quarters of 2013. Fourth quarter numbers look much better, however: net exports may add 0.8% to GDP, assuming December’s real goods balance equals an average of October and November. If so, trade – which we had assumed would be a modest drag on 2013 growth – would add 0.1-0.2%. Again, this is not a big swing in growth, but it helps at the margin.

Looking ahead, our outlook for trade is mixed. Economic growth abroad is variable, with Europe slowly emerging from recession but growth slowing in developing Asia and a number of commodity-producing countries. Among advanced economies, US economic growth is still comparatively strong, which suggests US imports should grow faster than exports, all else equal. However, all else is not equal: US domestic energy production is surging, reducing demand for energy imports and even pushing up US petroleum exports (Figure 9). A sharply narrower deficit in petroleum products is the result (Figure 9). For now, we think macroeconomic trends will roughly offset an improving energy situation, leaving net exports a neutral factor for GDP in 2014. We recognize we may be too cautious on energy, however.

Figure 8: Trade Deficit Narrowing… Figure 9: …Due Largely to Petroleum Products United States, SA, USD

Real Trade Balance and Export & Import Growth

Trade Balance, Total, Goods, census basis, Constant Prices, 2009 chnd prices Exports, Goods and services [c.o.p 12 months] Imports, Goods and services [c.o.p 12 months]


Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug08 09 10 11 12 13

Exp

ort

, Im

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(%

)

-40

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-20

-10

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Tra

de B

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(bi

llio

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-55.0

-52.5

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-47.5

-45.0

-42.5

-40.0

-37.5

-35.0

United States, Petroleum, Constant Prices, SA, USD, 2009 chnd prices

Exports Imports

Exports [ - Imports, Petroleum, Constant Prices, SA, USD, 2009 chnd prices]


Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug08 09 10 11 12 13

Pet

rol B

alan

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US

D (

billio

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32.5

Government consumption probably fell again in the fourth quarter after rising marginally (+0.4%) in Q3. Overall, government consumption added 0.1% to Q3 real GDP growth after three years of fiscal restraint (Figure 10). Federal government spending remained constrained by sequester and was further reduced by a partial government shutdown in October. State and local government spending, however, rose again in Q3 and appears to be heading upward as economic growth and prior spending restraint have improved state and local budget balances.


For 2014 as a whole, government consumption probably will be only a small drag on growth. Federal government spending will be held down by sequester. However, a recent budget agreement increased spending by $45 billion in fiscal year 2014, so federal fiscal drag will be smaller than previously anticipated and should run its course by year-end. We also anticipate Congress will increase the nation’s debt limit without too much drama, reducing a source of economic uncertainty that likely hampered growth last year. State and local spending should pick up, but after years of cutbacks, we expect caution will be the norm – for a while at least.

Figure 10: Fiscal Drag Moderating Figure 11: Inflation Remains Subdued Government Consumption Expenditures and Gross Investments, Contribution to GDP, AR, SA

Federal State and LocalSource: Reuters EcoWin

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q308 09 10 11 12 13

Per

cent

-2.0

-1.5

-1.0

-0.5

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2.0

United States, Overall and Core Inflation Indices, Year-Over-Year

Price Index, Personal Consumption Expenditure, Overall, Total, SA, 2009=100 [c.o.p 12 months] Price Index, PCE, Overall, PCE less food and energy, SA, Index, 2005=100 [c.o.p 12 months] All urban consumers, U.S. city average, Consumer Prices, All items, 1982-1984=100 [c.o.p 12 months] All urban consumers, U.S. city average, Consumer Prices, All items less food and energy, 1982-1984=100 [c.o.p 12 months]



Per

cent

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-2

-1

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We don’t mean to be repetitious, but inflation remains low and generally eased in 2013, although overall inflation picked up slightly over the past couple of months (Figure 11). The Consumer Price Index (CPI) was up 1.5% for all items and 1.7% excluding food and energy prices in 2013. The PCE deflator was up just 0.9% overall and 1.1% excluding food and energy over 12 months ending in November – well below the Federal Reserve’s 2% target. Although excess capacity is gradually diminishing, progress is slow, and we foresee little inflation pressure emerging for several years despite highly accommodative monetary policy.

We will conclude this section, as usual, with a look at broad balance sheet trends in the US. Debt-to-GDP fell again in Q3 (latest data available) as household and corporate financial deleveraging continued (Figure 12). In contrast, corporate nonfinancial borrowing rose for the sixth consecutive quarter, something we are watching carefully. Federal government borrowing slowed as the 12-month trailing budget deficit narrowed to about 3.3% of GDP in December.

We generally expect those trends to continue. Households continue to shed debt, reflecting cautious use of credit cards and tighter mortgage lending standards, although student and auto loans are growing rapidly. Financial companies likewise are deleveraging their balance sheets, but the pace is slowing there too. Banks have spent five years raising capital and shrinking balance sheets, and their recapitalization is nearly complete. Indeed, most large banks already fully comply with more-rigorous 2016 capital standards, and others are making rapid progress toward meeting them. Finally, nonfinancial corporations already have begun to borrow more rapidly. To date, that borrowing has been used to add to financial assets and repurchase common


equity, not to expand capacity. The nonfinancial corporate “financing gap” (capital expenditures minus internally generated funds) remains negative (see Figure 20 on page 10), although not by much anymore. This bears watching but does not yet sound alarm bells in our view. Finally, government debt should stabilize and maybe even drop a bit as a proportion of GDP for the next few years, assuming spending discipline holds. However, as baby boomer retirements accelerate, US fiscal situation will deteriorate dramatically absent reform. Our conclusion is that headwinds to growth from deleveraging are still present – and probably will be for some time – but they are diminishing. This is not the end of deleveraging, but it may be the beginning of the end.

Figure 12: Deleveraging Slowed, but Not Moving Back to “Old Normal”

United States, Flow of Funds Debt Outstanding, SA, USDDebt to GDP: Total, Financial, Household, Business, Federal

Total Debt Outstanding / Nominal Gross Domestic Product Domestic nonfinancial sectors, nonfederal, households total debt / Nominal Gross Domestic Product Domestic financial sectors total debt / Nominal Gross Domestic Product Domestic nonfinancial sectors, federal government total debt / Nominal Gross Domestic Product Domestic nonfinancial sectors, nonfederal,nonfinancial business total debt / Nominal GDP


55 60 65 70 75 80 85 90 95 00 05 10

Secto

r Deb

t, Perc

ent of

Nomin

al GDP

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Market Outlook

Long-term Treasury rates rose again in the fourth quarter as the Federal Reserve announced plans to taper its securities purchases. The 30-year benchmark Treasury yield rose by 27 basis points (bp) to 3.96% on December 31, although it has recovered to 3.76% as of today (Figure 13). The 10-year Treasury note yield rose 41 bp to 3.03% as of year-end; it has rallied back to 2.83% so far in January. The Fed left the federal funds rate target unchanged at 0.25%, where it is likely to remain throughout 2014.

At its December 2013 meeting, the Federal Open Market Committee (FOMC) decided to begin winding down its quantitative easing program (QE3), reducing securities purchases from $85 billion ($45b in Treasuries, $40b in mortgages) per month to $75 billion ($5b cuts in both Treasuries and mortgages). In a subsequent press conference, outgoing Fed Chairman Bernanke indicated that the FOMC expects to end its securities purchase program by the end of 2014 but probably not so soon as mid-year. With eight FOMC meetings in 2014, reductions in purchases of $15 billion per meeting would bring QE3 to a close in July; at $10 billion per meeting, the program would end in October or December. Thus, the Fed is signaling it expects to taper purchases by roughly $10 billion per meeting. Chairman Bernanke left some wiggle room, however, noting that the FOMC will respond “appropriately” to incoming economic data.


Figure 13: Treasury Rates Up Again Figure 14: Credit Spreads Narrowed United States,Benchmark Interest Rates, USD

Government Benchmarks, Bid, 30 Year, Yield, Close Government Benchmarks, Bid, 10 Year, Yield, Close Policy Rates, Fed Funds Target Rate


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United States, Long-Term Corporate & High Yield Spread

Moody's Baa-Rated Long-Term, Yield Spred to 30-yr Treasury, Close Merrill Lynch, High Yield Master Index, Yield Spread to 10-year Treasury, Yield to Worst


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A $10 billion-per-meeting pace of tapering would mean the Fed would purchase about $140 billion more securities than it would under a $15 billion-per-meeting path. While that’s a lot of dollars, economists estimate that an additional $140 billion of Fed purchases would reduce long-term interest rates by about 6 bp. At this point, we think Fed taper is largely priced into markets, and tweaks to its pace should not affect yields too much.

Figure 15: Little Net Expansion from QE3 Figure 16: Bank Loan Growth Slowing (Note: New reserve definitions introduced July 2013; series adjusted & spliced thereafter)

Federal Reserve, Total Assets and Excess Reserves

Federal Reserve banks, total assets H.3, Res Dep Inst NAdj, Excess reserves, Discontinued H3 - Excess Reserves (new concept) H3 - Total Assets minus Excess Reserves , Discontinued H3 - Total Assets minus Excess Reserve (new concept)


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Assets and liab of comm banks, bank credit total, SA [c.o.p 52 weeks] Assets and liab of comm banks, consumer [c.o.p 52 weeks] Assets and liab of comm banks, commercial & industrial, SA [c.o.p 52 weeks]


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The Fed’s balance sheet is now over $4 trillion, but most reserves created by QE3 have wound up back at the Fed as excess reserves (Figure 15). The Fed’s net assets (i.e., total assets less excess reserves; red line in Figure 15) have barely moved higher since the start of QE3. Other than what’s probably a year-end spike, there is no indication that the Fed’s expansion of base money is rapidly working its way into the economy. Indeed, bank credit growth is slowing (Figure 16). We are watching for signs of excessive credit expansion, but we do not see them today.


The FOMC also updated its economic and interest rate forecasts in December. Fed Board members and regional Fed presidents expect real GDP growth of 2.8-3.2% in 2014 and 3.0-3.4% in 2015, well above private economists’ consensus forecast of 2.6% and 2.9%, respectively. Despite the Fed’s robust growth outlook, the Fed’s median expectations for the federal funds rate are 0.25%, 0.75% and 1.75% at year-end 2014, 2015 and 2016, respectively. Market-implied forward interest rates are broadly in-line with those expectations.

We believe the FOMC’s economic forecasts are too optimistic. If so, then monetary policy tightening may come later than the Fed’s current expectations, and market expectations for higher policy rates should be pushed out as well. Simply put, we think the current Treasury yield curve already incorporates meaningful acceleration in economic growth. We anticipate that long-term Treasury rates will drift higher over coming years, but only modestly and by less than market forwards. We are mindful that there may be periodic “growth scares” that could push rates upward quickly, and investors should be prepared for volatility in 2014. However, we do not think a large, sustained increase in long-term interest rates is in the cards this year.

Credit spreads narrowed in the fourth quarter, largely offsetting higher Treasury rates. Long-term Baa-rated corporate bond spreads narrowed by 29 bp to 141 bp on December 31, and they are little changed in January (Figure 14). High yield spreads narrowed by a whopping 98 bp to finish the year at 265 bp, and they have tightened another 10 bp so far in January. Prices of preferred securities were mixed during the quarter, with retail taxable preferred securities down 1.5% and institutional preferred securities up 1.2%2. Since year-end, those indices are up 3.1% and 0.8%, respectively.

Figure 17: Corporate Profits Near Record High Figure 18: Balance Sheets Strong Corporate Profits (w IVA & CCAdj) as Share of GDP

Corporate Profits, With IVA and CCAdj, Total before tax, Percent of GDP, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, Total, Current Price Corporate Profits, With IVA and CCAdj, Total before tax, Percent of GDP, Post-WWII Average, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, Total, Cu Corporate Profits, With IVA and CCAdj, Profits after tax total, Percent of GDP, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, Total, Current Prices, USD Corporate Profits, With IVA and CCAdj, Profits after tax total,Percent of GDP, Post-WWII Average, Current Prices, AR, SA, USD .. [ / National Income Account, National Product Account, Gross Domestic Product, Overall, Total, Cur


60 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

Pro

fit S

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Nonfinancial Corporate Health: LTD/Credit, Liquidity, and Interest/EBIT

Corporate Nonfinancial Interest / Earnings before Interest & Taxes, Percent, AR, SA Nonfinancial Corporate Securities and mortgages / Total Borrowing Total liquid assets / Short-term Liabilities


90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

LT D

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2 The sectors referenced are represented by the Bank of America - Merrill Lynch 8% Capped Hybrid Preferred Securities IndexSM (P8HO) and BofA - Merrill Lynch 8% Capped Corporate US Capital Securities IndexSM (C8CT). Returns quoted are price returns only, not total return, which includes income and is higher.


Figure 19: Loan Quality Improving Figure 20: Cash Flow > Investment CapEx Bank Commercial & Consumer Loan Delinquency & Charge-Off Rates, SA

Delinquency rates, all banks, commercial and industrial loans Charge-Off Rates, all banks, commercial and industrial loans, AR Delinquency rates, all banks, Real estate loans, commercial Charge-Off Rates, all banks, real estate loans, commercial, AR Delinquency rates, all banks, consumer loans, all Charge-Off Rates, all banks, consumer loans, all, AR


90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

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Nonfinancial Corporate Borrowing: Financing Gap & Corporate Bonds

Flow of Funds Instruments, Corporate and Foreign Bonds, Net issues, nonfinancial corporate business Flow of Funds Sectors, Nonfarm Nonfinancial Corporate Business, Memo: Financing gap


90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

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As they have since early 2010, fundamental credit conditions generally continue to improve. Corporate profits are near record levels as a proportion of GDP (Figure 17). Interest expense as a percentage of earnings before interest and taxes is low and stable; long-term debt to total debt is holding near its record high and contributes to low refinancing risk at these companies; and liquidity remains near its record high (Figure 18). Loan delinquencies and charge-offs are falling and, in many sectors, near historic lows, strengthening bank earnings and balance sheets (Figure 19). Finally, nonfinancial corporations, which we indicated earlier have increased borrowing in recent quarters, continue to generate more cash internally than they are spending on capital investments, despite increasing their issuance of corporate bonds (Figure 20). The “financing gap” remains negative (meaning internally generated funds exceed capital expenditures), though it is shrinking. Taken as a whole, credit conditions are highly favorable for preferred securities.

Looking ahead, we foresee moderate economic growth with improving credit conditions. While economic growth is likely to improve over coming quarters, we think interest rates already largely reflect that view. The Fed is going to remove monetary policy accommodation (taper securities purchases) only slowly – and be even more deliberate about tightening (increasing the federal funds rate). Long-term Treasury rates are likely to bounce around this year, but we don’t expect them to go up a lot. On the credit front, we remain watchful, as always, for signs of credit excess, but so far we do not see them. By most measures, credit quality continues to improve, particularly at financial companies. We think that adds up to a favorable environment for investors in preferred securities. We thank you for your trust in us and wish you a healthy and prosperous 2014.

Flaherty & Crumrine Incorporated January 17, 2014


© 2014, Flaherty & Crumrine Incorporated. All rights reserved. This commentary contains forward-looking statements. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast; the opinions stated here are subject to change at any time and are the opinion of Flaherty & Crumrine Incorporated. Further, this document is for personal use only and is not intended to be investment advice. Any copying, republication or redistribution in whole or in part is expressly prohibited without written prior consent. The information contained herein has been obtained from sources believed to be reliable, but Flaherty & Crumrine Incorporated does not represent or warrant that it is accurate or complete. The views expressed herein are those of Flaherty & Crumrine Incorporated and are subject to change without notice. The securities or financial instruments discussed in this report may not be suitable for all investors. No offer or solicitation to buy or sell securities is being made by Flaherty & Crumrine Incorporated.

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