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Economic Forecast 2016, Part 2: Headwinds and Tailwinds

By KC Mathews

 

As I mentioned in part 1 of our economic forecast (March BankNews), I expect our economy to continue to grow at a slow and steady pace in 2016, due in part to the several tailwinds and a few headwinds.

Tailwinds

The labor market, consumer confidence and low interest rates are a few of the positive variables that support our expectation for steady, ongoing economic expansion.

The robust labor market gives us confidence that the U.S. economy will continue to grow at a steady pace. By the end of 2015, the number of full-time workers rose to a record high of 122.6 million. Federal Reserve Chairman Janet Yellen suggested in her recent testimony that payroll growth of 100,000 per month can absorb all of the new entrants into the labor market.

For additional perspective, historically payroll growth of 200,000 per month supports economic growth of 2.5 percent or better. Falling in line with our forecast, we expect 200,000 new jobs will be created on average per month in 2016.

Additional data supports a solid labor market. The median duration for the unemployed fell to 10.5 weeks, the lowest in seven years. Finding part-time workers is becoming more difficult and as the job market improves, we think more people will be encouraged to consider seeking employment. As the labor market tightens, wages will be on the rise as well.

This dovetails into consumer confidence. When consumers feel good, they will support the economy by spending. Consumer confidence was relatively flat throughout 2015, but remains at a level that supports economic growth. Confidence is primarily driven by the labor market, stock prices and home prices.

The strength in the aforementioned labor market, paired with home prices up 5.5 percent last year, should continue to support confidence. Lower oil prices also gave most consumers a good feeling as their transportation costs were reduced. The wild card here is the stock market. Investors saw mediocre returns last year (only 1.4 percent return from the S&P 500) along with higher volatility. Weak markets and an increase in volatility may shake consumer confidence this year.

The Fed has kept interest rates low for seven years. We think interest rates will be on rise throughout 2016, ending the year at 1 percent. However, from a historical perspective, the Fed policy remains extremely expansionary, affording consumers and businesses access to inexpensive capital.

Perhaps China is getting a bad rap; it seems to be blamed for any problem ranging from stock market volatility to global warming.  However from our point of view, it’s not all bad. The United States imports more goods from China than from any other country. As China devaluates its currency, the yuan, those everyday goods we import become cheaper, which is good for consumers. As China’s economy slows to a more sustainable level, the demand for energy and commodities wanes and prices are reduced. Again, this is good for the U.S. consumer.

Not everything outside of the United States is necessarily a negative story, as some would lead consumers to believe. With low interest rates and a quantitative easing program, Europe could experience economic growth in the 1.5 percent to 2 percent range. This may not sound like much, but remember in 2014 Europe grew at a 0.8 percent pace and last year at 1.5 percent.

Headwinds

It’s not all rosy. Some headwinds lead to slower growth and some may not have a significant impact on our economy directly, but rather they may spook risk markets. Stocks are included in this category.

The recent U.S. manufacturing data is suggesting an oncoming economic contraction. For two quarters now, the ISM Purchasing Managers Index has been below 50, indicating a contraction. The good news is the non-manufacturing data is solidly in growth territory, albeit trending south. Back to the bad news, historically the manufacturing data leads the non-manufacturing data. Once again, we think the current data supports a tortoise-like economy in the U.S.

The Fed has a tough job: maximize employment, stabilize prices, support global markets, normalize interest rates. Oh, and don’t send us into a recession. Many recessions have been blamed on the Fed for creating a policy error, which is typically viewed as moving too fast or too soon. At this time we don’t see a policy error at hand. The Fed plans to move at a measured pace and it doesn’t look like it will threaten a tortoise-like expansion.

Issues in the global economy will constrain growth in the U.S. and, as we mentioned, China is slowing. It will have an impact on other emerging markets as well as the U.S. to a lesser extent. We don’t believe the Chinese stock market gives us any indication of economic fundamentals due to the speculation in their markets and government intervention. However the massive volatility of their stock markets sends a violent reaction to markets around the globe. If downward pressure continues, it could negatively impact consumer confidence in the U.S.

Energy is also an important variable. Even though low energy prices are good for the consumer’s wallet; tension in the Middle East may create an uneasy global economy. And while much of this won’t significantly affect the U.S. economy, it may affect our markets in the short run.

A Slow and Steady 2016

In 2016 we anticipate GDP growth between 2.2 percent and 2.5 percent. We think this will be supported by the labor market once again as businesses create new jobs.

Domestic equity returns may once again be challenged, profits are in question and valuations may contract. We expect 3 percent earnings growth which should lead to total returns in the 4 percent to 6 percent range.

We also think interest rates will be on the move this year, expecting both short-term and long-term rates to increase. Fed Funds should end the year at 1.25 percent.

The moral to our economic story is slow and steady, which won’t be all bad on a relative basis. Our economy expanding at an approximate 2.3 percent pace will allow the Fed to normalize interest rates and companies will find a way to be profitable and continue to hire workers, supporting consumption.

 

KC Mathews is executive vice president, chief investment officer of UMB Bank, n.a., Kansas City.

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