Friday, June 5, 2015

"A Bump in the Road to 3% Growth," UCLA Anderson Forecast, June 2015

Just like last year, the economy hit a weather-induced
speed bump in the first quarter. Nonetheless we believe that
the economy will be back on its 3% real growth path by the
third quarter and continue at that pace through 2016. (See
Figure 1) At that rate of growth the economy will likely be
generating jobs at a 250,000/month clip and the unemployment
rate will close out the year at just below 5%. (See
Figures 2 and 3)
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

The Oil/Gas Price Conundrum

Although oil prices have rebounded from the first
quarter low they remain roughly half the peak levels
achieved in 2014. (See Figure 4) As we previously noted,
we expected the economic response to be a sharp decline in
oil drilling activity and a surge in consumer spending. Thus
far, we have gotten the drop in oil-related capital spending
where we forecast a $45 billion decline from peak to trough
at an annual rate. (See Figure 5)

However, we have yet to see the approximately $150
billion annualized reduction in gasoline prices to flow
through to consumer spending. (See Figure 6) Simply put,
instead of spending, it appears that cash strapped consumers
are paying down debt and increasing their savings. It’s
a thought echoed by Wal-Mart in its latest conference call
with investors which highlighted the soft retail environment.
Needless to say, this behavior is not accord with the historical
economics playbook. Nevertheless, for the time being, we
are assuming that the “tax-cut effect” of lower gas prices
will gradually find its way into higher consumer spending.

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

Figure 4 West Texas Intermediate Crude Oil Price,
2007Q1 – 2017Q4F
Source: Commodity Research Bureau and UCLA Anderson Forecast

Figure 5 Real Gross Investment in Mines and Wells,
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 6 Real Consumption spending,
Sources: U.S. Department of Commerce and UCLA Anderson Forecast
2007 2009 2011 2013 2015 2017

Figure 7 Consumer Price vs. Core CPI,
2007Q1-2017Q4, %CHYA
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 9 Trade weighted Dollar with Majority Currency Partners,
Sources: Federal Reserve Board and UCLA Anderson Forecast

Simply put, service prices and especially residential
rents are rising in excess of 2%. Underpinning the increase
in service prices will be the early signs of increasing wages
across most of the economy with notable pressure on lowend
wages. As we noted in the past, increases in state
mandated minimum wages and the actions by such large
employers as Wal-Mart, Target and Aetna are accelerating
this trend. Thus, we would not be surprised to see hourly total
compensation rising at a 4% pace by yearend. (See Figure
8) This domestic pressure will more than offset the fall in
import prices coming from the stronger dollar. (See Figure 9)

Inflation and the Fed

With the unemployment rate essentially at the Fed’s
target, all eyes are now focused on inflation. It has been our
view for a while that the core inflation rate, that is, the rate
of inflation excluding food and energy prices, would soon
be above 2% and that the headline rate will be there too
once oil prices begin to rise, which they have. (See Figure
7) This data will put to rest all of the over-hyped deflation
talk we heard earlier in the year. As a result, the quarterly
run-rate for inflation by both measures will be in excess of
2% by the third quarter of this year and it will be there on a
year-over-year basis by the first quarter of 2016.

figure 8 Total Compensation per Hour, 2007Q1-2017Q4
Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Thus, with the Fed’s dual mandate soon to be met, the
only question remains is the timing the move off the zero
interest rate policy that has been in effect since December
2008. As recently as last quarter we thought the Fed would
move in June. However, given the recent soft patch in the
economy our best guess is that the move will occur in September.
 We do not believe that a modest increase in the federal funds rate from zero
to 25 basis points will be traumatic. As Fed Vice-Chairman
Stanley Fischer recently noted, “we are going to be changing
monetary policy from the most extremely expansionary
we’ve been able to do in all of history to an extremely
expansionary monetary policy.”1

Thereafter we forecast that the Fed will only gradually
increase the funds rate at a pace consistent with 25 basis
point increases at every other meeting of the Open Market
Committee. (See Figure 10) Concomitantly, longer-term
interest rates rise as well, albeit at a slower pace with the
yield on 10-year U.S. Treasury bonds reaching 4% in 2017.
For those who fear the impact of higher short-term
interest rates on the stock market, we would remind them
that history suggests that it takes several rate hikes to cause
a significant correction in stock prices. Moreover, although
the Fed takes into account the effect of asset prices on the
economy, it would be a mistake to believe that Fed Chair
Janet Yellen is the stock market’s fairy godmother.

Figure 11 Yield on German Bonds, May 31, 2014 – May 15, 2015

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

Keeping a lid on long-term interest rates will be the
unusually low interest rates now in evidence in Europe.
As recently as April, the yield on 10- year German Bunds
approached zero! Since then they have more “normalized”
to about 60 basis points. Nonetheless, as deflationary fears
in Europe abate and the early signs of growth we are now
witnessing become realized, we expect interest rates in
Europe to rise as well.

Strength to Come from Housing and Equipment

Although we may have jumped the gun a bit last
quarter given the poor weather in most of the country, we
continue to believe that the housing market is strengthening.
Strong jobs gains, increased household formations, still low
interest rates, the easing of mortgage underwriting standards
and modest price increases will lead to a robust construction
market. Housing starts are forecast to increase to 1.16 million
starts this year and 1.37 million starts next year compared
to 2014’s start level of 1.00 million units. (See Figure 12)
Indeed housing starts rebounded in April to 1.14 million
units on a seasonally adjusted annual rate basis making
it the highest monthly total since 2007.

Part of the gain represented a catch up from the weather induced
 sub-one million
unit annual rate of starts in the prior two months. Moreover,
with rents rising well above the rate of increase in consumer
prices, recent shift from ownership to rental units will abate
leading to higher single-family and condominium starts.

On the business side, we forecast that investment in
equipment will rebound from a 5.7% overall growth rate
this year to 8.7% in 2016. (See Figure 13) Our confidence
in that eventuality stems from the waning of the negative
effects coming from the drop in oil-related capital spending
and the need for business to invest in the technologies being
embedded in a wide range of capital goods. That spending
along with housing will provide the fuel for our 3% real
growth forecast going forward.

Figure 12 Housing Starts, 2007Q1-2017Q4F,
Thousands of Units, SAAR
Source: U.S. Bureau of the Census and UCLA Anderson Forecast

Figure 13 Investment in Equipment,
2007Q1 -2017Q4F

Sources: U.S. Department of Commerce and UCLA Anderson

Military Spending to Increase

For the past year we have argued that increased global
tensions will reverse the four year decline in military spending.
(See Figure 14) We see nothing on the horizon to change
our thinking. If anything, we are concerned that the very
modest increases we are forecasting are too low. In fits and
starts Congress is moving in a more “hawkish” direction.

Despite the first quarter bump in the road, we think
the economy remains on track to a 3% growth path for real
GDP. As consumer spending begins to reflect the decline
in gasoline prices, the plunge in oil-related capital spending
abates and then reverses, housing starts and equipment
spending rise, the underpinnings are there for moderate
economic growth. In this environment, the unemployment
rate will drop below 5%, inflation will move above 2% and
the Fed will embark on a gradual tightening process starting
this September.

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