May 16, 2017
- Underlying economic fundamentals remain strong in the U.S.
- Low unemployment and modest inflation create a favorable environment
- Will this translate to positive opportunities for investors?
After years of sluggish growth following the 2008 financial crisis, the U.S. economic expansion has gained momentum. The economy is near full employment (defined as an unemployment rate of 5% or less), and modest inflationary pressures have taken root. The Federal Reserve (the Fed) may be close to achieving its dual mandate of maximum employment (meaning a low unemployment rate) combined with price stability.
The labor market’s long journey back
In October 2009, the U.S. unemployment rate touched 10%, its highest level in 35 years. Since then, unemployment has dropped steadily as the market recovered from the depths of the financial crisis. The unemployment rate was down to 4.5% as reported in April with room for continued improvement through 2017. Moving forward, we expect that fewer workers will be forced to remain in part-time and marginally attached employment categories. Instead, they will find more full-time opportunities.
As our economy moves closer to full employment, upward pressure on wages are likely to result, which could lead to higher inflation.
Inflation is picking up
A combination of rising wages, recovering energy prices and firmer economic growth, led headline inflation (as measured by the Consumer Price Index) to come in at 2.12% as reported in April. That’s higher than the levels we’ve seen for inflation in recent times. Yet the Fed tends to pay more attention to another inflation measure, Core Personal Consumption Expenditures (PCE). That number was reported at 1.75% in April. This is still below the 2% inflation level that the Fed targets on an annual basis.
With the potential tailwind of the Trump administration's pro-growth agenda, a trend of modestly higher inflation could be welcome if it is driven by stronger demand for goods and services across a broad range of the economy.
The Fed’s successful strategy
The Fed has been able to restore market confidence and encourage economic growth through seven years of highly accommodative monetary policy. The Fed slashed federal fund rates to a record low in 2008 of 0.25%. It subsequently followed through with multiple rounds of quantitative easing, primarily a program of buying bonds to help keep rates low and encourage additional economic activity.
Since then, the economy has stabilized, and key measures like new job creation have proven to be strong enough to allow the Fed to raise rates three times since December 2015.
We believe the Fed may raise rates another two times this year and perhaps three more times in 2018.
Investing in an improving economic environment
With the labor market near full employment, inflation at healthy levels and economic growth continuing, how should investors respond?
For stock investors, equity valuations remain at elevated levels, suggesting that stocks will only modestly benefit from improvement in the economy. The expectation of rising interest rates implies tempered return expectations for fixed income investments moving forward.
This theme of modest returns is quite the opposite of what we see across the economic landscape more generally, where the theme seemingly is one of more of everything: more employment, more inflation, more growth, more interest rate hikes, and more risk.
Thoughtful portfolio construction and investor discipline are essential. Diversification remains key in this environment as it typically has over time. To further diversify traditional stock and bond portfolios, investors may want to consider the benefits of allocating a portion of their portfolios into asset classes like alternatives. These offer the potential to generate incremental return above that of traditional asset classes at a time when it seems that we could expect more of virtually everything, with the possible exception of investment returns.