Odds Against Current Downtown Continues For Long

OCEAN CITY — In our Jan. 17 Weekly Letter (Making Sense of the Employment Report) we focused on the December U.S. payroll  data indicating a weaker pace of job creation than expected. Since then, additional economic indicators have heightened concerns about a slowdown. The January payroll report was disappointing as well. Measures for industrial production and manufacturing, retail sales and the housing sector have shown some weakness too.

However, there have been some positive indicators as well. An important measure of consumer confidence, the University of Michigan’s Index of Consumer Sentiment, was steady in February, and an indicator of small business confidence ticked up, showing that business owners are more positive about their sales and plan more hiring.

Bank of America Merrill Lynch (BofAML) Global Research Economist Ethan Harris says there are reasons to be optimistic about a bounce back from this softening. While difficult to quantify, severe winter weather in many parts of the country from December through February likely weighed on economic activity. Harris adds that weather may not be the only factor holding back growth recently; he expects a slowdown in inventory investment to be a headwind as well. We recommend against making significant portfolio changes in response to these recent data points, preferring to see a trend develop.

However, we would start to become concerned if the data do not bounce back once the weather normalizes.

The soft economic numbers were one cause of a 3.5% decline for the S&P 500 in January. However, a strong rebound in February has erased most of these losses in both U.S. and global equities. Positive developments in Washington and investors have received three pieces of good news from Washington in the past couple of weeks. First, the U.S. debt ceiling, which reflects the federal government’s ability to borrow to pay its bills, has been raised through March 2015. This development is positive for the markets as the politically volatile issue was arguably a headwind for the economy by weighing on consumer and business confidence.

Second, the new Federal Reserve (Fed) Chair Janet Yellen, in her first testimony before the Congress, supported a “measured” pace of reduction in monthly bond purchases

(tapering) with continued emphasis on keeping short-term interest rates low for some time. She defended the taper by noting that the economy has made progress, reducing the need for accommodation. Investors had gotten nervous about the economy and how it would affect the Fed’s outlook and policy, and walked away from the testimony with more confidence.

Third, the federal government’s fiscal health continues to show improvement. The Congressional Budget Office (CBO), in its February update, cut its estimate of the federal budget deficit for the current fiscal year to $514 billion, down from its previous forecast of $560 billion. Harris points out that this represents just 4.1% of gross domestic product (GDP), or less than half of the peak proportion of about 10% in 2009. According to the CBO’s projection, the deficit will hit 2.6% of GDP in 2015.

All in all, these developments have reduced political uncertainty as the debt ceiling, Fed leadership transition and U.S fiscal health were viewed as headwinds at the beginning of the year. More stability on these fronts should lend support to a sustainable economic recovery.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)