Saturday, March 14, 2015

An Island of Stability in a Volatile World, UCLA Anderson Forecast, March 2015

Amid slow growth and currency devaluations
throughout much of the developed world, the United States
looks like an island of stability in a very volatile world. We
continue to believe that the U.S. economy is on a 3% real
GDP growth tack over the next two years. (See Figure 1)
With that, payroll employment will be increasing at a solid
250,000 jobs a month pace and the unemployment rate will
hit 5% by yearend. (See Figures 2 and 3) To be sure, the
labor force participation rate will remain far lower than what
it was prior to the financial crisis.

Figure 1 Real GDP Growth, 2007Q1 -2017Q4F
Source: Sources: U.S. Department of Commerce and UCLA Anderson

Figure 2 Payroll Employment, 2007Q1 – 2017Q4F
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Currency Wars

In a rerun of the 1930s, the developed world is witnessing
a series of central bank driven competitive devaluations
that was initiated by the United States in 2010 with what is
now known as QE2. Put bluntly, each trading bloc is seeking
to export the economic weakness they are experiencing to the
rest of the world. As a result, along with policy uncertainty
within the Eurozone, the U.S. dollar has soared, rallying 16%
from the 2014Q3 to 2015Q1F. (See Figure 4)

For the world economy as a whole, a series of competitive
devaluations cannot work unless the cumulative rounds
of quantitative easing ignite global growth. Meantime, with
Europe and Japan mired in near-zero growth, the U.S. looks
like an exception.

The combination of very sluggish growth in Europe
and Japan, near zero inflation rates and the implementation
of quantitative easing policies has created an unprecedented
environment of negative interest rates. Where the so-called
zero bound for interest rates has previously been broken in
periods of extraordinary financial crisis (i.e. 2008 and 1933)
negative short-term interest rates have become rather com-

Figure 3 Unemployment Rate, 2007Q1 -2017Q4F
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4 Trade-Weighted Dollar with Major Currency Trading
Partners, 2007Q1 – 2017Q4F
Source: Federal Reserve Board and UCLA Anderson Forecast

Figure 5. Global Economic Forecasts, 2014-2017, Real GDP, %chya
Sources: Goldman Sachs Global Economics Weekly, February 12, 2015

mon place. Furthermore, 10-year sovereign debt for much
of Europe and Japan now trades well below 1% making U.S.
yields at 2% looking like Mount Everest. (See Figure 6)

A strong dollar that raises export prices mixed with
weak economic activity abroad is not a good recipe for export
growth. As a result, real exports will only grow a modest
3-4% pace over the next few years, well below the 9% clip of
nearly a decade ago. (See Figure 7) Concomitantly a stronger
U.S. economy coupled with cheaper import prices will suck
in imports from most of the world. Real imports are forecast
to increase at a 7% pace this year and next, well above the
3.4% average from 2012-2014. (Figure 8) Remember here
we are talking about real imports which ignore the huge
drop in the price of oil.

Figure 6 Sovereign Debt Yields for Selected Countries at
Various Maturities, February 24, 2015
Sources: CNBC and Bloomberg

Figure 7 Real Exports of Goods and Services,
2007-2017F, Annual Data
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 8 Real Imports of Goods and Services,
2007 -2017F, Annual Data
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 9 Federal Funds vs. 10-Year U.S. Treasury Bonds,
2007Q1 -2017Q4F
Sources: Federal Reserve Board and UCLA Anderson Forecast

Getting Ready to Move Off of Zero

Despite getting a major break from the dramatic decline
in oil prices and the strong dollar which are temporarily
suppressing inflation, we believe that the Fed will soon
move to end its 6+ year zero interest rate policy. Given the
strengthening labor market and the likely bottoming of inflation
in the second quarter, we think the Fed will embark on
a very gradual pattern of increasing the federal funds rate.
(See Figure 9) By this we mean that instead of raising rates
.25% at every meeting as was done in the mid-2000s, we
believe that the Fed will initially increase rates at alternate
meetings. Similarly, it seems that long-term interest rates
bottomed in early February and despite very low rates of
interest in Europe and Japan the yield on the 10-year U.S
Treasury bond is now on a path to rise from the current 2%
to about 4% in late 2016.

The very low rates of inflation we are now experiencing
will soon reverse as oil prices rebound, more on that
below. Indeed headline inflation as measure by the consumer
price index will likely rise to 3% or more by late 2016. (See
Figure 10) In a similar vein, core CPI will likely to be running
above 2.5% as well. Moreover, wage compensation
after being muted for many years is about to show more
robust gains from about 2% to somewhat over 4% during the
next few years. (See Figure 11) We believe that Wal-Mart’s
move to raise their lowest wage to $9.00 an hour in April,
above the current national minimum wage of $7.25 an hour,
of this year and to $10 an hour next year “rang the bell” to
a new regime of higher wage growth.

The Mostly Ups and One Big down from Lower Oil

The $50/barrel collapse in oil prices brings a gross
savings to the economy of about $350 billion a year and
net savings of about $150 billion a year; the latter being the
reduced cost of imported oil. (See Figure 12) More simply,
with the United States consuming 135 billion gallons
of gasoline a year, a $1.00 a gallon reduction amounts to
$135 billion. Although much of this savings has yet to flow
through to retail spending, we do note that restaurant and
bar sales were up 11% year-over-year in January and overall
consumer spending is strong. (See Figure 13)

Figure 10 Consumer Price Index vs. Core CPI,
2007Q1 – 2017Q4F
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 11 Total Compensation per Hour, 2007Q1 – 2017Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 12 West Texas Intermediate Crude Oil, 2007Q1
Source: Commodity Research Bureau and UCLA Anderson Forecast

Figure 13 Real Consumption Spending,
2007Q1 -2017Q4F, Quarterly Data

It’s very obvious the drop in the price of crude oil,
has put the domestic oil industry in a world of hurt. We
estimate that the industry is losing about $200 billion a year
in revenues. Moreover, the oil intensive regional economies
of Texas, Louisiana, Oklahoma, Alaska and North Dakota
will suffer with them. However, the decline in oil prices
involves more than a loss of revenues for the domestic oil
producers; it is also causing a dramatic drop in the capital
spending associated with new oil wells. Most people including
more than a few economists do not realize that mining
nonresidential fixed investment (almost all of it related to oil
and gas production) is larger than commercial construction.
As a result, investment in this sector will plummet over the
next few quarters from an annual run rate of $140 billion to
about $100 billion. (See Figure 14)

Housing Construction Accelerating

The combined effect of lower gasoline prices along
with relaxed down payment requirements, strong employment
growth that is supporting new household formations,
low interest rates that are likely to stay lower longer is causing
us for the first time in several years to raise our estimates
for out year housing starts. For example, last quarter we were
forecasting 2015 and 2016 housing starts at 1.209 million
and 1.344 million, respectively. We are now at 1.248 million
and 1.392 million for those years. (See Figure 15) As
with prior forecasts we continue to believe that multi-family
housing starts will exceed 400,000 units a year in both 2015
and 2016. Thus, the increase from prior forecasts will be
coming from the single-family starts.

Figure 14 Real Gross Investment in Mines and Wells,
2007Q1 -2017Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

There is a lot of anecdotal evidence that housing activity
began to significantly improve in late January. Traffic
is up at new developments and builder optimism is rising.
Perhaps the drop in gasoline prices is showing up in the
form of increasing demand for housing. While consumers
are probably wisely concluding that today’s gasoline prices
might not be here forever, they are likely not to go back to
their old highs for many years to come.

Defense Spending to Increase

You don’t have to be a geopolitical strategist to figure
out that the world is in disarray. With the United States
policy facing challenges in Ukraine, the middle-east and
the South China Sea, the post Iraq War decline in defense
spending is behind us. As we have done in prior reports,
we believe that defense spending is now on the rise. (See
Figure 16) Our view is buttressed by the fact that President
Obama has asked Congress to lift the sequestration limits
on both domestic and defense spending. We believe that the
Republican Congress will be more than willing to give him
the higher defense spending he is requesting.

Figure 15 Housing Starts, 2007Q1 -2017Q4F
Sources: U.S. Bureau of the Census and UCLA Anderson Forecast


Despite weak global growth and the very strong U.S.
dollar, the economy remains on a 3% growth path for real
GDP over the next two years that will bring the unemployment
rate down to 5% by the end of this year. While inflation
is being temporarily suppressed by the drop in oil prices,
it will soon be running above 2% as oil prices gradually
recover. In response to the improved labor market and the
expectation of higher inflation, the Fed will begin a gradual
tightening process in June. The near-term downside for the
U.S. economy will come from a collapse in the capital spending
associated with oil and gas production, while housing
starts will advance more quickly than previously predicted.

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