PNC Investment Perspective

Transcription

1 The Inflation Debate Inflation can have a significant effect on the economy and the markets. Although inflation has not been an issue for some time, the rise in the Consumer Price Index earlier this year sparked renewed attention and trepidation regarding the possibility of inflation. Many investors are concerned this indicates a sustained increase in consumer prices that may result in higher inflation. IN THIS ISSUE: The Inflation Debate How Strong is the Economy Really? Retirement Focus For more insights and perspectives on key issues from James Dunigan and other senior PNC investment professionals please visit pnc.com/investmentcorner U.S. Consumer Price Index YEAR-OVER-YEAR PERCENTAGE CHANGE In order to build a comprehensive understanding of the inflation picture, there are several aspects to consider. Over the past few years, the potential for inflation has been low due to the confluence of several factors. A relatively weak employment market and subdued increases in the cost of labor has resulted in little pressure on higher overall prices. Typically, rising labor costs lead the Consumer Price Index by about a year. The current lack JAMES P. DUNIGAN Mr. Dunigan is Executive Vice President and Managing Executive, Investments for PNC Asset Management Group. He has served in a variety of client advisory, investment management and executive roles with PNC since 1987.

2 of strong growth in wage rates indicates that the short-term appears to hold little potential for inflation. In the past, according to Cornerstone Macro, we have not seen significant wage growth until the unemployment rate falls below 5.5%, below the most recently published 5.9% rate. Another key element helping to temper inflation expectations is the current stability and, in some cases declines, in the commodity and food markets, which usually account for the bulk of price volatility. The low volatility currently experienced is partially due to the rise in U.S. energy resources, primarily domestic natural gas, which is keeping energy prices low. Food inflation has also been relatively muted for the past several years, although prices have not been quite as stable as energy. In addition, global considerations are having a positive impact on inflation potential. Weaker international growth, especially among emerging market countries, is dampening rises in prices. Weaker international markets are also having a positive influence on the strength of the dollar, resulting in cheaper imported goods. This generally forces domestic producers of goods to keep prices lower in order to be competitive. A final factor contributing to the muted potential for inflation may be attributable to the trend of banks recently to hold higher levels of excess reserves on their balance sheets. This may be contributing to the current low velocity of money, and, from a monetary perspective, inflation does not tend to accelerate when the velocity of money is slowing. This does not mean there is no potential for inflation in the near term. Earlier in 2014, there was a modest increase in inflation. Core inflation, or the Consumer Price Index excluding gasoline and food prices, ticked higher due to price increases in only a limited number of areas, new vehicles, clothing, health care and travel. Producer prices have not shown much movement, so have not been a factor in inflationary pressure. Finally, the overall global inflation picture has been encouraging, again suggesting a low inflation outlook. U.S. CPI Energy Index CPI Less Food and Energy PERCENT

3 While we are not overly concerned about the threat of inflation in the short term, we believe there are several potential triggers that could signal potential growth in inflation. Continued increases in consumer goods prices Continued strong monetary growth Faster than anticipated wage growth Increases in energy prices Noticeable improvement in the unemployment rate As the economic recovery continues, the Fed is active in monitoring and evaluating potential indicators of an inflationary environment, including various Consumer Price Index measures. Wage inflation, a key portent of inflation, currently hovers in the 2% range, where it has stagnated since the Great Recession. Unless wage inflation hits 3%, we believe that it is unlikely that policy makers will feel that overall inflation is a threat. The Fed has reinforced its intent to keep the federal funds rate low well beyond the end of monetary stimulus, although most economists feel that if inflation rises above 2%, the Fed could change its position in an attempt to control prices in a still fragile economy. There are several measures the Fed could take to help control inflation. Raise the rate it pays on bank reserves to incent banks to retain funds Increase the cost of borrowing to try to moderate demand for new loans Raise the reserve ratio on bank deposits to temper the expansion of credit and money Implement a large scale reverse repurchase agreements program to quickly reduce excess reserves at banks Consider increasing the federal funds rate sooner than the expected timeframe of mid-2015 if inflation or economic growth is stronger than anticipated Unless wage inflation hits 3%, we believe that it is unlikely that policy makers will feel that overall inflation is a threat. We continue to have a positive view regarding the sustainability of the economic expansion, but we remain cognizant of the potential downside risk that exists. We maintain our preference for high-quality securities, because they are likely to perform better in a financially challenged environment. We also hold strong conviction that investors should focus on what they can know and control, to help confirm that their asset allocation is truly reflective of their needs and risk tolerance. 3

4 How Strong is the Economy Really? The U.S. recovery appears to be on track. Some wonder if the economy and the markets are overheating. Equity markets have been on an historic five-year bull market run in the post-recession recovery environment, with the Dow Jones Industrial Average (DJIA) above 17,000 up from below 7,000 in 2009, while rates remain at historic lows. Unemployment appears to be trending downward. Investors question whether interest rates and economic data such as jobs support a strong market and low rates. We have already discussed the inflation environment and its likely impact on rates. Another indicator of economic strength, which relates strongly to the potential that the Federal Reserve (Fed) will raise rates, comes from the semiannual testimony that Janet Yellen, Chair of the Federal Reserve, gave in July to Congress. Yellen gave no signal when an increase in rates might occur. This indicates to us the Fed does not yet believe the U.S. economy is strong enough for a rate increase, which is likely to have some negative effects on the stock and bond market. MONTH-OVER-MONTH, THOUSANDS Positive Trends in Payrolls Growth Payrolls Growth Average, An area that the Fed is likely to be watching closely are employment numbers. Overall, the trend has been positive this year, although August unemployment numbers that were released by the Bureau of Labor Statistics (BLS) on September 5, 2014, were weaker than anticipated. Numbers released in October, however, were strong with unemployment falling below 6% for the first time in six years. Monthly payroll growth has been strong and if it remains so for the remainder of 2014, it could be one of the strongest years since When looking at jobs data, we believe that it is important to examine the types of jobs that are growing. While job growth has been relatively strong across most industries, we find it encouraging that higher-paying employment, such as manufacturing, office-using and service providing positions, has been leading growth. The Fed has made it a stated goal to maximize employment while taking measure to keep inflation at 4

5 Unemployment Rate Below Fed Forecast 12% 10% 8% 6% 4% 2% 0% Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Jul 14 bay. The figures released by the BLS in October show a 5.9% unemployment rate, a decline of over 1% year on year from It is uncertain at what unemployment rate a tightening job market promotes inflation. This rate, called the nonaccelerating inflation rate of unemployment (NAIRU), is estimated by the Federal Open Market Committee (FOMC) to range between 5.2% and 5.5%, although other estimates range from 5% to 6%. The current unemployment rate is close to the upper end of that range, increasing the risk of inflationary pressure. In addition, although we have not seen significant pressure on wages at this time, there has been a steady decline in initial jobless claims, back to or even below its historical average of about 300,000 new filings each week. Accompanying that has been a steady increase in job openings almost back to its historical average. However, we believe that underlying factors could reveal a weaker labor market than indicated by the unemployment rate. First, a substantial portion of the decline in the unemployment rate is attributable to a drop in the labor force participation rate, which has fallen from a prerecession peak of 66.4% to 62.8%, its lowest level since the 1970s. While this is partly due to long-term unemployed individuals who may no longer seek employment, analysis from the Council of Economic Advisors suggests that approximately half of this is due to the aging U.S. workforce and older workers permanently leaving the workforce. If this is true, this may represent a fundamental shift in normal participation rates, and the Fed may find it acceptable if this rate is maintained. We believe that there is some empirical evidence to support this view; the labor participation rate has been stable so far this year. Another key factor is the fact that there is a large quantity of underemployed people who are taking jobs they are overqualified for or accepting part-time jobs while they look for full-time opportunities. If you factor in the underemployed into the unemployment rate (the U-6 rate), it still remains well above its historical average. The quits rate and hiring rates also support a less robust employment situation than appears based solely on the unemployment rate. U-6 Rate Above Historical Average PERCENTAGE U-6 Unemployment Rate HISTORICAL AVERAGE

6 Besides unemployment, other metrics that we analyze include manufacturing, production and the housing market. On the good news front, figures released by the Fed indicate strong industrial production numbers which have surpassed their prerecession peak and are on target with historical averages. The ISM Manufacturing Index has also been strong for the most part, with a minor dip earlier in the year. Housing has not fared as well, but has recovered to some extent. Gains in housing prices have slowed, although are still strong at 10%, but new home sales have stagnated at a low level for close to two years. Housing statistics overall have weakened in the first part of As one of the primary drivers of the recession, it remains an area of focus for the Fed, and continued looseness in the housing market could be another justification for keeping the fed funds rate, and by extension, mortgage rates, low for the time being. Retirement Focus There seems to be an increased level of concern around investing for retirement. Why is that? If rates do rise, it is likely that bond and equity markets will be negatively affected. There are many other factors that the Fed examines to evaluate the relative strength of the economy and pressure to raise rates. At this time, the economy appears to be on a positive track, especially with stronger top line employment figures. If this should change or the labor market should improve more quickly than the Fed would like, the Fed could take action. As discussed, if inflation appears to be a threat, this could also cause the Fed to raise rates. If rates do rise, it is likely that bond and equity markets will be negatively affected. Typically, the markets seem to factor in rate increases before they actually occur, perhaps due to the high level of communication and advanced warning the Fed now gives. However, if it is a sudden rise in response to an extreme market situation, such a rapid increase in inflation, markets may not be able to react first, which could magnify the potential for downward movement. Bonds are likely to react first and in a more permanent fashion, while equity moves tend to be more mild and more temporary. PNC continues to keep a close watch on the economic environment and Fed policy. In recent years, individuals have been increasingly focused on investing for retirement. This has been a particular area of emphasis in the post-recession environment, as investors realize that traditional forms of retirement funding, such as pensions and social security, may no longer be sufficient to meet one s retirement needs. In addition, as life expectancies continue to rise, many retirees can expect to enjoy an extended retirement period. Many individuals wonder how they can invest successfully in preparation for retirement. We believe that a primary consideration in developing a successful retirement strategy is developing a definition of risk in relation to retirement. When investing for retirement, risk can be defined as the possibility that your retirement assets will not be sufficient to cover your essential living expenses. This translates into a retirement goal that resonates with most individuals: provide the cash necessary to fund essential purposes during retirement. While this is the most fundamental objective individuals investing for retirement will have, this does not mean that there are not potential additional retirement goals, such as leaving a legacy, philanthropic objectives or a retirement that allows for a specific lifestyle. 6

7 How can defining retirement as a goal benefit investors? One of the main benefits of explicitly defining retirement as a goal is that it helps focus investors on progress toward meeting that goal rather than how the markets are doing overall or performing versus a benchmark. This can help investors avoid emotional reactions to the market, particularly during times of volatility. When the markets are uncertain it is tempting to try to time the markets to try to capture the best returns. This is not usually an effective strategy due to the unpredictable nature of market declines. Long-term investing captures both ups and downs. The average annualized total return of the S&P 500 for the twenty-year period through the end of 2013 was 9.2%. Remaining fully invested (in stocks) during this period versus missing the best ten or twenty days would have had a significant effect. Investment Parameters $100,000 fully invested for twenty-year period through end of 2013, without reinvestment of dividends $100,000 fully invested for twenty-year period through end of 2013, without reinvestment of dividends, excluding ten best days $100,000 fully invested for twenty-year period through end of 2013, without reinvestment of dividends, excluding twenty best days Ending Assets $395,240 $197,850 $123,060 For illustrative purposes only and not intended to reflect any specific product or strategy. We believe strongly that an asset allocation should be based on goals and risk tolerance that considers one s time horizon to retirement. Once an asset allocation has been determined, individual asset classes can be selected to fill the portfolio. It is our view that stocks can serve as an integral part of a retirement strategy. Over the long term, stocks have tended to produce significant positive real returns, maintaining an investor s purchasing power. However, equities also tend to experience a higher level of downside volatility than other asset classes. Investing for retirement, however, often involves a long-term time horizon, and many individuals investing for retirement find the additional volatility acceptable. Fixed income and cash can also serve important roles in a retirement investment strategy, by delivering the potential for a steady income stream and less volatility, as well as downside protection. For potential additional alpha and diversification benefits, alternative investments typically have lower correlations with other asset classes. To potentially achieve one s investment objectives, we believe investors must keep their portfolios aligned with their goals. We believe that systematic rebalancing can provide a significant contribution to meeting one s retirement goals. Rebalancing helps to bring an investor s portfolio back in alignment with the asset allocation that was developed to meet one s goals and risk parameters. Benefits of Systematic Rebalancing DOLLARS With Annual Rebalance No Annual Rebalance Source: Bloomberg L.P., PNC 7

8 It also provides investment discipline by selling assets that have appreciated in value and buying those that are now relatively inexpensive. We believe this is much more effective than attempting to time the market, which often results in buying high and selling low. While it is often tempting to focus on short-term needs and think that there is still plenty of time to invest for retirement, we believe that starting to contribute early is a critical element of a potentially successful retirement plan. The longer the time period available for investing, the longer one s returns can be reinvested and benefit from the power of compounding. For instance, based on an annual return rate of 5%, an initial investment of $10,000 becomes $26,500 after twenty years, but accumulates to $70,000 after forty years. The investment period is double but the assets are almost triple at the end of the time period. The effects are even more compelling if an investor is participating in a company retirement plan with an employee match. Investing for retirement can be difficult, especially in times of volatility or market downturns. Defining one s goals, setting a strategy and then sticking with it are crucial steps in achieving one s retirement goals. PNC uses proprietary tools, analytic tools and investment experience to develop asset allocations that are designed around client objectives. We believe in taking the following disciplined steps to develop a strategic approach: Select an appropriate asset allocation to help investors reach their objectives Establish a road map to long-term goals Allow for evaluating progress towards goals on a consistent basis Move beyond a performance-based focus on simply beating an index Your PNC Advisor can work with you to develop a customized plan for your needs. Value of a $1,000 Over 40 Years at Various Assumed Growth Rates Growth of 401(k) at $6,000-Per-Year Contribution with a 50% Employer Match Over 40 Years at Various Assumed Rates of Return THOUSANDS OF DOLLARS % 5% 7% MILLIONS OF DOLLARS % 5% 7% YEARS SINCE INITIAL INVESTMENT YEARS SINCE INITIAL INVESTMENT Source: PNC The projections regarding investment returns are hypothetical in nature, do not represent any specific product or strategy, do not reflect actual investment results, and are not guarantees of future results. 8

9 The material presented in this newsletter is of a general nature and does not constitute the provision by PNC of investment, legal, tax or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at The PNC Financial Services Group, Inc. ( PNC ) uses the names PNC Wealth Management, Hawthorn, PNC Family Wealth and PNC Institutional Investments to provide investment and wealth management, fiduciary services, FDIC-insured banking products and services and lending of funds through its subsidiary, PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and uses the names PNC Wealth Management and Hawthorn, PNC Family Wealth to provide certain fiduciary and agency services through its subsidiary, PNC Delaware Trust Company. Securities products, brokerage services and managed account advisory services are offered by PNC Investments LLC, a registered broker-dealer and a registered investment adviser and member of FINRA and SIPC. Insurance products may be provided through PNC Insurance Services, LLC, a licensed insurance agency affiliate of PNC, or through licensed insurance agencies that are not affiliated with PNC; in either case a licensed insurance affiliate may receive compensation if you choose to purchase insurance through these programs. A decision to purchase insurance will not affect the cost or availability of other products or services from PNC or its affiliates. Hawthorn and PNC do not provide legal or accounting advice and neither provides tax advice in the absence of a specific written engagement for Hawthorn to do so. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors, LLC, a wholly-owned subsidiary of PNC Bank and SEC registered investment adviser. pnc.com PNC Institutional Investments offers an array of competitive investment management and administrative solutions for retirement plans, corporations, unions, municipalities, nonprofits, foundations and endowments. For more information, please visit pnc.com/institutionalinsights PNC Wealth Management, Hawthorn, PNC Family Wealth and PNC Institutional Investments are registered trademarks of The PNC Financial Services Group, Inc. Investments: Not FDIC Insured. No Bank Guarantee. May Lose Value. Insurance: Not FDIC Insured. No Bank or Federal Government Guarantee. Not a Deposit. May Lose Value The PNC Financial Services Group, Inc. All rights reserved. 9