Economic Overview. Bruce McCain, Key Private Bank Chief Investment Strategist. June/July Investments are:

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1 Economic Overview June/July 2013 Bruce McCain, Key Private Bank Chief Investment Strategist Investments are: NOT FDIC INSURED NOT BANK GUARANTEED MAY LOSE VALUE NOT A DEPOSIT NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY

2 Economic Outlook From the United States to the emerging countries of the world, economic growth has been disappointing this year. Many of the countries in the developed world that would be willing to consume more do not have the resources to drive strong growth. And countries in the emerging world that have built their economies on selling to the developed world have struggled to grow faster. Few countries seem able to achieve stronger growth on their own. Growing global interdependence and the internal weaknesses of most economies make improved global trade critical for most economies. Fortunately, while economic malaise may remain a concern, most economies are still growing and world growth should accelerate as the year continues. The U.S. economy at a glance: For the 2nd Quarter of 2013, the government reported that U.S. Gross Domestic Product (GDP) grew 2.4%. Consumer spending provided 2.4% to GDP growth, and residential construction contributed another 0.3%. Nonresidential investment added 0.2%, while rising inventory build added 0.6% to overall growth. Net exports subtracted 0.2% and reduced government spending subtracted another 1.0%. Consumer confidence has improved, but the ability to spend remains mired in sluggish income growth. Consumer confidence seems to have risen sharply despite rising taxes and concerns about deficit reductions. Yet intentions to spend have not improved, and retail sales have shown little growth. Income growth, particularly after taxes, remains the missing ingredient for faster spending growth. Better income gains will require stronger job growth, more paid hours or higher wages than we are seeing. Overly optimistic production rates in the 1 st Quarter forced businesses to cut back in recent weeks. Business confidence has risen, although not to the degree that consumer confidence improved. Yet production measures show businesses have cut back as we have progressed through the 2 nd Quarter. The immediate problem likely stems from an inventory buildup in the 1 st Quarter. Sluggish sales growth and uncertainty about costs continue to make businesses wary about investing. Economies around the world show decelerating growth, yet there are few signs of an imminent recession. The financial crisis in Europe seems to be under control, although economic growth there remains problematic. Global trade and production have slowed, but broad global recession still seems unlikely. Monetary policy has been very accommodative over the last year, making continued growth more likely. An inventory correction seems to be under way, but production should reaccelerate once that is complete. 2

3 Equity Outlook Short-term market rallies are often built on explanations that later prove overblown. Many currently believe that the massive Federal Reserve quantitative easing (QE) purchases have propelled the sharp rally in equities this year, augmented by private investment money flowing out of bonds and into equities. The statistics suggest both effects have been exaggerated. Even if all the QE money had gone into equities, prices theoretically would have risen only 3% this year. And while some money has flowed into equity mutual funds this year, mutual fund statistics suggest the money flowing into equities has been modest and that investors have been putting even money into bonds. The economy and earnings continue to grow while valuations are reasonable, but the focus on QE suggests the fundamentals do not currently excite investor enthusiasm. QE should not end before economic growth improves, but equity prices must ultimately rest on earnings and valuation. The U.S. rally has stalled as interest rates have risen and overseas equity markets have pulled back. Higher yielding, defensive sectors have underperformed more cyclical sectors over the last month. Year to date, the Health Care, Financials & Consumer Discretionary sectors have outperformed while the Materials, Utilities, Telecom & Technology sectors have lagged the S&P 500 as a whole. Quantitative easing has provided extra justification for buying, but is not a substitute for stronger growth. Asset prices can rise as the Fed purchases bonds, but without improved growth that pushes up valuations. The Fed could conceivably achieve its employment objective and still not generate remarkably stronger growth. Any rally in equities will be most sustainable if earnings growth largely matches increasing prices. Valuations should have room to rise, but weak growth and higher interest rates will not inspire investor enthusiasm. The rapid rally and the complacency among professional investors also raise the shorter-term investment risks. Many argue prices will continue to move higher simply because of quantitative easing. As speculation about the tapering of purchases has risen, increased market swings attest to rising anxiety. Already, the equity markets have priced in all of the money the Fed has added to date and more. With questions about fundamental growth rising, the odds of a pause in the equity rally seem relatively high. Equity outlook With valuations still reasonable, continued growth argues that equities will prove to be good investments longer term. The emerging markets still offer stronger growth and lower valuations than other regions of the world. Most developed countries of the world are growing, but at a slower rate than the U.S. economy. Overseas investments provide diversification to the longer-term risks of concentrated investments in the United States, while investments in smaller U.S. companies can help improve the potential for growth. 3

4 Fixed Income Outlook Interest rates have moved higher this past month as investors are anxious that the Federal Reserve may begin tapering its monthly $85 billion bond purchases. Specifically, the intermediate portion of the yield curve has seen yields rise the most. Interestingly, inflation expectations are decreasing at the same time nominal rates are increasing. This causes real interest rates to go up. Internationally, bond market risk has reversed its recent downward pattern and is trending higher again. European sovereign debt spreads across the entire risk spectrum, including the more financially stable nations, are now headed higher. Bond price volatility has also ticked up modestly. Key bond market data points to ponder include: Despite rising nominal rates, inflation expectations continue to fall both domestically and abroad. The one-year forward inflation rate is currently 0.59%, declining from 0.86% last month. This rate is down from 2.37% at the end of March. Greece, Portugal, Italy, and Spain have seen its Sovereign debt yields increase noticeably over the past month. Portugal has seen the biggest increase in yield on its 10-year debt, rising 0.96% in only one month s time. Investment-grade corporate bond spreads have increased and are currently 0.11% higher over the past month. So far, despite higher yields on investment-grade corporate bonds, below investment-grade bonds have been slightly more resilient to negative price movements in this rising interest rate environment. 4

5 Bruce McCain Bruce McCain is the Chief Investment Strategist for Key Private Bank and directs the research efforts that support the strategy team s work. He has also served as Director of Research and as a portfolio manager at Key. Bruce is a member of the CFA Institute, Cleveland Society of Security Analysts, and is a nationally respected investment strategist who appears frequently on Bloomberg TV and CNBC. He is also quoted regularly in national publications and media outlets. 5 Information provided is not intended to be individual investment advice