Managing Director, Senior Portfolio Manager
Portfolio Strategy Analyst
The U.S. economy appears to be entering 2015 with a considerable amount of momentum. While global worries remain, here at home, the incoming news on a broad range of economic activity has been unmistakably strong and indicates the economy is more able to cope with external shocks than at any other time since before the recession. Add in the consumer-spending boost from the further falls in oil prices, and we continue to be confident in prospects for growth in the year ahead.
The outlook for the U.S. economy was already positive even before the recent collapse in energy prices. After the weather-related economic contraction of the first quarter of 2014, economic output has improved dramatically. Third quarter GDP grew at 5.0%, its fastest rate in 11 years, driven by better than expected consumer spending and business investment. This occurred after a healthy 4.6% growth rate in the second quarter. While we do not expect that same pace of activity to be sustained, the strength in several growth drivers indicates that the U.S. economy is in an increasingly better condition.
The primary engines of growth are aggregate consumption, business capital spending, and state and local government outlays – all of which appear to have picked up in pace. After many years of weakness and rebuilding, the financial positions of these sectors are once again healthy enough to allow normal business-cycle relationships to take hold, and higher real economic growth to be sustained. Even more encouraging, the U.S. economy appears to be entering a sweet spot, where the improvement in domestic demand and labor market conditions is happening at the same time as declining oil prices, helping to keep a lid on inflation.
Faster job growth is a good sign that the economy has shifted into a higher gear and can offset weaker growth in the rest of the world. Employment gains have steadily improved over the past year, with the number of industries adding jobs in November jumping to its highest amount since the late 1990s. While it is too soon to conclude that the tighter labor market is generating more wage pressure, a host of indicators suggest that it will not be long before workers begin to see pay raises.
In the meantime, the decline in oil prices is helping to put more money in consumers’ pockets, boosting their purchasing power. It is understandable why Americans are increasingly upbeat. It is estimated that the average household will save $500-$800 a year from the drop in gasoline prices alone. Together with better job security, this gain in real income is finally allowing households to spend more freely.
The United States has been among the better performing global economies, partly reflecting the aggressive policy actions taken a few years ago. The marked improvement in economic fundamentals should allow the Fed to proceed this year toward policy normalization and the first rate hike. However, elsewhere in the world, the opposite story continues to play out, and with inflation pressures low, we expect the Fed to move at a patient and measured pace.
Japan’s attempts at aggressive monetary stimulus have thus far failed to boost growth, and the success of further stimulus efforts from the European Central Bank, if enacted, is not ensured. Likewise, troubles in Russia, the Ukraine, and Iraq continue to raise additional concerns about potential negative impacts on global economic growth and financial markets. Nonetheless, we believe the United States is well-positioned to weather these headwinds and continue to buck the trend of weakness elsewhere in the world.
THE FED – In mid-December, the Federal Open Market Committee (FOMC), the monetary policymaking arm of the Fed, had its final meeting of the year, at which it began to establish the groundwork to raise short-term interest rates in 2015. The FOMC has not stated when the Fed expects the rise to happen, but the market expectation is that the move will occur in the second half of 2015.
The FOMC announced that the Fed would be “patient” in the beginning of the normalization of monetary policy. As to when the “lift off ” of interest rates will occur, at the press conference following the FOMC meeting, Fed Chair Yellen suggested that it would be unlikely that the Fed would raise rates for at least the next couple of meetings. Therefore, it is assumed that the earliest a rate rise will occur is three months following the removal of the term “patient” from the press release.
The FOMC updated its outlook on the following economic indicators:
- Labor: The FOMC upgraded its view of the labor market, stating that it had improved further and that the “underutilization of labor resources continues to diminish.” The Fed pushed down its projection for the year-end 2015 unemployment rate to 5.25%, from 5.5%. It is currently at 5.8%.
- Inflation: The below-trend inflation rate partially reflects the decline of energy prices. If energy prices stay low, or head lower, the inflation rate is apt to fall further. However, the FOMC has a longer-term view on inflation. The Fed expects inflation to increase gradually due to continued improvements in the labor market, which will push it back to the target rate of 2.0%. Accordingly, the year-end 2015 projection was decreased to 1.3%, from 1.75%; the longer-term projection remains at 2.0%.
- GDP: The Fed made no changes to the level of economic growth. The projection for domestic GDP in 2015 is 2.8%, and in 2016, it is projected to be 2.75%.
EMPLOYMENT – Labor gains in 2014 continue to be impressive and are on track to have created 2.7 million jobs – an important change following five years of elusive gains. Job growth, which has been picking up at a faster pace in the past few months, should play into the strong economic momentum in the fourth quarter. The momentum in the fourth quarter follows strong economic growth in the previous quarters (third quarter GDP increased at a rate of 5.0%, and second quarter GDP increased 4.6%) and is very impressive compared to the average growth rate of 2.3% since the end of the recession. Overall, the gains have been broad-based among all industries, and the work week has extended out to 33.8 hours, a post-recession high.
Wage gains have been markedly sluggish for the past few years, which has restrained household income. However, a combination of those gains, albeit feeble, along with the longer work week and the impressive aggregate gain in payrolls (employment is up 10.4 million from the low in 2010), has given a boost to nominal income. Combined with lower gasoline prices, households now have the ingredients for stronger spending.
INFLATION – Consumer prices have been on a downtrend since hitting a recent peak this past spring. The Consumer Price Index (CPI) stands at 1.3%; it was 2.1% back in May. The main driver behind this move has been energy prices, which have fallen in each of the past five months and are down 4.8% overall in the past year. Gasoline, the most visible component of energy and 6.0% of the CPI, has fallen a whopping 10.5% in the past year. AAA’s national average price of a gallon of gasoline is now $2.23, down from April’s price of $3.67.
This lower level of inflation does create a bit of a conundrum for the Fed since CPI is getting further away from the target inflation rate of 2.0%. Although, the Fed will probably view the recent drop in energy prices as transitory. The Fed’s key measure for inflation is the Core Personal Consumption Expenditures Price Index (PCE), which excludes food and energy prices, and has been hovering around 1.5% for the past several months. The future direction of inflation appears to be a battle between the upward force of the tightening of the domestic labor market and the downward force of global disinflationary pressures.
THE CONSUMER – The uptick in consumer spending is a welcome sign for retailers following several months of seesaw readings. After four months of declines in gasoline prices, which provided more discretionary money to spend, households are now ramping up their spending. This delay in spending is consistent with past decreases in gasoline prices; households tend to wait to see the money in their bank accounts before spending. This event is still unfolding because the sharpest decrease in gasoline prices occurred in November, and households have yet to fully adjust their spending. Furthermore, gasoline futures prices are showing lower gasoline prices in the months ahead. The drop in gasoline prices will be an important tailwind for this economy.
CHARTS OF THE MONTH – RUSSIA
The plunging energy prices and contracting economy are forcing painful cuts in government spending.
The ruble has fallen 40.0% this year and more than 10.0% in the past two weeks alone. This is starting to show in the form of higher inflation.
At 8.3%, inflation is at its highest level in more than three years. It is having a significant impact on consumer spending due to the erosion in real disposable income.
Oil prices are at their lowest levels in more than five years. According to published reports, half of Russian government revenue comes from oil.
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