Portfolio Strategy Analyst
By most accounts this has been a disappointing economic recovery. Yet, like a tortoise, the U.S. economy continues to chug along, in stark contrast to a still struggling Europe or the one-time hares of China and other emerging market countries where growth is now waning. Indeed, after one of the deepest recessions in history, we would argue that the U.S. economy continues to perform reasonably well given the historic post–financial crisis challenges that have confronted it.
Most of those headwinds have now faded. The housing and banking sectors are now back on their feet, household net worth has recovered while debt has been reduced, and the unemployment rate has returned to its historic average of about 5%. In fact, as monetary authorities around the world remain set on further easing measures to revive flagging demand, here at home we have finally reached the stage where the Fed is confident enough to start the process of policy normalization and we can begin to think about inflation.
This tug of war between domestic strength and global weakness is one reason that overall U.S. growth has been slow. After leading the economy out of recession, energy and exportoriented manufacturing sectors have been hit especially hard by the double whammy of collapsing energy prices and the higher dollar. Reduced energy investment and net trade have been sizable drags on growth in both 2014 and 2015. The good news is that much of this painful adjustment is now largely behind us, paving the way for steadier growth in 2016.
More importantly, however, U.S. domestic demand continues to show significant strength helping to offset weakness overseas and keep overall economic growth solid. Brisk employment growth, rising incomes, and significant savings at the pump have boosted consumer spending to around a 3% pace over the last five quarters, and households should remain active this year as these tailwinds continue to play out. The housing market also seems set for further gains with rising household formation and tight supply keeping demand and pricing strong.
Given that monetary policy works with long and variable lags, we agree with the Fed that conditions in the economy are now strong enough to no longer warrant the extraordinary “zero interest rate policy” it has maintained for the last 10 years. However, Fed officials appear in no hurry to return interest rates to more normal levels and are expected to tread slowly. Monetary policy should remain accommodative for some time, enabling the economy to absorb any remaining labor market slack while keeping the infl ation dial moving toward the 2% target.
Putting all of this in perspective leaves us a bit less jaded than other market commentators who do not seem to expect much out of the U.S. economy in 2016 and remain frustrated at its inability to achieve “escape velocity.” Although another year of “more of the same” slow growth may not be very exciting, the reality of lower U.S. trend growth is neither subpar or surprising, especially when one takes into account today’s lower structural population growth as well as the reversal in the consumer debt binge that helped boost GDP over the 30 years leading up to the global financial crisis.
The corollary to this is that the moderate pace of economic expansion has helped keep inflation in check and monetary policy very loose, while preventing the buildup of excesses, such as overheating of cyclical sectors that could leave the economy vulnerable to recession. The U.S. economic expansion is set to turn seven years old this year (long by historical standards), yet the recovery in cyclical spending as a percentage of potential GDP still remains far below the levels seen in past expansionary periods (Figure 1). In other words, the expansion seems to have a lot of mileage left in it, and so far the tortoise appears to be winning.
It finally happened. Seven years to the day from when the Fed lowered the federal funds rate down to the near-zero range of 0% to 0.25% (from 1%), the Fed raised the target range up to 0.25% to 0.50% (Figure 2). And the Fed did it with a united front on the decision. There was not one dissension, despite all of the comments from dovish to hawkish, by policymakers since the previous Federal Open Market Committee meeting. This marks the first time in 11 years that the Fed has initiated a tightening cycle.
By most accounts, the move was a “dovish hike.” Chairwoman Yellen avowed her intention to make additional rate increases to the benchmark overnight rate at a gradual pace, but she refrained from any discussion of a schedule of future interest rate increases, instead stating that any future rate increases will be data-dependent. Based upon the Fed’s projection for year-end 2016, it plans to raise the federal funds rate a total of 100 bps next year, a pace much slower than past tightening cycles. That being said, the market is not as aggressive as the Fed is with regard to future rate increases. The federal funds futures market is only forecasting about a 50 bps increase next year.
Employers continue to add workers onto their payrolls at a relatively healthy clip, which, as the Fed has acknowledged, has helped to reduce slack in the labor market. The November payroll report was not as strong as the October report (which was solid due to a catch-up following two relatively weak reports), but it was strong enough to give the Fed continued confidence that the full employment portion of its mandate is being met (Figure 3).
November’s nonfarm payrolls grew 211,000, just slightly below the 220,000 average of the past year. Since the depths of the low point of the recession, nonfarm payrolls have increased by 13.3 million jobs, more than off setting the 8.7 million jobs lost during the recession. The unemployment rate held steady at 5% for the second month in a row. It has fallen an average of one percentage point per year for the past five years.
The theme of the past year or so has been the price weakness in the commodity complex. This has been the driving force behind keeping inflationary prices low. For example, overall inflation, the Consumer Price Index (CPI), has been up just 0.5% in the past year. The price increase of the components that make up the service portion of CPI (62% of the index) have risen 2.5% in the past year – a pace that has been relatively stable for the past three years. Whereas the price increases of the goods/commodity portion of CPI (38% of the index) have fallen 2.9% in the past year (Figure 4). It has been in the negative territory for 13 months.
Although there is broad commodity disinflation/deflation, this has been partially off set by service prices that have been kept high due to shelter costs (3.2% year-over-year) along with high medical costs (2.9% year-over-year). Medical costs have been on a tear in the past three months, up 5.1% of the annual rate.
With the downward pressure on goods/commodities, the Fed believes that infl ationary pressures will stay low for some time. The Core-Personal Consumption Expenditure Price Index, the Fed’s preferred infl ation proxy, is currently at 1.3%. The Fed does not expect it to move up to its target rate of 2% until the end of 2018.
The rout in commodity prices this past year has surpassed the level that most analysts had expected. In the broadest measure, the Bloomberg Commodity Index fell 24.7% in 2015. That marks the worst yearly return since 1998, with the exception of the recent financial crash (Figure 5). The most notable of the commodity price decreases was gasoline, which fell 10.9%, to the level of $2.00 per gallon. Since we see gasoline prices advertised every time we drive past a gasoline station, this drop is noticeable. But many other commodities have experienced price weakness and are trading at their cycle lows or all-time lows.
Crude oil, natural gas, and precious and industrial metals have all suff ered from the supply and demand rebalancing that is occurring due to the slowdown in economic activity (demand) and the subsequent need for many countries to produce more of their respective commodities (supply) to help service debt responsibilities. At some point in the rebalancing, low prices of several commodities should start to knock out some of the higher-priced producers.
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