3Q2014 Economic Update

October 18, 2014

The third quarter had a positive start, following the good news that the U.S. economy posted a robust 4.6% real GDP growth rate in the second quarter – a complete rebound from the first quarter, when weather was largely responsible for a miserable -2.1% growth rate.  At August’s annual economic policy symposium in Jackson Hole Wyoming, Fed Chair Janet Yellen indicated the Fed expects to complete QE3 during October’s FOMC meeting.  QE3 started in September 2012 as unemployment stood at 8.1%.  Two years later, the unemployment rate has fallen to 5.9% in September.  It has declined faster than the Fed had anticipated and now decisively below its initial 6.5% threshold.  As part of the tapering process, the Federal Reserve has reduced its monthly bond asset purchases from $35 billion at the start of July to $15 billion at the onset of October.  Despite significant progress from the labor market, the consensus estimates for rate hikes is sometime in 2015.  This is mostly due to the fact inflation is still under the Fed’s 2% target and long-term inflation expectations are well anchored.  In addition, 2014 marked the U.S. dollar’s strongest year since 2008.  The currency’s strength helped keep inflation in check as the costs of imported goods were reduced; however, this strength also has the potential to curb economic growth, as exported goods and services are less competitive on the global market.

Across the Atlantic Ocean, all signs pointed to a weakening economy and deflationary risk in Europe.  The euro-zone’s second quarter real GDP growth rate was flat.  Europe’s average unemployment rate was still elevated in the low double-digits, with Germany’s unemployment rate holding close to 5% and Spain hovering at 25%.  Meanwhile, as a sign of economic weakness, euro-zone inflation declined to its lowest level in five years, propelling the ECB to take further easing measures to avert deflation.  Further monetary easing measures and weaker economic prospects tend to weaken currency.  Meanwhile, the yield on 10-year German bunds dipped below 1% compared to 2.5% for 10-year U.S. treasury notes.

In the emerging market regions, geopolitical risks abound as the conflict between Russia and Ukraine escalated in the wake of the shooting down of a Malaysia Airline flight by separatists.  The stiff economic sanctions posted by the West on Russia not only hurt their intended target but also threatened to push Europe into recession.

In conclusion, the global economy is engaged in a game of tug-of-war.  On one hand, the U.S. economy is pulling ahead, while Europe is slipping as it deals with deflationary challenges and geopolitical risks.  Emerging markets are increasingly becoming heterogeneous.  The implication is that passively investing in the broad index might not work as well as before.

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