Perspectives & Planning Winter 2016
January 15, 2016
The U.S. economic recovery is now well into its seventh year. In the post war period, economic recoveries have averaged just under 5 years (58 months) in duration. Despite the longevity of the current expansion, the U.S. economy should enjoy another year of moderate growth in 2016 and the probability of recession appears quite low. GDP should advance by around 2.5%, which is similar to the growth experienced in 2014 and 2015.
The driving forces behind GDP growth in 2015 were quite different from the prior year. The boom in energy investment, which helped power the early stage of the recovery, peaked in late 2014 only to collapse in 2015 due to a global supply glut. Manufacturing suffered more broadly as the strong dollar crimped exports and made imports more competitive. However, the consumer, buoyed by rising real disposable income thanks to continuing solid employment trends and low inflation, spent on travel, dining, homes, and cars.
The trends that characterized 2015 should persist into 2016. Energy and commodities more broadly are unlikely to rebound quickly. Dollar strength is likely to continue to weigh on manufacturers and even businesses catering to foreign tourists. Consumers will more than offset these headwinds. Job creation should remain relatively robust with payrolls growing on average by 175,000 per month driving the unemployment rate lower towards 4.5%.
With job prospects secure and consumer balance sheets in good repair, we assume that consumers will spend the windfall from lower energy prices and expect that consumption should grow by at least 3%. Household net worth has climbed by $18 trillion over the pre-recession peak as stocks and houses have appreciated and savings have increased. If even a tiny fraction of this wealth is spent, the impact would be substantial. Consumers also have the ability to borrow. Despite the fact that consumer credit is again growing steadily, debt relative to household income has declined to pre-housing bubble levels and delinquencies on consumer loans are at record lows.
The level of interest rates is a key variable in credit creation. While the Federal Reserve has finally lifted rates off the “zero lower bound”, the impact has been largely on the short end of curve. The 10-year Treasury note yield at 2.2% is unchanged from the beginning of 2015. With the Fed’s favorite measure of inflation, the core Personal Consumption Expenditures (PCE) deflator, still well below 2%, additional rate increases are likely to be gradual and intermittent with the Fed Funds rate likely to end the year at 0.75% to 1.00%. Longer term Treasury yields will likely follow suit and rise modestly to a range of 2.625% to 2.875%.
With bond yields and mortgage rates remaining low, housing activity could increase by as much as 15% to 1.275 million starts. Another positive is the belated increase in the number of households. During the recession, household formation plummeted to just 0.5% and was slow to recover. Growth in households has finally rebounded to slightly above 1%, a rate more in line with demographics. Given severe underbuilding, demand for homes should remain ample relative to supply. We would also note that employment in construction has more than offset the steady decline in energy sector jobs. The auto sector should also continue to perform well in 2016. However, given the long running strength in auto sales, the auto cycle is probably far closer to peak than housing.
The government sector is expected to contribute to growth this year. The recently agreed upon increase in the debt ceiling also provided for a modest $80 billion increase in Federal spending spread over the next two years. Local governments are enjoying revenue increases and are boosting spending as well. Cutbacks in municipal employment continued for several years into the recovery and are finally being reversed. Sequestration also constrained Federal outlays. As a result, after the 2009 stimulus, the recovery was atypical in that it was almost exclusively a function of private sector activity as was job creation.
As for the global economy, the developed countries should generally fare better. GDP should rebound in both our North American neighbors, Canada and Mexico, as both economies adjust to lower energy prices. The Eurozone economy continues to be aided by stimulus measures taken by the European Central Bank. Many of the economies on the periphery are at long last performing better. With the consumer leading the way, growth could approach 2%. Japan should also turn in a stronger performance spurred by easy money and economic reforms.
However, slowing Chinese growth continues to be an issue for many emerging markets. The decline in energy and other commodity prices will continue to pose a challenge for most of Latin America, the Middle East, and Russia. The virtual closure of Beijing for over 2 days due to high levels of pollution was a clear reminder that the old Chinese economic playbook is in need of drastic revision. Nonetheless, Chinese growth appears to be stabilizing near 6% and world GDP should grow at a slightly faster pace of 3.4% in 2016 versus 3.1% in 2015.
Financial Market Outlook
Although the U.S. recovery appears fairly durable, the equity bull market that has accompanied it is looking somewhat frayed at this juncture. Volatility has increased markedly since the summer devaluation of the Chinese yuan. Lingering uncertainty over the pace of Fed tightening has also contributed. As such, the process of financial market normalization, which appears to be entering its final stage poses challenges to investors despite the apparent health of the economy.
2015 earnings are likely to be about flat versus the prior year largely due to the evaporation of energy sector profits, and market gains have evaporated as well. 2016 earnings should increase in the high single digits as the drop in energy sector income is anniversaried. The stock market will hopefully take its cue accordingly with the potential for a like advance.
Given economic uncertainty in China and the travails of commodity producers, we continue to favor foreign developed markets versus emerging markets. India, however, has replaced China as the growth champion of the BRICS. Its large, domestically oriented economy is relatively insulated from the soft global conditions and has ample room to benefit from market oriented reforms. With a leadership position in IT services, India continues to show enormous potential. However, with an economy approximately a quarter the size of China’s (at official exchange rates), India cannot provide a full offset to slowing Chinese growth.
Bond returns will remain unexciting; the gradual upward pressure on rates from the Federal Reserve tightening cycle will erode principal and offset interest income. However, the strong dollar should tamp down inflation and stay the Fed from becoming trigger happy. Foreigners are likely to continue to view dollar denominated debt as attractive given even lower rates abroad. Additionally, the contraction of the budget deficit and the decision to increase issuance of short term bills at the expense on longer notes and bonds will further constrain supply.
Credit spreads widened in 2015 and spreads over Treasuries for junk bonds ballooned due to the high proportion of energy debt in this sector. While it appears that the adjustment appears well under way, it may be premature to become more aggressive on high yield and we would continue to focus on high quality corporate credits. Municipal debt held up well in 2015 and still makes sense for high income investors, although specific credits are to be avoided.
Given our relatively positive view of the economic climate coupling moderate growth with low inflation, a bear market in equities or investment grade bonds does not seem very probable. However the carnage in junk bonds might be a harbinger for a greater selloff in stocks. At the very least, it indicates tighter credit conditions and could inhibit M&A activity at the margin. As noted above, our expectation is that the current tightening cycle will be very gradual. However, if inflation were to accelerate, it would be necessary to reassess the outlook for the Fed. Investors are not prepared for a sharp move in rates.
Risks have obviously not abated on the international side. Geopolitical risk is omnipresent. Sadly, however, the recent terrorist attacks would indicate that it is more elevated than it has been for some time. While the developed economies have been resilient in the face of such assaults, there could be impact if they were to increase in frequency. Recent tension between Russia and Turkey adds another hot spot to our perennial list, which encompasses the Mideast, India and Pakistan, and the South China Sea.
The economic slowdown in China remains cause for concern. Thus far, the Chinese seem to be managing the transition from heavy industry to a more consumer driven, service oriented economy with mixed results. The modest Chinese devaluation in August 2015 seemed to have outsized impact and it is not possible to rule out another devaluation if the Chinese economy were to take another leg down. Investors should realize that the direct effect on the U.S. is almost negligible and the impact should be more muted as the market becomes inured to such developments. Undue dollar strength can be destabilizing and one would hope that a strengthening global economy would effectively put a brake on a runaway greenback.
Our base case is that the U.S. economy should fare reasonably well in the year ahead. While we have elaborated a number of potential pitfalls, there is also upside given the improving finances of most consumers. As a result, we do not see systemic risks in our financial system similar to 2007 and would observe that the energy/junk bond bubble has already burst and appears contained. We view the equity market as offering attractive opportunities, certainly relative to bonds, and with that in mind would like to wish all our a clients a healthy and prosperous 2016.
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.
Weston Securities Corporation is a Broker/Dealer, Member FINRA/SIPC. Securities are offered through Weston Securities Corporation, which is a sister company of The Washington Trust Company, of Westerly and Washington Trust Wealth Management is a division of The Washington Trust Company, of Westerly.