Thursday, April 7, 2016

Disturbances in the Force, UCLA Anderson Forecast, April 2016

The January to February drop in stock prices, down
13% from early December, sent shivers through the economy
engendering fears that a new recession was at hand. (See
Figure 1) The markets were disturbed by fears of a far bigger
slowdown in China, continued stagnation in Europe
and Japan, a break in oil prices to $10 below the financial
crisis levels of 2009 and that the European banking system
was on the brink of a new crisis. (See Figure 2 which uses
the share price of Deutsche Bank as an example) However,
the markets soon calmed down and wiped out much of
their earlier losses as strong data from the consumer side
of the economy indicated that retail sales were solid and
employment growth remained robust. Simply put, aside

Figure 1 S&P 500, March 2015-March 2016
Sources: Standard & Poor's via

from modest declines in the industrial sector, there was no
recession in the data.

However, there are more disturbances on the horizon.
In June, the United Kingdom will vote on whether or not it
will stay in the European Union, commonly known as the
“Brexit” referendum. Whether leaving the European Union
is a wise move or not, the transition period will likely be
occasioned by increased market volatility. In the U.S. there
are two major presidential candidates who want to “blow
up” the global trading system as we have known it since the
end of World War II. Economists might not know all that
much, but trade wars usually do not lead to prosperity,
quite to the contrary.

Although we continue to believe the economy remains
on track for moderate growth, we are not as ebullient as
prior forecasts. The inventory correction we were looking
for last quarter is taking longer than we expected and though
the ramp up in single-family housing starts continues, it is
tracing a shallower path than what we previously thought.
(See Figure 3) For example, inventory accumulation added
$78 billion to real GDP in the fourth quarter of 2015; this
sector will only add $25 billion in this year’s third quarter,
a contraction of $53 billion. Thus, instead of looking for
3.3% growth in real GDP for 2016 on a fourth quarter-

Figure 2 Deutsche Bank Stock Price, March 2006-March 2016

fourth quarter basis we are now calling for a more modest
2.7% growth rate. (See Figure 4)

Despite the slower GDP growth rate, the economy
remains on track to create 2.4 million jobs this year and
1.5 million jobs next year as the economy operates at full
employment. (See Figure 5) Similarly, the unemployment
rate which stood at 4.9% in February, is on track to decline
to 4.6% by yearend. (See Figure 6) The rate of decline will
be slower than in the past few years as for the first time the
labor force participation rate is on the rise, a good thing.

Figure 3 Change in Real Inventory
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 4 Real GDP Growth
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 5 Payroll Employment
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 6 Unemployment Rate
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Monetary Policy: From ZIRP to NIRP

While the Federal Reserve left its zero interest rate
policy (ZIRP) behind last December, the European and
Japanese central banks have embarked on a negative interest
rate policy (NIRP) with unknowable consequences. Apparently
the $12.5 trillion of bond buying that the global central
banks embarked upon since 2008 hasn’t been enough to pull
both Europe and Japan out of the quagmire they now find
themselves in. In a negative rate regime instead of paying
interest the borrower receives interest and lender pays interest.
It is truly an “Alice in Wonderland” world. Reflective
of the dour outlook, negative yields are common in many
developed markets. (See Figure 7)

The obvious problem with NIRP is that it will destroy
the business models of life insurance companies and pension
plans and has the potential to do the same for the banking
system. We don’t know how much lower negative interest
rates can go and we don’t know whether it would be legal
for the Federal Reserve to undertake such a policy if it is
deemed necessary.

Meantime, the Fed appears to be ready and willing
to raise interest rates this year. Consistent with the March
Fed statement, we expect two or maybe three increases
in the Fed Funds rate this year with the first one likely
to be in June. (See Figure 8) Thereafter, we expect gradual
increases with the Fed Funds Rate ending 2017 at about 2%.
With much of the world in NIRP territory, policy rates will
be constrained in the U.S. The same holds true for longerterm
rates where we forecast the 10-Year Treasury to end
2016 at about 2.6% and end 2017 at about 3.6% compared
to a mid-March rate of 1.9%.

Figure 7 Government Bond Yields in Selected Countries,
March 18, 2016
Sources: The Wall Street Journal

Figure 8 Federal Funds vs. 10-Year U.S. Treasury Bonds
Sources: Federal Reserve Board and UCLA Anderson Forecast

Figure 9 Consumer Price Index vs. Core CPI
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Nevertheless, the Fed will be under pressure to raise
interest rates because it is about to get the inflation it has
been praying for. Specifically, as of February, the year-over-year
increase in core consumer prices was 2.3% and it is
forecast to approach 3% by 2017. (See Figure 9) Similarly,
with oil prices likely to have bottomed earlier this year, and
with the tightening labor market finally working its way
into employee compensation, headline consumer prices will
be rising at a 3% clip by the end of 2016. (See Figures 10
and 11) We would note that as of mid-March the price of
oil was tracking above our forecast and whether that trend
continues could very well depend upon an OPEC/Russia
meeting scheduled for April 17.

The U.S. Consumer is in Good Shape

Despite issues concerning the distribution of income
and debt burdens, the U.S. consumer remains in good shape
overall. Consumption will continue to be on a 3% growth
path throughout 2016 and it will be accompanied by a saving
rate in excess of 5%. (See Figures 12 and 13) Where
previously we thought that much of the consumer benefits
flowing from lower gasoline prices would be spent, a goodly
portion of it was saved. That being said, the lower gasoline
prices seem to have found their way into generating near
record automobile sales.

Housing starts continue to improve, albeit at a slower
pace than we previously thought. After reaching 1.106
million units in 2015, we forecast starts to increase to 1.24
million units and 1.43 million units in 2016 and 2017, respectively.
(See Figure 14) Our prior forecast for 2016 was
for 1.4 million units, but the forecast for 2017 is much the
same as before. Homebuilders did not ramp up single-family
production as fast as we thought and they concentrated their
activity on the higher end of the market. There is now anecdotal
evidence that the builders are shifting their emphasis
towards starter homes where there is real pent-up demand
coming from increased household formation, modest income
growth and rising rents. Our prior forecast for multi-family
starts of in excess of 400,000 units a year remains on track.

Figure 10 Oil Prices, West Texas Intermediate
Sources: Commodity Research Bureau and UCLA Anderson Forecast

Figure 11 Employee Compensation
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 12 Real Consumption Expenditures
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 13 Savings Rate
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 17 Real Private Gross Domestic Investment in
Commercial Buildings
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 16 Real Gross Private Domestic Investment in
Mines and Wells
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Capital Spending Growth Remains Tepid

With the industrial economy in a shallow recession and
oil exploration capital spending dropping below the nadir
of 2009, we should be thankful for the modest increases in
capital spending we are witnessing. Specifically, we forecast
that equipment capital spending will increase at a 4-5% pace
over the next few years, not great, but certainly not a recession.
(See Figure 15) On the other hand, investment spending
on structures is in the midst of a two-year decline triggered
by the collapse in oil exploration spending. (See Figure 16)
Specifically, real investment in mines and wells will have

Figure 14 Housing Starts
Sources: Bureau of the Census and w Anderson Forecast

Figure 15 Real Gross Private Investment in Equipment
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

declined by 60% from $137 billion in the fourth quarter
of 2014 to a forecast $56 billion in the first quarter of
2016. Most people don’t realize that construction in the oil
exploration and production sector was far larger than the
entire commercial construction sector, no more.

On the other hand, commercial construction is gaining
strength. Improved fundamentals for office and industrial
construction are driving spending in this sector that is being
fueled by an abundance of capital seeking modest yields in
a low-yield world. (See Figure 17) In contrast, spending on
retail structures is now being driven by negative fundamentals brought about by e-commerce. Major malls are seeking
to remain relevant by making huge investments in renovation
on the order of $500-$800 million per mall at the high end.

Exports Remain a Real Risk

With a strong dollar and weak economic growth in
Europe, Japan, Canada, China, Brazil and the Middle East,
the U.S. export sector remains under pressure. We are still
forecasting minimal growth this year, but the real risk is that
we can very easily have a decline. (See Figure 18) If you
want to tell a story about a U.S. recession it would have to
begin in this sector, but even with a modest decline it would
not be enough to put the U.S. into a recession.

Figure 18 Real Exports
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Government: A Modest Positive

After several years of decline, federal purchases are
once again on the rise. Whether federal spending continues
to rise over the intermediate term will largely be dependent on how this year’s election turns out. (See Figure 19) The
increase this year is due to the temporary lifting of the
sequester that has been in place since 2013. Similarly, the
much larger state and local sector has been growing since
2014, but it will once again face the twin pressures of higher
pension and Medicaid outlays as the decade ends.


We don’t see a recession this year or next and we do
envision inflation rising above the Fed’s 2% target. As a
result, we are forecasting slow and steady increases in the
Federal Funds rate over the next few years. And although
we have continued growth in 2018, a forecast that far out is a
conjecture. Growth will be driven by increases in consumer
spending and housing along with the end of the inventory
correction we are now going through. The risks we envision
largely come from outside of the U.S. domestic economy
where disturbances in Europe and Asia along with domestic

politics have the potential to cast a pall over the economy.

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