In a year dominated by mostly positive economic news, the U.S. Federal Reserve Board decided that the job market and economy at large had recovered enough to merit the discontinuation of the extraordinary monetary support it had provided since the Great Recession began in late 2007.
The decision to fully taper the third round of quantitative easing in the fall of 2014 is expected to be followed in mid-2015 by the first Fed rate hike in nine years. This may be the most telling sign that the U.S. economy is recovered from the Great Recession and the financial crisis that precipitated it.
As we move into 2015, the Fed’s moves and decisions will continue to be a major theme. We also expect falling oil and commodity prices, inflation, the rising dollar, and job and wage growth to play important roles in a U.S. economy that continues to demonstrate its resilience in the face of potential internal and external disruptions.
In this month’s commentary, we’ll discuss our views on the year ahead and identify factors likely to act as catalysts. We’ll also talk about factors that have the potential to hold the economy back. But we’ll start with a wrap-up of 2014 and place the news and views in context for the markets.
2014: The Year That Was
In 2014, the economy finally emerged from the anemic, stop-and-go growth rates that had characterized the past five years since the Great Recession ended. While growth stumbled in the first quarter due in part to the impact of the polar vortex’s extreme cold weather, it picked up significantly in the second and third quarters. According to the U.S. Department of Commerce’s Bureau of Economic Analysis, the U.S. economy grew at a rate of 4.6% in the second quarter and 3.9% in the third quarter.
Unemployment continued to fall during 2014, and evidence toward the end of the year suggested that wage pressures were beginning to build that had the potential to increase the salaries and wages of U.S. workers, which have been stagnant since the beginning of the recession. The unemployment rate fell from 6.6% in January to 5.8% in November.
The price of oil was cut nearly in half between June and December, reaching lows not seen since 2009. The lower prices put more disposable income in the hands of consumers, along with businesses in some industries, and contributed to already low inflation.
Housing, on the other hand, was a disappointment. Housing starts rose less than expected, due to a lack of first-time homebuyers and weak formation of households. Tight credit and rising levels of student debt were responsible for keeping many potential first-time home buyers on the sidelines. Home prices rose an average of 6.4% in 2014, according to Zillow.com.
The political backdrop to the economy was at least neutral, if not supportive, in 2014. Mid-term elections returned the Senate to the republicans. And Congress was able to pass a spending bill in December to fund the government into 2015, averting another potential government shutdown.
2015 Economic Themes
Many of the economic themes that dominated 2014 are likely to reoccur in 2015. Here’s an overview:
Interest rates | All eyes are on the Fed as economists expect a rate increase in the middle of the year, with the potential for additional hikes by the end of the year. That being said, the Fed is cautious in terms of doing as much as possible to ensure that economic growth at the current rate or better is sustainable before increasing rates. And even if rates do increase, they are still quite low by historical standards.
Inflation | Inflation continues to weigh in at the lower end of expectations, and that trend will continue, and even accelerate, if the prices of oil and other commodities fall or even stabilize at recent lows. The Fed takes inflation and inflation projections into account when determining the direction of future rates and is wary of inflation falling below its target of 2%.
Oil prices | While falling oil prices are a plus for consumers and businesses that consume oil, they are a negative for certain manufacturing companies and the fracking-based industries that have grown in the U.S. With the Organization of the Petroleum Exporting Countries (OPEC) declining to lower production at its meeting in November and the world awash with oil at a time when demand is low, oil prices could easily remain low through 2015 and beyond. Oil prices stabilizing at this level or lower have the potential to add just under .5% to U.S. GDP growth in 2015.
Unemployment and wage growth | The marked improvement in the unemployment rate in 2014 means that the economy is approaching full employment. Wage growth appears to finally be accelerating, which should be a positive for consumer spending. Wage growth has the potential to accelerate from an average of 2% to 3.5% as we approach full employment, a situation where nearly every American who is willing and able to work is able to secure a job, in 2016.
Housing | The factors that held the housing market back in 2014 and earlier should continue to fade in 2015. As mortgage standards are relaxed, we expect more first-time buyers to begin to enter the market, and new home construction should also pick up.
Rising dollar | Supported by discontinued quantitative easing and an improving economy in the U.S., not to mention loose monetary policy in developed economies overseas, the dollar is expected to continue to rise in 2015. Through December, the U.S. Dollar Index was trading at its highest level since 2009. A stronger dollar is likely to contribute to other trends expected to occur in 2015, including weaker commodity prices, lower inflation and increased consumer spending.
Emerging markets | On the downside, falling oil and commodity prices as well as the potential for rising rates and an even stronger dollar are wreaking havoc in emerging markets. In December, the Russian ruble experienced its largest one-day decline, sparking a sense of economic chaos. Emerging market countries frequently borrow money denominated in foreign currency (usually in U.S. dollars), and so a stronger dollar leads to more expensive interest payments and lower economic growth. Lower growth in emerging markets and the potential for geopolitical turmoil has the potential to negatively impact the U.S.
Implications for Markets
The U.S. is in the fifth year of a bull market and in the sixth year of an economic expansion. However, domestic economic fundamentals are supportive of a continued positive expansion of corporate profits and job creation. If valuation levels remain constant, mathematically this means that stocks will rise in price by the percentage of growth in corporate earnings. However, valuation levels are notoriously difficult to predict. Investor sentiment, interest rates, inflation and currency movements all affect what investors are willing to pay for one dollar of corporate earnings. Multiple expansion has been a consistent theme since 2011, and if that trend continues, it’s clearly a positive for stocks. But if multiples contract, equity investors are in for something new for a change – losses.
By Christopher Bremer, director, private client services portfolio management
Northwestern Mutual Wealth Management Company