We saw a trifecta of important economic reports last week, with third-quarter GDP figures, the Institute for Supply Management Survey and October’s jobs report all coming through. The common theme across all three was that the US economy is improving, but remains troubled by the long-term structural problems of slow wage growth, weak consumption and a shrinking labour force.
The headline numbers were impressive, with the economy unexpectedly accelerating to a 2.8% growth rate in the third quarter and with a higher-than-expected 204,000 new jobs created last month.
A look behind the numbers, however, showed some troubling signs. Much of the acceleration in growth last quarter can be attributed to a temporary build-up in inventories. And both the GDP report and the jobs report painted a picture of an economy that is not creating jobs fast enough to put any real upward pressure on wages – a fact that is hurting consumer spending.
While the dynamic of modest growth and stagnant wages is not benefitting many households, it is proving to be a boon for corporate earnings. We are well into the third-quarter earnings season, and so far we’ve seen almost 75% of companies beat earnings estimates, while just over half have experienced better-than-forecast sales.
In other words, while only about half the companies have been able to beat their top-line forecasts, many more have delivered impressive bottom-line results, thanks in large part to slow wage growth. This strong trend in corporate earnings has been a key factor in supporting this year’s rally in stocks.
We believe this can continue into 2014, although higher rates suggest that any gains are likely to be accompanied by more volatility.
Looking ahead, we would expect the current dynamics – slow but improving growth, muted spending, low inflation, and a slow grind higher in real interest rates – should persist at least into early 2014. We would be most cognisant of that last factor when thinking about portfolio construction.
While we do not expect interest rates to rise quickly or dramatically, we do think they are headed higher, which would represent a significant obstacle for certain asset classes. As such, we would suggest investors underweight those areas of the market that are most sensitive to increases in interest rates. US Treasuries and TIPS would be at the top of that list, but stocks that serve as proxies for the bond market and gold also warrant some caution.
For stocks, we are thinking specifically of the consumer staples and utilities sectors. Both came under pressure on Friday when bonds sold off, a not-uncommon trend.
As for gold, we believe the precious metal has a place in investors’ portfolios, but an environment of rising real rates tends to be a headwind for gold. Since late October, for example, real rates have climbed roughly 20 basis points, and at the same time, gold prices dropped approximately 4% to 5%.
