Managing Director, Senior Portfolio Manager
Portfolio Strategy Analyst
While the recent decline in energy prices and the pullback in long-term interest rates have increased market concerns over potential economic weakness overseas, American businesses and consumers have been decidedly more upbeat. Measures of confidence have surged recently, hitting multi-year highs that reflect the improving domestic economic landscape. We continue to share this sentiment, believing that despite headwinds from abroad, conditions are in place for the U.S. economy to enjoy its strongest period of sustainable growth since the end of the recession.
Although the weaker than expected 2.6% gain in fourth quarter GDP was somewhat disappointing, especially following the strength of growth in the prior two quarters, we believe there is not much to be alarmed about. Importantly, the pickup in economic growth seen recently has been driven by a more healthy combination of strength in private domestic demand that appears well supported fundamentally.
Households, in particular, look to be enjoying the benefits of the economic gains accumulated over the last several years. Consumer finances are much-improved since early 2009 with the value of household assets increasing by 38.0%, and liabilities as a percent of disposable personal income have come down to a 25-year low. Indeed, with the financial profile of many Americans now in order, consumer spending surged to a 3.8% annual rate over the last six months of 2014, which is the fastest pace since 2005, and far above the 2.4% average annual rate seen since the end of the recession.
With the collapse in energy prices increasing households’ purchasing power, we expect strong consumption growth to continue to drive economic growth ahead. Looking forward, the slump in gas prices is expected to leave households with close to $100 billion extra per year to spend on other goods and services. Add to this the drop in long-term interest rates, which has lowered borrowing costs for many households and businesses, and we believe the outlook for consumer spending will be substantially better over the next year.
Of course, it would help if the global backdrop was better. Recent data indicate that the stronger dollar and the slowdown in economic growth abroad have impacted the domestic manufacturing sector – which has been an important source of U.S. growth since the early stages of the recovery. Monetary stimulus in the Eurozone and Japan, while helpful, is not enough to overcome the long-term structural issues confronting these economies. However, it is worth remembering that while overseas growth has slowed, those regions have not slumped into recession, making the impact on the U.S. economy very modest.
Although the strength of real economic growth and employment suggest that the Fed should begin to raise interest rates very soon, the mixed news on wages, lack of any pickup in core inflation, and recent market volatility will likely persuade officials to delay the lift-off of the federal funds rate until at least mid-year. This should hopefully provide time for the economy to gather further momentum. Even so, we believe the domestic drivers of higher, more self-sustaining growth are already in place, and we remain optimistic that the drag from weakness abroad will not be enough to overcome the inherent strengths here at home.
THE FED – There has been significant progress in the Fed’s goal of attaining maximum employment, which is one of its dual mandates (the other is stable prices). Based upon job growth alone, nonfarm payrolls are up 11 million from the depths of the recession and up two million from the peak prior to the recession. This gives the Fed justification for its planned increase in the federal funds rate later this year. This increase in interest rates is not intended to slow the economy, but rather to normalize interest rates. The current zero interest-rate policy (ZIRP) has had the federal funds rate trading in a range of 0.0% to 0.25% for more than six years. Although it assisted in lowering the cost of capital, which helped with the recovery, it also serves to misallocate capital, which can distort or manipulate markets and may cause asset bubbles.
The Fed expects the federal funds rate to be around 1.125% by the end of 2015. That level, when adjusted for inflation, puts the real federal funds rate near zero – which, based upon history, is a stimulative level. It is also well below the Fed’s long-term neutral federal funds rate of 3.75%.
EMPLOYMENT – There was vigor in hiring in 2014, when 3.0 million were newly employed, which was the largest increase since 1999. This caused the unemployment rate to plummet to 5.6%, the lowest reading since June 2008. Unfortunately, the decline was driven by a drop in the labor force (the denominator in the unemployment equation). This puts the unemployment rate near the level that many believe is NAIRU – otherwise identified as the acronym for Non-Accelerating Inflation Rate of Unemployment. NAIRU is the level of unemployment that, if the unemployment rate falls below, will cause inflation to rise.
The average hourly earnings rate is $24.57 per hour, and has increased just 1.7% for the past 12 months. It has been averaging around 2.0% since the end of the recession, which is a rate much lower than past economic recoveries. There are different theories about the persistently low level of wages. The most popular is that there is too much slack in the labor market. The second is that there has been a change in the composition of jobs being filled and that has skewed toward lower paying jobs. The third reason is that there is pent-up wage deflation – employers did not cut wages during the recession, so they do not have to quickly increase them now, especially with the very low level of inflation.
INFLATION – Consumer prices have risen at their slowest annual pace in more than five years – up just 0.8% in the past year. The catalyst behind this, of course, is the global plunge in energy prices. Energy prices have fallen in each of the past six months, and are down 10.6% from this time last year. Gasoline prices are also down 21.0% for the same time period.
This deflationary trend is also getting a boost from the stronger dollar. Clothing, for example, is mostly imported. Clothing prices fell 1.2% in December, the largest decrease since 1998; this is on top of a 1.1% decrease in November. This is how “importing deflation” works: downward price pressure on imported products puts pressure on domestic producers, which forces them to lower their prices to compete.
The lower energy prices are expected to find their way into no-energy components of inflation as businesses will have lower costs, especially in the transportation of their goods and services. This may eventually lead to downward pressure on core inflation, which excludes food and energy costs, and is the Fed’s preferred way of observing inflation. Currently, the Core Personal Consumption Expenditure Price Index is at 1.4% for the past twelve months.
CONSUMER CONFIDENCE – Households have been excited about the remarkable drop in gasoline prices which, at $2.04 per gallon, have fallen $1.93 (52%) since their recent cycle peak in April 2014. This has provided a boost to real incomes and has caused a surge in consumer sentiment to the highest level in more than a decade. The University of Michigan, which has been measuring consumer sentiment since the late 1940s, is a staple for understanding consumer attitudes towards the business climate, personal finance, and spending. Sentiment has been on an upward and erratic trend since the end of 2011, and currently stands at 98.2, above the long-term average of 85.2.
Although confidence has benefited from record highs in the stock market and the low unemployment rate, it is clearly the decline in gasoline prices that has given this index a boost over the past few months. If gasoline prices continue to remain low, or decrease further, this index is expected to continue with its upward trend.
CHARTS OF THE MONTH – HOUSING
Housing starts have recovered from the depths of the recession, but at the current pace of about 1 million units a year, they are well below the pre-recession average of 1.5 million.
Multi-family starts have fully recovered to pre-recession levels. Single-family homes have a long way to go.
The home ownership rate is returning to levels last seen before the period of easy access to credit.
Global deflationary pressures are pushing down interest rates, including mortgage rates.
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