Economic Perspectives

Paul Single
Managing Director
Paul.Single@cnr.com
(415) 576-2531

Steven Denike
Portfolio Strategy Analyst
Steven.Denike@cnr.com
(212) 702-3500

By most measures, the U.S. economy is continuing to do quite well. Accelerating job gains and increases in income have helped boost the confidence of American consumers, as well as prospects for sustained growth. While the large decline in oil prices and the rise in the dollar are producing both winners and losers, we believe these factors are a net benefit to the U.S. economy, given its domestic consumer orientation. Although manufacturing can be expected to suffer somewhat in coming months, and net trade will be a drag, the collective benefits of both to the much larger domestic sector of the economy should help ensure that overall U.S. growth remains strong.

The diverging fortunes of domestic demand and net external demand are already being reflected in recent data releases. Business surveys within the manufacturing sector indicate that conditions have slowed. With its larger exposure to trade and inputs into the oil sector, the stronger dollar is making U.S. exports more expensive overseas. At the same time, demand for them continues to be sluggish. While global indicators have shown signs of improvement, and the recent rebound in oil prices has reduced downside risks, we believe the outlook outside of the U.S. remains weak.

We are skeptical about quantitative easing improving economic growth in Europe, where long-term structural problems cannot be resolved by a flush of liquidity. The last-minute agreement to the latest Greece crisis is yet another example of European policy-makers’ resolve to avoid a day of reckoning. This serves as a reminder of how a currency union without a complete banking, political, and fiscal union is not viable long-term, particularly given the economic imbalances between the weaker peripheral nations and the stronger nations in the core.

Unfortunately, the outlook in Japan, China, and other parts of the world is not much brighter. This means that U.S. production and exports, particularly those that are petroleum-related, are likely to suffer in the near term – reversing some of the strong progress made towards narrowing the nation’s trade balance. Nevertheless, for a largely consumer-focused economy like that of the United States, the benefits accrued domestically from a stronger dollar and lower oil prices are powerful tailwinds helping to keep inflation and interest rates low while boosting Americans’ purchasing power.

Non-manufacturing surveys, which are much more domestic-focused, have strengthened recently. In addition, gains in the labor market, particularly service-oriented, show no signs of letting up. The January jobs report was exceptionally strong, highlighting the solid underlying momentum of the U.S. economy. In fact, the economy is doing so well that in the last three months alone it has created more than one million additional jobs. Even the rise in the unemployment rate to 5.7% was a good sign, as it was driven by greater labor force participation. Most encouraging are the indications that the strength in hiring is finally translating into modest wage increases, with average hourly earnings posting a 0.5% gain in January.

All things considered, there are plenty of reasons to believe that U.S. consumers are finally back in the driving seat. It is true that retail sales have disappointed recently, and spending data suggests consumers are saving a larger portion of money from lower gasoline prices than many anticipated. A new Visa consumer survey reported that so far only 25.0% of the gas dividend is being spent, while data from Bank of America suggests the same. However, consumers should not be expected to spend all of the savings from lower oil prices at once. As lower oil prices become more ingrained, and wages pick up, we believe households will likely become more confident in increasing spending levels – helping to further fuel economic growth.

THE FED – Statements and speeches from policy-makers of the Federal Open Market Committee (FOMC) – the monetary policy-making arm of the Fed – continue to be somewhat ambiguous. There are vastly different ranges of opinions regarding the strength of the economy, inflation, and international developments. There is even greater uncertainty surrounding the most appropriate path of increases for short-term interest rates. Here is our overview of some of the Fed’s views:

> Economy – The economy is growing strongly and the Fed’s view is the most upbeat since the end of the recession (June 2009). The Fed expects stronger economic activity in the year ahead.

> Inflation – The Fed is aware that the drop in energy prices has been holding inflation down. Although it views this as transitory, some policy-makers are concerned that other commodity prices are falling, which is helping to bring down the core inflation rate. With the Fed’s preferred measure of inflation, the Core Personal Consumption Expenditures Price Index (Core PCE) below its target rate for 25 consecutive months, the FOMC may want to wait until it sees a reversal in the downward direction of inflation before an increase in interest rates is warranted.

> International Developments – The Fed is concerned about the deterioration in the global economic situation, and subsequent downside risks to the domestic economy. That said, the Fed is optimistic that global central banks are making the tactical moves to stimulate their respective economies – especially the European Central Bank’s recent announcement of quantitative easing. The Fed is concerned about the strength of the dollar due to the weakening of the export-related part of the economy. Also, headlines related to China, petroleum exporting countries, Greece, Ukraine, and ISIS continue to weigh on consumer sentiment.

> Monetary Policy – The Fed wants to increase interest rates. This is not to slow the economy down, but to bring rates back to a more “normal” level. Although there is no clear view on the timing and approach of the first interest rate hike of the federal funds rate, the one thing that is clear is the need to be cautious in the timing and magnitude of any such hikes. Several policy-makers (known as “hawks”) note the risks of keeping interest rates near zero (as they have been since December 2008) and seek to head off inflation and help prevent a possible financial bubble. Other policy-makers (“doves”) fear a policy mistake and believe that a premature rate increase might snuff out economic expansion. Most policy-makers are concerned whether the economy will continue to remain on solid footing after the effect of the drop in energy prices and other factors dissipates. They believe that they can be “patient” in waiting for an interest rate lift-off.

EMPLOYMENTThe growth in employment has been astonishing. More than one million jobs have been created in the past three months. This is something that is extremely rare; the last period of such strong growth occurred more than 17 years ago. The unemployment rate has ticked up to 5.7% from 5.6%. This seemingly ominous uptick actually stemmed from a positive factor – it was due entirely to a surge in the labor force, brought upon by prospective workers coming off the sidelines after many years of discouragement.

There was more good news in salaries, which got a boost in January after dropping in December, helping to assuage concerns that workers’ wages will not rise despite the 11 million new jobs created since the lows of the cycle. Wages are up 2.2% in the past year and the average workweek remains at the cycle high of 34.6 hours.

The robust growth in the labor market is encouraging, especially as the steady pace of hiring is helping to increase the confidence of many households. Expectations are for this trend to continue. Confidence reports indicate that American households are encouraged enough by the prospect of getting a job, and have begun to look actively for work. All of this solid momentum, along with the drop in energy prices, should serve to provide powerful gains in consumer spending this year.

INFLATIONThe plunge in energy prices over the past few months has helped to drive down inflation. The yearover- year change in the January Consumer Price Index is -0.1%; it had been up to 2.1% this past May. The Core PCE Index, which strips out food and energy prices, is at 1.3%. It has been below the Fed’s target inflation rate of 2.0% for almost three years.

The two major indicators of pipeline inflationary pressures remain very low. Import prices have fallen 8.0% in the past year. This metric is influenced heavily by the drop in fuel prices, which are down 39.0% overall in the past year. Even when excluding the fuel category, import prices have fallen 0.9% in the past year, with most declines found in all of the major categories; this is due mainly to the global commodity disinflationary pressures. The other pipeline metric, the Producer Price Index (PPI), is down 3.1% in the past year (energy prices are a big influence in this drop). Excluding fuel, food, and energy, the PPI has increased just 1.5% in the past year.

CHARTS OF THE MONTH – ENERGY

Oil prices have fallen $58.62 (54.0%) since last July’s peak of $107.62.

economic perspectives

Fracking and other advanced drilling technologies from non-OPEC countries are adding more supply into the market.

Also, the global economic slowdown has caused a drop in demand for oil.

The demand and lower oil prices have helped cause a reduction in domestic oil rigs.

 
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