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Why 2014 Will Be a Fundamentally Different Year

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January 22, 2014
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With the calendar turned to a new year, we eagerly gaze to the opportunities of 2014 and what lies ahead for the fixed income markets. On the whole, there is consensus that this new year will see higher interest rates across the spectrum as the US economy expands more rapidly, the Federal Reserve tapers its asset purchase program and investors seek higher returns in other asset classes. However, exactly how much higher interest rates will be at year end is quite uncertain; below we share our thoughts on why the US economy will continue to perform well and how the Fed will handle raising the Federal Funds rate. 

The US economy expanded a brisk 4.1% in the third quarter of 2013 and a majority of leading economic indicators continued to increase in the final months of the year. Consensus estimates for full year growth are 1.7%. This compares to growth of 2.8% in 2012, 1.8% in 2011 and 2.5% in 2010. Consumer spending accounts for nearly 70% of US economic activity, so close attention will be paid to job creation, wages, and inflation. Should businesses continue to expand and hire more workers through 2014, the unemployment rate will decline from the current level of 7%. In fact, Federal Reserve policymakers expect the unemployment rate to decline to around 6.4% by the end of 2014, and private sector estimates target an unemployment rate around 6.8%. Much attention will be paid to this metric as the Fed has stated that unemployment falling below 6.5% is the threshold for considering an increase to short term interest rates. We believe unemployment may decline below 6.5% by the end of 2014, in part due to a smaller labor force, retiring workers and more part time workers. So, while unemployment will decline, we will need to see an increase in wages to substantiate stronger consumer spending. 

Business spending is likely to increase as well. According to recent data from the Federal Reserve, corporate balance sheets are flush with cash as more than $1.9 trillion sits idle. This statistic has been frequently cited as the most likely reason for expanded hiring. However, it has failed to occur. There hasn't been a sufficient sense of urgency - a catalyst - to put the cash to work. Is 2014 different? We think it will be due to a combination of aging equipment, an increase in domestic manufacturing, and an expansion of credit to businesses. Some segments of business have been able to tap the credit markets and raise significant amounts of cash. However, in some cases these funds have been used to benefit shareholders in the form of stock buy-backs and higher dividends. We believe 2014 will see greater use of corporate cash towards revenue expansion. 

Government spending is also set to increase. Federal spending will rise incrementally, a bit of relief after a year of sequestration cut deeply into many corners of government spending. Additionally, state and local governments are set to expand as tax revenues increase. We must not overlook the importance of the debt-ceiling debate. The spending bill was only part of the debate and some Republicans allowed the spending bill to pass while vowing to hold a strong line against increasing the debt ceiling. We expect Congress to raise the debt ceiling, though we may see late-hour negotiations that might create volatility in financial markets in March and April. 

Finally, investor appetite may shift. After marginal losses for Treasuries in 2013, investors may look towards other asset classes, such as high yield debt and equities, for greater total return or foreign developed market bonds and emerging market bonds where central banks are increasing or maintaining stimulus. 

Twenty years ago the Federal Reserve began raising interest rates in a somewhat radical fashion catching many market participants off-guard. The Fed raised the overnight lending rate by 3% in 12 months, sometimes jumping half a percent at a meeting. Ten years ago, the Federal Reserve raised rates in a "measured pace" - gradual quarter-point increases for 2 years. Markets performed substantially better under the "measured pace" doctrine. While the first increase in the Federal Funds rate may not occur in 2014, the structural requirements will be set in place this year. We expect once the Fed begins raising rates, it will be in a gradual, measured pace. 

The views, opinions, beliefs, conclusions, and other information expressed in this material is not given, verified, or endorsed by Square 1 Financial, Inc. or any of its affiliates. Instead, this material is solely the work of the author, and represents his views, opinions, beliefs, conclusions, and other information he wishes to present, in all cases without any manner of endorsement from or verification by Square 1 Financial, Inc. or any of its affiliates.

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