Continuing our Outrageous market predictions with the US Economic Outlook 2014
President Harry Truman once stated “Give me a one handed economist … All my Economists say ‘on the one hand, on the other’”.
Nearly 5 years after the GFC (Global Financial Crisis), the US economy has failed to improve to a level that reflects economic expansion. With an annual GDP growth rate of only 2.5%, when factoring in Inflation of 1.5%, the real rate of growth for the US economy is a bottom line 1 to 1.5%! Based on this, it is no wonder that unemployment remains stubbornly high.
From this point forward, the US economy has one of two paths to take. It will either Boom, or it will Bust. It won’t sustain neutral growth for too much longer, so you will have to decide which way you think the economy will go. Before we give you our outlook for the US economy in 2014, we’re going to lay out the facts, as we see them, and establish what we are currently dealing with.
The US Federal Reserve & Bond Buying (QE) – a changing of the guard
The US Federal Reserve (Central Bank) has been cautious through the tail-end of 2013, due to uncertainty on economic strength. The government shutdown in October heightened weakness in US economic data and recent retail sales from Black Friday have done little to add support.
Through the middle of 2013, investors began speculating when the Fed would end Quantitative Easing (QE), causing a slump in the stock market. However, as the US economy has failed to gain any traction in its recovery, the outlook for 2014 is that the Fed will continue to maintain support for the economy, and if there are any signs of economic weakness, will actually increase QE.
This leads us to a changing of the guard. Ben Bernanke ends his term as Fed Reserve Chairman early in 2014. Taking over is Janet Yellen. As the first women to take on the role, Yellen has a daunting task in front of her as the economy fails to gain traction from the current Fed stimulus. With a strong economist background and having been pivotal in supporting Bernanke in his QE approach, on the surface it would seem, nothing is likely to change.
There are two paths Yellen could take in the management of QE. Decrease the stimulus and let the economy stand on its own two feet. Or, raise QE to help boost the economy, but at the same time increase its dependence on the Fed – like a drug addict needs a fix. The precedence has already been set with the recent European financial crisis, which continues to maintain a long-term Recession in countries such as Greece, Italy and Spain.
Pumping stimulus into these economies has not yet resulted in economic growth. Europe broadly remains in a Recession with only a select few key economies showing growth. So why would we expect an increase in QE from a Yellen Fed Reserve to stimulate the US where it has failed in Europe? QE is merely managing the economy in a consolidation phase for now, buying time to ‘see what else’ will happen.
The Fed Reserve has two mandates: 1) to keep inflation under control, and 2) to stimulate employment. Since the GFC, the Fed has successfully managed inflation, although it wasn’t hard in the current economic environment where consumers have cut spending and increased savings. In relation to Employment, however, whilst it has improved, it is not reflective of a strong economy. In fact, there is evidence that although the Unemployment rate has decreased, the number of unemployed who have given up work and the number of workers who want more hours (referred to as under-employed), have increased substantially.
Yellen is regarded as an economic “dove” which means her focus is likely to lean more toward tackling unemployment than inflation. As discussed above, inflation is of little concern – unemployment is. After all, a country with higher unemployment will struggle to stabilise and genuinely expand.
If we go back in time to the 1930s – and America’s New Deal policy – perhaps we may see Federal spending on infrastructure something we discussed in our article on 30/10/2013. With funds directed into improving the aged infrastructure in the US, creating jobs, and of course the multiplier effect as money from public spending stimulates that of the private sector – certainly a possibility and more importantly would directly impact on unemployment. This is the kind of QE policy which would quickly see the economy standing back on its own two feet and, what’s more, leave a legacy of world class infrastructure behind.
Earnings results have been surprisingly good for US companies through 2013. This has been due in part, to Company’s streamlining their business practices, and this unfortunately continues to be reflected in the Unemployment rate, which remains quite high.
Aggressive company cost cutting has driven the stock market higher, and along with extremely low interest rates, are the key driving factors behind corporate profits. But this hard to see continuing in 2014 – after all, how much more costs can be cut?
One source of fuel for US companies, has come from the US dollar, where its ongoing weakness has provided stronger export opportunities and overseas driven revenue. This has certainly been a major bonus, for the manufacturing sector.
Equally, technology developments have provided support in terms of energy. Specifically, the fracking industry has introduced a new lease of life into the oil and gas industry, again providing an important and supportive factor.
Our concern at a corporate level, is that valuations are based on earnings growth and quite where that can continue to come from (there is only so much more that can come from savings) is the question. If we see public spending jump and roll through into the corporate sector, that may well underpin future growth, but as we move through 2014 and particularly into the 3rd and 4th quarter reporting seasons, may start to highlight some vulnerability.
As such, we will be particularly mindful of hedging through long positions to insulate from any earnings disappointments.
Has unemployment bottomed out? Will we see renewed growth in 2014?
We will need to see improving economic conditions before any signs of improvement in Unemployment. And unless Unemployment improves, we won’t see the Fed ease QE.
Although many investors monitor the Unemployment rate fastidiously, what they fail to see is the ‘other’ data.
Here we have statistics from the US Bureau of Labor Statistics, showing the number of Unemployed who are ‘Discouraged’ from participating in the workforce. It also shows the average duration for unemployment.
The interesting fact about this data is that it has failed to decline since peaking in 2010, following the GFC. If the economy had really been improving, this would have declined to previously lower levels.
The next graph, sourced from calculatedriskblog.com, shows an even more interesting picture.
Reviewing all the recessions over the last 60 years, this data shows the time of recovery in Job losses from the peak of employment.
The current recovery is clearly outweighing all other Recession periods, with the recent 2001 recovery the 2nd largest period. Does this mean recoveries are becoming bigger and longer?
Don’t underestimate the dire position US Unemployment is in. It will take more than QE to stimulate an improved workplace, and without more workers earning money, there will be less taxes and less money flow. 2014 will see a turn in the Unemployment, but in the 2nd half of the year.
In normal economic conditions, we watch Inflation figures like a Hawk. Any signal of rising inflation results in Central Bank intervention to raise Interest Rates. Currently, Inflation is well within the target levels of the Fed Reserve, but at the same time, Interest Rates are at rock bottom lows.
Interest Rates will remain stagnant in first quarter of 2014, starting a rising cycle in the 2nd quarter. The Fed has no-where else to go but to print money or buy bonds as Rates are at rock bottom. If the economy surprisingly improves to a point where Inflation exceeds the target range, then the Fed will be forced to raise Interest Rates. But this won’t happen in 2014.
Past performance reflects future performance
A stock market correction is defined as a 10 to 20% decline. We haven’t seen this sort of movement in the markets for more than 2-years. This is despite the fact that headline events have included a European Recession, Doom & Gloom for countries such as Greece, Italy, and Spain, a US Government shutdown, several Debt Ceiling frights, the Fiscal Cliff, and Sequestration.
Based on the last correction in Jul/Aug 2011, the S&P500 index has risen 60%. Why? Low Interest Rates and Quantitative Easing (QE) measures from the US Federal Reserve are the key factors. The US economy has slowly been improving with company profits leading the way.
But as we’ve highlighted, company profits may not have the same punch in 2014 as they had in 2013. And when the Fed Reserve ends its stimulus programs in the 2nd half of 2014, this will cause concerns amongst investors. Unless there is a clear improvement in the GDP growth rate, there is a high probability of a market correction over the next 12-months.
The above chart shows the DOW Jones Industrial Index between 1928 through to 1930 – the Boom market just before the greatest stock market crash of the modern era. Accompanying this is the Dow Jones from May 2012 through to late 2013. The price activity is almost identical.
So while we will abide by strategies that meet the trend criteria, the first signs we get of a breaking trend, and we will be more Bearish than Grizzly Adams (a 1980’s TV series).
US Economic Outlook 2014 – Summary
There are many other factors that affect economic strength. All playing their part to piece together the jigsaw puzzle. One missing piece, and the puzzle is incomplete.
Our key view for the US economy is that there will continue to be stagnated growth. While the US stock market has continued to rise through 2013 despite the same weak economic story, we can’t help but view the stock market as being a little Overbought in relation to the economics.
It won’t take much to spook investors and send the markets tumbling. But while there is very little else for investors to put their money, the stock market will remain buoyed by hopeful ignorance. So while we view the markets’ as having limited opportunity for a continued Bullish run, we also don’t believe there will be a cataclysmic Bear market either. The big variable here is an improvement to the underlying economic state of play and, in particular, unemployment. Something that Ms Yellen will almost certainly have to target.
We look at 2014 as maintaining a stagnant range. Investing in stocks will almost be futile for the average investor, but for the initiated who understand using options, strategies such as the Covered Call/Buy-Write, Collar and Protected Put, will outperform the markets.
Outrageous Market Predictions 2014
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