2016: The Fed Acts? Consumers Spend? Inflation Returns? Possible Economic Impacts?
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Liftoff—Finally The Federal Reserve Open Market Committee (FOMC) meets on December 15-16 to consider, among other issues, raising the Federal funds rate. Even the man-on-the-moon, or out of respect to today’s sensitivities—the person-on-the-moon, waits with great anticipation for this well telegraphed decision. The publicity surrounding this decision over the last year seems similar to the noise surrounding Y2K—perhaps with the same muted reaction. Currently, nearly all observers expect an increase of 25 bps (0.25%). If financial markets act as a discounting mechanism, then markets have already made adjustments to the likely liftoff. How Fast to the Next Rate Increase As important, the market will remain concerned about the speed for further rate increases. The minutes of the October FOMC meeting stated: “…the expected path of policy, rather than the timing of the initial increase, would be the more important influence on financial conditions and thus on the outlook for the economy and inflation, and they noted the importance of underscoring this view at the time of liftoff.” Overall, markets look to the FOMC to follow any liftoff in December with increases of 75-100 bps in 2016. If this pace of 100 bps annual increases continues for about three years, it would be less rapid than the average of the Fed’s previous three tightening moves. Economic Models and the Great Monetary Experiment Finally, it should be noted that the Fed’s economic forecasts generally proved to be more optimistic than the actuals in the past. Certainly, the changes brought on by the great recession as well as the Fed’s own great experiments with monetary policy made many of the historic relationships used in econometric models less reliable for forecasting. Therefore, the speed of future FOMC rate increases will likely differ—faster or slower—from the Fed’s initial comforting statement. Divergence—Fed vs ECB ECB Lowers Deposit Facility Rate Fed liftoff will follow the European Central Bank’s (ECB) easing on December 3. The ECB lowered their deposit facility rate (interest paid on excess reserves to depository banks) 10 bps to -30 bps. In addition, the ECB maintained its large scale asset purchase programs (Q.E.). The ECB easing reflects their concerns over continued deflationary forces in Europe. Reduction of the ECB’s deposit facility rate will likely force those European banks, outside the euro-zone, to lower their deposit rates even further into negative territory. They will make this move to avoid further strengthening of their currencies against the euro. Could Negative Rates Be in the Fed’s Future The divergence in central banks’ policies around the world reflects their varying states of slower cyclical recovery when compared to the more advanced U.S. recovery. Again, the ECB telegraphed its rate move sufficiently in advance so that we do not expect a material change in the dollar’s value. However, if the U.S. economic recovery lags the Fed’s expectations, the FOMC may look to the ECB’s negative deposit facility rate experiment as a new tool. With a slowly growing economy, the Fed funds rate increases may stall at levels not too distant from its current zero interest rate policy (ZIRP). The FOMC then might face the same situation as the ECB and ultimately move rates into negative territory. Not Your Father’s Liftoff—the Next Step of the Fed’s Great Monetary Experiment New Tools for Liftoff We pointed out in an earlier commentary (May 4, 2015) that when the FOMC ultimately lifts the Fed funds rate, the tools used will be different than those of the past. These new tools add further to the uncertainties following liftoff. Before the financial crisis, the Fed raised or lowered the Fed funds rate by altering the amount of Reserves. The Fed made this change by purchasing or selling treasury bills. Before the financial crisis total depositary reserve balances from commercial banks averaged $20 billion and excess reserves—balances in excess of those needed to satisfy the Reserve balances for each bank—averaged a total of about $1.5 billion. In comparison, as a result of the Fed’s great experiment with monetary policies—i.e. Q.E.—reserve balances now total about $2.7 trillion, or 135 times the level before the financial crisis. In addition, nearly all of that total represents excess reserves. With these historically high excess reserves, depository banks neither need to borrow from the Fed nor other banks. Bottom line, the traditional means of managing Fed funds rate changes through repurchases or sales of bills no longer works. In our May commentary, we outlined the new tools the Fed will use. These new tools include the use of interest on excess reserves (IOER) for depositary banks and overnight reverse repurchase agreements (ON RRP) for non-bank lenders. Rather than going into details on these two tools, we would suggest a reading of either our May commentary or a recent report on this subject by the Federal Reserve bank of Chicago. From Very Accommodative to Accommodative—but Not Tightening Importantly, Fed policy will shift after liftoff from very accommodative to just accommodative—not tightening. The Fed will continue to retain a record high balance sheet of over $4 trillion of government bills and agency paper compared to roughly $900 billion before the financial crisis. For the near future, the Fed intends to roll over its balance sheet investments not reduce them. It remains unlikely that the Fed will begin reducing these investments in 2016 unless the economy shows greater than expected growth or inflation and requires tightening. As a result, there should be ample liquidity for the economy to grow at least as fast in 2016 as this year. Inflation Outlook—2016 The price index for personal consumption expenditures (PCE) averaged 1.2% on a trailing four-quarter basis since 2012. The next graph pictures U.S. inflation over the last 10 years. The FOMC’s longer term goal for inflation stands at 2% and remains one reason the FOMC delayed liftoff. For 2016 and beyond there may be reasons why the PCE price index may move closer to their 2% goal. U.S. inflation over the last 10 years A recent study by the Federal Reserve Bank of Cleveland titled “Explaining Low Inflation: Model-Based Decomposition,” not surprisingly, cited declining energy prices and the strength of the dollar as reasons holding back increases in the price index. We suspect this conclusion would not surprise most investors. The study does point out that the rising dollar did not influence core inflation until the third quarter of 2014. The Cleveland Fed study concludes lower energy prices and the stronger dollar should prove temporary relative depressants to headline inflationary numbers. While some expect further dollar strengthening following liftoff, the dollar should already anticipate most of that impact. In the case of energy, moderating the decline may depend, in part, on the Saudis reversing their current goal of increasing production to protect their market share. If these trend shifts prove to be the case, not a certainty, then inflation should gradually increase towards the FOMC’s goal of 2% over the next two years. Economic Outlook 2016 Overall Growth—Nominal Vs Real Most economists project a continuation of modest G.D.P. growth in 2016 ranging between 2-2.5%. With subdued inflation, nominal G.D.P. growth will range roughly between 3.7-4.2%. We cite these nominal numbers because Americans live in a nominal not a real growth world – and even economists live in that nominal world. This modest nominal growth rate barely exceeds the average real growth rate of roughly 3.1-3.2% from 1969-1998. We emphasize this comparison as one potential reason for the caution on the part of both consumers and corporate decision makers. Most Americans do not think of their income in real dollars but in nominal dollars. So at modestly higher levels of inflation than at present (and therefore higher nominal dollar income), consumers and corporate decision makers may “feel” better off. That result might generate both more investment and more consumption. Consumer Outlook 2016 Autos Consumption spending will continue to benefit from lower oil prices—there are more consumers than oil workers—and from lower unemployment rates. Contrary to our earlier expectations, consumers showed some reluctance to spend part of their energy savings. The fact they kept their wallets relatively closed shows up in the recent increase in the savings rate to 5.6%. This savings rate represents the highest in nearly three years. Despite the higher savings rate, auto sales grew to record levels. Low interest rates and the nearly 26% drop in gasoline prices this year stimulated vehicle demand. According to J.D. Power and Associates, monthly transportation costs remain nearly in line with costs incurred a decade earlier despite rising sticker prices. This comparison reflects lower interest rates, reduced gasoline prices, and extended loan terms which offset higher sticker prices. In 2016, industry analysts expect light vehicle production should continue at the current high level plateau of around 18 million vehicles. And with the emphasis on larger vehicles, the profitability of North American production should attain levels comparable to those of German auto manufacturers. Eventually auto sales may be effected by the extended length of today’s financing terms—nearly six years. The extended terms will push out the time when today’s car buyers can return to the market. Such concerns will not likely show up until sometime after 2016. For 2016, auto and light vehicle sales should continue their contribution to maintaining the strength of the U.S. Economy. Housing Housing lagged its normal early contribution to the cyclical recovery. And when the housing recovery finally showed up, the initial strength came primarily from multi-family construction. For housing to contribute more importantly to G.D.P. growth in 2016 will require greater new single family house construction (see graphs below). So far, the slow recovery in single family housing reflects the relative absence of first time home buyers. Currently, first time home buyers comprise less than 30% of the market compared to about 40% historically. Since the beginning of 2015, average hourly earnings increased 2.6%. This increase stands out as the strongest cumulative growth since the labor department kept tab of this data in 2009. The improving employment outlook should result in greater first time buyer confidence. In the meantime, the single family housing recovery and its potential broad effect on housing related consumption will help determine the rate of economic growth in 2016. Consumers—Changing Attitudes—Big Box vs On-Line—Goods or “Experiences” In our slow growth economy, the cumulative change brought by on-line shopping continues to impact big box retailers. Since the great recession, on-line shopping doubled its share of all sales from 3.6% in 2008 to 7.4% this year. At the same time, today’s consumer shows less willingness to open their wallets with possibly more conservative and changed attitudes towards spending. Those who lived through the great depression, the so called greatest generation, remained conservative in their approach to consumption and financial security throughout most of their lives. Perhaps, the great recession created the same conservatism in today’s consumers. Time will tell whether we saw the end of the shop-till-you-drop consumer generation. Nonetheless, we suspect that as the economy slowly “normalizes,” so will consumer attitudes towards spending. At the same time, big box retailers may also be feeling the shift by many consumers from acquiring goods to acquiring “experiences” – today’s new buzz word. Millennials (20-30 years old) make up a growing part of this demand for travel, dining, and other similar types of consumption “experiences.” Starbucks represents a great example of successfully marketing “experiences.” Over our investment career, we looked to consumerism as our national “religion,” with shopping centers representing its cathedral. But with changing consumer attitudes, on-line shopping, and slow economic growth, retail space will likely decline over the second half of this decade. According to a Wall Street Journal article, retail space per capita declined from 49.8 square feet in 2009 to 48.3 square feet this year. Macy’s plans to close 35-40 stores in 2016. Other major store chains will do the same. Obsolete retail malls throughout the country will likely be closed or converted—particularly if their mall flagship stores close. For investors, growth will come from those products and services that can meet these changing shifting forces. Industrial Key to Growth for the Last Half of the Decade No doubt such variables as the strength of the dollar and lower oil prices will affect industrial output in 2016. Nonetheless, in our opinion, the key question for 2016 and the second half of this decade will be U.S. labor productivity growth or the current absence of such growth. Admittedly, measuring productivity improvement causes great controversy as to how to broadly reflect the impact of new technologies. Nonetheless, since the recovery began, productivity growth averaged about one percent. This compares to about 2.2-2.6 % from the 1990’s until the great recession. In part, declining productivity helps explain the lack of greater wage gains despite declining unemployment. Combining not much better than 1% productivity improvement with roughly 1% growth in the labor force limits U.S. G.D.P. growth to about 2%. Therefore the urgency to solve stagnant labor productivity reflects one key need to achieving higher levels of economic growth. Postponed Capital Investment In the case of stepping up capital investment in our industrial plant, fiscal policies such as investment tax incentives would help stimulate expansionary spending. The need for this investment can be illustrated by Morgan Stanley’s estimate that the age of U.S. industrial equipment averages about 10 years—the highest since 1938. The cautious approach of American industry could, in part, reflect continued concerns left over from the great recession. This may, in effect, be no different than the similar caution exhibited by consumers in their increased savings rate. Twenty seven percent of CEOs in the recent business roundtable survey looked to reduce their capital spending in the first half of 2016. That’s the largest share since the end of the last recession. Share Buybacks or Capital Investment While companies hold back expanding capacity, they continue to grow their spending on share buybacks. In part, this provides a less risky method to grow earnings per share – but does not, by itself, increase either net income or jobs. Share buybacks for S&P 500 index companies increased over 10% in the third quarter when compared to the prior year. And impressively, share buybacks increased 80% from a decade ago according to S&P Dow Jones indices. With investors showing less enthusiasm for share buy backs and the likelihood of rising borrowing costs, corporations may slow down share buy backs overall in 2016. The Need for “Animal Spirits’ and Risk Taking To increase economic growth, corporations will need to shift more of their spending from share buybacks to investing in plant equipment as well as people. It may require leadership from Washington that encourages business risk taking. Enacting various fiscal policies and reducing regulatory actions could help to unleash what Keynes called “animal spirits.” Unfortunately, we do not expect that leadership to appear all of sudden in Washington. Ultimately, business and investors must look to new leadership that will come after the 2016 elections. Encouraging such spirits could lead to expansionary business strategies replacing those which simply juice earnings per share through share buybacks. Those corporations that supply technologies and capital equipment to improve productivity will benefit from such a change. First Quarter 2016—the Seasonal Adjustment Quirk Returns. Finally, will we see the same issues distorting initial first quarter 2016 G.D.P. results that we saw in 2015? Seasonal adjustments show up most forcefully in the first quarter. This results from a combination of the strength of the Christmas season ending in the prior quarter and the potential impact of weather related issues. Maybe global warming will finally come through to boost first quarter results. Just be alert to the possible seasonal adjustment issues in the upcoming first quarter. And Don’t Forget Election Year 2016—Growing and Slicing the Economic Pie This year’s presidential election, more than ever, represents a choice between how to grow the economic pie and then how to divide up the resulting pieces. As a side note, this year’s showbiz presidential political debates created profits for the networks for the first time. The congressional elections and particularly those in the senate will prove important. Currently the U.S. Senate comprises 54 republicans, 44 democrats, and 2 independents who vote with the democrats. In this year’s election, 34 senate seats come up for re-election. Of those 34 seats, republicans currently hold 24. Therefore, democrats need to win only 5 of those 24 seats to gain effective control of the senate. The presidential coat-tails in each state will likely prove to be a key determinant of this outcome. With republicans controlling 231 seats in the house and with a majority of 44, it seems unlikely the democrats will gain control of the house. With the 2016 election year, business and investors should not expect any meaningful new fiscal programs this year. Although, surprisingly (as of this writing), congress passed a five-year plan to fund infrastructure projects and the president will likely sign the measure. Final Comments Most economists seem more downbeat than usual considering they forecast continuation of similar economic growth in 2016 as occurred this year. On a positive note, economics 101 tells us that monetary policy influences the economy with a lag. If that proves true, then the very accommodative Fed policies could lead to greater growth than forecasted in 2016 and beyond. The policies of the ECB should contribute to continued economic improvement in Europe. And with that, we might see the euro strengthening accompanied by a declining U.S. dollar – all to the benefit of U.S. corporate earnings and U.S. exports. At the same time, one must recognize concerns caused by the negative effects from the strong dollar and the long-term concerns of excess debt in the developed and emerging economies. Nonetheless we remain cautiously optimistic for 2016 as U.S. economic growth continues to benefit from liquidity supplied by the Fed. We would not be surprised to see 2016 economic growth exceed consensus forecasts. We expect equity market prices will likely track the growth of earnings per share in 2016 but without benefitting from P/E multiple expansion. This would represent a change. In the recent past, multiple expansion helped overall stock performance exceed earnings per share growth. With the likelihood of rising interest rates, multiples will probably either show little change or more likely decline. Have a healthy, prosperous, and peaceful new year! The opinions expressed are as of the date written and may change as subsequent conditions vary. This paper is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader. Sources: Minutes Of Federal Open Market Committee, October 27-28, 2015, Federal Reserve Board Explaining Low Inflation: Model-Based Decomposition, Saeed Zaman, Federal Reserve Bank Of Cleveland “Shrinking U.S. Shopping Malls Get Makeovers,” The Wall Street Journal, November 24, 2015 “The Missing Piece in America’s Economic Growth,”U.S. News and World Report, August 6, 2015 “November Manufacturing ISM Report on Business,” Institute for Supply Management, December 1, 2015 “The Overnight Money Market,” Economic Perspectives, Federal Reserve Bank of Chicago The post 2016: The Fed Acts? Consumers Spend? Inflation Returns? Economic Impacts? appeared first on BPV Capital Management. |
