Fourth Quarter 2014 Letter
January 7, 2015, By: Harris L. Kempner, Jr., President
We expect the U.S. economy to have real growth of 3 ½-4% in 2015, and thus to continue to decouple from much of the rest of the world, much of which is in slow-down or stagnation. In arriving at this, rarely have we noted that the economy of the U.S. and much of the rest of the world is so functionally affected by the cost of two major commodities – the cost of petroleum and the cost of money, as defined by interest rates. To be as precise as possible, we expect oil to range between the present $50/bbl and $65/bbl for the rest of the year, and interest rates to be up by a minimum of 25 and perhaps 50 basis points by the end of 2015.
Oil’s cost is dominated by the present world supply surplus and OPEC’s open gates policy that helps maintain it. The over 50% drop in oil prices in the last six months is known to us all, and is not likely to change much until markets balance more in late 2015-2016, or unless OPEC unexpectedly changes its stand. This sets up true economic advantages for consumers this year and is on balance, a tailwind for most industrialized economies including the United States. As one perspective of how this affects the United States, oil & gas related employment is 818,000 people, which is only .6% of U.S. total employment of 139+ million people. It is clear to us that cheaper oil will benefit the U.S. job market over all.
The price of money on the other hand, will be more a function of decisions made by the Federal Reserve as to whether to tighten in the face of presently slow inflation, but potential future price pressures. Please keep in mind again that labor is the most important cost factor in the U.S. economy. We see job availability as beginning to tighten, primarily because of lower overall unemployment throughout 2015. Further, according to the Wall Street Journal, at the start of 2015 the minimum wage increased in over 20 states. We expect that interest rates will be ratcheted up by the Fed toward the middle or end of 2015. This will occur in anticipation of inflation, regardless of what happens internationally or to the current CPI at the time, but we do not believe such moderate rate increases will derail strong U.S. economics. Because, despite the difficulties in the world around us and a Fed tightening to come, the picture of the United States economy is extraordinary.
- GDP growth for the 2nd and 3rd quarters, along with our expectations for the 4th quarter, should result in average GDP growth of approximately 4% for the final three quarters of 2014. This is a high growth pattern for the U.S., particularly when compared to our recent growth levels.
- Employment is increasing and we expect wage pressures and prices to increase during the year at a more rapid pace than has been true since 2007.
- U.S. deficits are coming down rapidly. We expect that unless there are major tax rate changes that affect 2015, the federal deficit in the U.S. will be less than 2.5% of GDP – well down from 10.8% in 2009.
- The U.S. Consumer will be benefited both by the decreased price of commodities, particularly oil, relatively low interest rates, and increasing real wages to their healthiest point since 2006.
- For the first time since 2009, overall state, local, and government spending is expected to increase in the United States – a major tailwind for the U.S. economy.
- This domestic strength leads us to project increased earnings for U.S. companies, even though some will be negatively affected by overseas difficulties.
We believe that all this will be happening, regardless of the foreseeable international economic difficulties; and therefore there will be pressures on wages and on associated costs, sufficient for the Federal Reserve to require interest rates to rise as previously stated. Of course, international or domestic events could unravel this picture, but we find such black swan events are not projectable.
Internationally, particularly outside of North America, the economic forecast is much less promising. We are skeptical than China can actually grow at their present government estimate of 7%, and it is at least possible that their growth will be much more sluggish than that. Despite the fact that they are a prime beneficiary of low oil prices, they are also entering a financial crisis of over-borrowing and underpayment that resembles what happened in the West in 2008-2009. We think this will be a larger factor than any benefits of lower oil prices and substantially reduce their growth rate. We are not forecasting a recession there, but it would not startle us to see them grow at only 3-4%. This will help keep a lid on commodity prices worldwide, and is one of the reasons why we don’t think oil prices will increase very substantially during the year.
Europe will be at best stagnant with questions continually arising about the validity of the Eurozone experiment. Germany’s growth is particularly slow. One factor in their favor which will help them is the relative weakness in the Euro and the lower price of oil, even in dollar terms in 2015. Both of these will enable them to be more competitive with exports, which is a crucial part of their economy. We do not believe, at this point, that Europe is going into an overall recession.
Japan however, is probably going into an overall recession and can’t be counted on much as far as world economic growth is concerned. And Russia, of course, is in an economic tailspin. This country could be the source of one or another black swan event that could undermine our forecast.
Even with the drop in oil prices negatively affecting the energy complex, we believe that the growth in the U.S. economy during 2015 will be sufficient to increase domestic corporate earnings overall. We expect the aggregate earnings increase of the S&P 500 to be between 5% and 7% – somewhat less than we anticipate the final numbers for 2014 will be. The salient question for any investor is whether overall price/earnings multiples will increase or decrease due to, what we project, will be the gradual interest rate increase policy of the Federal Reserve from mid-year onward. History indicates that it is almost always a negative to price/earnings for the market initially, but that the market P/E multiple can recover. This is particularly true if interest rates are moving upwards because the economy is getting stronger with relatively low inflation, which is likely to be the case this time.
Last quarter we stated that increased interest rates historically await wage inflation. We noted that here had been very little wage inflation in the five-year recovery and that continues to be true today. Remember that wages are about 70% of the cost of the U.S. economy. If they start to accelerate, inflationary pressures can materialize quickly. Everyone is trying to figure out when this might begin, which is why we think it is useful to have the insight provided by Nancy Lazar of Cornerstone Macro, who observes that “During the last two (economic) cycles, AHE (average hourly earnings) started to accelerate relatively sharply once unemployment declined to 5.5%.” If our labor participation rate does not increase soon, this point could be reached by mid to late 2015. That would make Fed tightening and higher interest rates much more likely.
We believe the U.S will be strong enough to continue to have above average growth in 2015 despite the travails of much of the rest of the world because of the internal dynamics described above. There are far more concerns about what may happen in the rest of the world this year than we have seen since the Great Recession and we will all have to keep an eye on whether these trends become much worse than we presently predict.