As we close out the first half of 2017, many of the major U.S. equity indices are at or very near all-time highs, equity market volatility is exceptionally low (Vix hovering around 10), unemployment, at just 4.3%, is at levels not seen since mid-2001, and inflation, although creeping upwards ever so slightly, remains benign. At the same time, the yield curve is flattening as intermediate and longer term bond yields are trending lower once again as are the prices for some commodities – most notably oil which is now below $44/bbl.
The U.S. economy is exactly eight years beyond the June 2009 official end to the Great Recession. During this eight-year window, we have seen the S&P 500 rise from 919 on June 30, 2009, to 2439 today (June 26, 2017). We have also seen unemployment fall from 9.5% to 4.3% (May 2017 figure, as June data is not yet available) and new home sales increase from an annualized rate of 384,000 units in June 2009 to an annualized rate of 610,000 units in May 2017.
However, now that the U.S. is eight years beyond the last recession and with U.S. equity markets feeling like they might be getting a bit top-heavy, many investors and market analysts are beginning to wonder what might lie ahead for the remainder of this year and into 2018. Much of the focus is once again on central bank activity around the world. For the past ten years, since the start of the financial crisis that eventually swept around the world, investors, market analysts, and economists have closely studied, analyzed, and followed what the major central banks around the world have done or not done in their attempts to curb the recession, stimulate economic activity, and encourage economic recovery from one of the most vicious recessions in recent history.
Central banks are primarily charged with managing the demand for, and supply of, money in their respective economies in order to help manage sustainable economic growth in a reasonable inflationary environment (usually around 2%). Central banks have several key tools at their disposal, including the ability to raise and lower important short-term (usually overnight) interest rates; the ability to buy and sell securities in the open marketplace; and the ability to set reserve requirements (the assets-to-liabilities ratios banks must maintain). Central banks use these tools to increase or decrease the amount of money in their respective economies and to make access to this money more or less expensive. As you would expect, cheap and plentiful access to money stimulates economic activity while more expensive and limited access to money slows economic activity.
In June 2017, the U.S. central bank (a/k/a the Federal Reserve) raised the federal funds rate by 0.25% for the fourth time since December 2015. At that time, the fed funds target range was 0% – 0.25%. Thanks to rate increases in December 2015, December 2016, March 2017, and June 2017, the target range is now 1% – 1.25%. Outside the U.S., however, key central banks remain fairly accommodative. For example, the Bank of Japan announced on June 16th that it will “apply a negative interest rate of – 0.1% to the Policy-Rate Balances in current accounts held by financial institutions at the Bank” and that it will continue to purchase Japanese government bonds, exchange traded funds, and Japanese real estate investment trusts. (http://www.boj.or.jp/en/announcements/release_2017/k170616a.pdf) In the European Union, the European Central Bank first took its key short-term interest rate into negative territory in June 2014 where it still remains (currently -0.40%). China’s central bank recently increased some of its short-term interest rates by 0.10%, in part to support the yuan. However, the bank also maintains this was not an official rate increase or indicative of any change in their monetary policy.
The U.S. was the first major world economy to respond to the Great Recession by using accommodative monetary policy to ward off the rapidly worsening financial crisis. In September 2007, the Federal Reserve (Fed) dropped the federal funds rate from 5.25% to 4.75%. In fairly rapid succession a number of other rate reductions ensued. By December 2008, the fed funds rate was essentially zero (0.0% – 0.25%) where it remained until December 2015. Along the way, the Fed used copious amounts of quantitative easing to further stimulate the U.S. economy. Although controversial and at times heavily criticized, the Fed’s efforts eventually enabled the U.S. economy to emerge from recession and begin on a slow and steady recovery path.
Unfortunately, a number of the world’s other major economies chose to respond to the financial crisis by following a path towards austerity. At the same time the Fed was injecting money into the U.S. economy, many European countries were removing money from their economies by raising taxes and cutting government spending in order to avoid becoming the next “Greece.” However, this approach failed to yield positive results and eventually these countries switched over to the accommodative measures employed by the Fed. These methods are starting to work and economic activity overseas is on the rise, but these economies are behind the U.S. in terms of where they stand on the road to recovery. It turns out, however, that the delayed use of accommodative policies by central banks outside the U.S. actually helped the U.S. economy make a smoother transition away from its heavy reliance upon the Fed’s accommodative policies to standing on its own. Just as the Fed was ratcheting back its support of the U.S. economy, the European Central Bank and the Bank of Japan were beginning to inject lots of money into their respective economies. Some of this money eventually found its way to the U.S. as overseas investors sought out the better yields available in U.S. bonds and dividend-paying equities. In a back-door sort of way and at a most useful time, the U.S. economy benefitted from quantitative easing efforts overseas and continues to do so.
At this juncture, halfway through 2017, the U.S. economy continues along its slow and steady path of growth – as measured by the Gross Domestic Product (GDP) – coupled with relatively benign inflation. As you can see in the GDP chart at left, 2017 began with a tepid 1.2% rate of growth in the first quarter. This has been the pattern of late – a sluggish start to the year followed by more robust growth.
Still, the U.S. economy has not been able to achieve an annual growth rate of 3% (or more) since 2005. More troublesome is the Congressional Budget Office’s projected average annual GDP growth of just 1.8% between 2017 and 2027. The International Monetary Fund (IMF) also just reduced its growth expectations for the U.S. economy – from 2.3% to 2.1% in 2017 and from 2.5% to 2.1% in 2018. The IMF also expects 1.9% U.S. GDP growth in 2019 and 1.8% GDP growth in 2020. The apparent inability of the U.S. economy to generate more robust growth suggests there may be issues or circumstances beyond the Fed’s control that are at play here. In no particular order, we think the following items may be contributing to the current state of the U.S. economy and the forecasted ongoing slow growth environment:
- The aging U.S. population – demographics are not in our favor right now as an aging population consumes more government resources (Social Security and Medicare) and leaves few workers to pay into and financially support these systems.
- Declining worker productivity – as you can see in the following chart, worker productivity in the U.S. over the last nine years is at levels not seen since the 1970s and less than half of what is was between 2000 and 2007. The widespread introduction of technology into the workplace contributed to heightened worker productivity between 1990 and 2007. Technology drove efficiencies in many industries and enabled workers to accomplish far more in less time. More recently, however, and in the absence of newer revolutionary technological advances with widespread applications throughout the workforce, technology is not the same driving force in worker productivity that is was not so long ago. While frustrating, this is also normal. There are certainly technological advances currently under way that may prove to be the next major boost to worker productivity – think driverless cars, artificial intelligence, advanced robotics, etc. But, as with all developments, they take time to mature and blossom and there are fits and starts along the way.
- Competing monetary and fiscal policies – for about ten years now, U.S. monetary and fiscal policies have been at odds with each other. On the one hand, the Fed has worked hard to stimulate and support the U.S. economy by making access to money cheap and plentiful. On the other hand, Congress, the entity in charge of fiscal policy, has raised taxes and imposed a plethora of onerous regulations onto companies and individuals. In other words, U.S. fiscal policies drew money out of the U.S. economy in the form of higher taxes and made it significantly more difficult for banks to lend money to individuals and companies. As a result, throughout the recession and recovery, U.S. fiscal policies muted what should have been the true impact of U.S. monetary policies.
- Rise in government regulations – as noted above, the large increase in government regulations over the last decade costs the U.S. economy a staggering amount of money. For example, the total annual cost of new rules and regulations implemented during the first seven years of the Obama Administration is estimated to be in excess of a shocking $100 billion. (http://www.heritage.org/government-regulation/report/red-tape-rising-2016-obama-regs-top-100-billion-annually) The time and money spent by the government on writing, implementing, and enforcing regulations and the time and money spent by individuals and companies to understand and then comply with the growing mountain of regulations is time and money that is not spent on other productive work such as hiring and training new employees or growing and expanding a business.
- The velocity of money is exceptionally low – the velocity of money measures how quickly a dollar circulates through the economy within a specified time frame. For example, if you earn $10 at work and then spend this money at the store and the store takes your $10 and pays its employee who then takes this money to buy a movie ticket… etc. As you can see in the Velocity of Money chart at left, velocity is at unprecedentedly low levels right now. Despite all the Fed’s quantitative easing efforts, much of that money still sits on bank balance sheets to this day. Why you may ask? See #4 above – primarily because of new banking regulations enacted over the last decade.
- Oil prices are falling again – Thanks to major increases in oil production capabilities in the U.S. and overseas, oil supply exceeds demand. Also, oil producers can now turn on and off their oil production capabilities far more easily than in the past. As a result, we expect oil prices will likely hover around $45 – $60/bbl for the foreseeable future.
- The Fed still has to deal with its $4.5 trillion balance sheet – although the Fed has been gradually tightening monetary policy over the last few years by first eliminating quantitative easing and then starting to normalize interest rates, the Fed still has to tackle its unwieldy balance sheet. As you can see in the graph on the following page, the Fed’s assets increased dramatically during the quantitative easing period (from well under a $1 trillion to almost $4.5 trillion) and have yet to be reduced.
- Eventual tightening by the other central banks – although a number of other central banks continue to employ highly accommodative monetary policies, at some point they too will need to change their policies and eventually begin tightening. The ripple effects of this when it happens could impact the U.S. economy just as the accommodative efforts have.
Although the U.S. is facing a number of challenges as it heads into its ninth year post-Great Recession, we are still cautiously optimistic that slow and steady economic growth will continue and that changes in corporate and individual tax rates could support and promote economic growth going forward. We also think that a long overdue overhaul of U.S. infrastructure (roads, bridges, electrical grids, air traffic control, etc.) would further promote economic growth over time. Stay tuned and we will update you on developments and our thoughts in next quarter’s Economic Review!