Despite 2013 proving to be a year of minor economic growth (below 2 percent YoY), the US economy is beginning to show signs that a sustainable uptick in growth is likely in 2014. The biggest change in the growth trajectory will be the reduction of the fiscal drag as a result of increased taxes and sequestration cuts put into effect in 2013.
The other major difference will be an increase in capital expenditure by corporations, as they prepare for a brighter future environment. We expect the economy to expand 2.5-3.0 percent in 2014, following 1.7 percent growth in 2013 (Figure 1). More importantly, the composition of growth will become more balanced, with a broader base of drivers, which is a divergence from the recent post-recession trend. So, what is the key difference in the year ahead? Business investment, along with the continued housing market recovery, should help to support stronger headline growth. The only major drag to growth in the outlook comes from government consumption, which is expected to subtract from GDP growth for the fourth year in a row. Even as growth moves closer to the long run average, overall GDP will remain below potential, although the somewhat faster pace of GDP growth should begin to close the gap between potential and actual GDP.
Despite the drag caused by reduced government spending and ongoing political uncertainty, core aggregate demand, as measured by real private sales, will continue to build momentum throughout the year. The year ahead should be marked by continued modest consumer spending but somewhat stronger business investment. These factors will combine to drive growth in real private final sales of 2.6 percent in the fourth quarter of 2013 to 3.3 percent by the fourth quarter of 2014. With core economic activity continuing to build momentum in 2014, the prospect of GDP returning to its historical 3.0 percent rate of growth will become increasingly likely in the years ahead.
Net exports will also play a more dominant role in supporting economic growth in 2014. We expect net exports to contribute 0.3 percentage points to overall GDP growth next year. Exports are expected to grow 6.6 percent, as somewhat stronger global economic growth along with the domestic shale gas boom, support the increased pace of export activity. The pace of import growth will also pick up compared to 2013 in lockstep with stronger real final demand growth in the United States.
We expect the manufacturing “renaissance” to progress as the global economy reaccelerates, and the consumer to remain resilient as job growth and consumer confidence improve from 2013’s modest 2.5 percent gain to around 4.4 percent in 2014.
Cheap US energy is a game changer. It is bolstering the US competitive position in energy-heavy industries, narrowing the current account deficit and underpinning long-term dollar strength. Energy price drops tend to increase GDP, push down inflation and boost consumption.
A critical question for Yellen (and policymakers elsewhere): How much of an economy’s woes (weak jobs and income growth) can be cured by monetary policy alone?
- US private sector employment is still 1.5 million below its pre-crisis peak and 10 million short of where it needs to be just to have kept up with population growth.
- There are more job vacancies than one would expect given high unemployment, as the so-called “Beveridge Curve” shows. This suggests skills shortages are holding back job growth.
- The unemployment rate is falling—but not always for the right reasons: Baby boomers are retiring, the share of women in the workforce has stabilized after a multi-decade rise, and young people are spending more time in school (racking up student debts in the process).
We expect the housing market recovery to continue in the coming year as residential investment plays a greater role in supporting headline GDP growth. Home prices will continue to appreciate but not at the pace observed over the past year. Housing affordability remains near its highest level in decades.
- Housing starts are still 44% below their 1970– 2008 average, The recovery has relied on investors chasing yield (first-time buyers are largely absent). The national housing market continues to transition away from a market driven primarily by speculators and investors to one being driven by the underlying positive fundamentals for both single and multifamily housing.
- Employment and credit availability are improving, albeit modestly, and the pace of the housing recovery varies considerably by region. After several years of dramatic price swings, home prices are set to moderate as supply adjusts to the economy’s slower long-term growth trend.
- Fed purchases of mortgages in 2013 amounted to more than three times net issuance, What happens when the Fed exits QE in earnest? Imbalances just might tip over.
Yellen is expected to remain dovish and transparent in order to reinforce increasingly positive economic fundamentals. Well-contained US inflation (of below 2 percent in 2014) is likely to help the Fed here. However the economy should be able to handle the Fed unwinding “emergency” policies and still move towards trend growth.
But Yellen may not start there. We see her giving even greater weight to the second part of the Fed’s dual mandate: full employment (over inflation). This means any QE exit will likely be offset by reassurances that rate hikes are still far away (forward guidance) and other measures.
We see the Fed using “forward guidance.” This means a lot of soothing promises not to raise rates until the economy is strong enough to warrant it. The Fed might even try to convince investors a little burst of inflation lies around the corner, encouraging people to spend.
Possible end already in March
Conditions are expected to improve over the course of 2014, and fall more in line with the Fed’s long run expectations of 2.2 percent–2.5 percent growth.
Secondly, the unemployment rate has declined from 7.9 percent in January to 7.0 percent in November (Figure 2). With the drop in labor force participation helping to lower the unemployment rate, the recent rate of unemployment continues to support the case for monetary easing. Yet, job gains have firmed since the start of the Fed’s most recent round of asset purchases and have picked up over the past four months. We believe the Fed will wish to see a few additional months of sound job improvement before scaling back purchases, in light of continued difficulty in lowering the unemployment rate.
We look for inflation to pick up over 2014, but to remain within the Fed’s comfort zone at 1.6 percent.
With economic fundamentals approaching a sustainable path, discussions have turned to monetary policy taking the first step toward normalization through a reduction in the pace of asset purchases. Which in some scenarios already starts as soon as March 2014.
The one sector of the economy that will continue to subtract from GDP growth in 2014 is government, specifically federal government spending. We expect overall government spending to decline with 0.5 percent for the year. The result will be a continued drag from federal spending throughout 2014, but this drag will not be as dramatic as the one observed in 2013. At both the state level and the local level, governments will continue to deal with modest revenue growth, but stronger tax collections should help to support somewhat higher state and local spending in the coming year. Thus, the higher spending at the state and local level will help to offset some of the expected drag from federal spending cuts.
Many investors are reluctant longs, and US equities look rich by most valuation metrics. Corporate profits are at a record share of output, with the wage share at a low. See the chart. This speaks to troubling trends of growing inequality and weak wage growth and brings into question the sustainability of these margins.
The S&P 500 is closing in on its best annual performance (~ 30 percent) since 1997, as accommodative monetary policy, an economic recovery gaining momentum and fading tail risks have fuelled risk appetite and P/E expansion. With the trailing P/E of the S&P 500 (16.6x LTM, last twelve months, earnings) above its 10 year average (15.7x LTM) and showing the strongest year of P/E expansion since 2009, equity appreciation will need to be driven by earnings growth in 2014.
Bubble talk is bubbling up. Should we be worried? Not yet, according to a market gauge that measures US corporate valuations, leverage and investor complacency. This simple tool divides enterprise value (EV) by earnings before interest, taxes, depreciation and amortization (EBITDA). We then divide the total by the volatility index to gauge investor complacency.
Where are we today? Valuations are roughly in line with their two-decade average (and leverage is lower). Yet volatility is hovering just above two-decade lows. The result: the market gauge stands well above its long-term average, but is far short of its pre-crisis highs. A reduction has to be driven by a falling EV/EBITDA ratio if volatility stays low. The longer markets rerate without profits, the greater the risk of a bubble.
Return to normalcy
Thus we could be about to return to a more “normal” investment environment. Volatility levels were remarkably low in 2013: as of early December, the S&P 500 had experienced only one “pullback” of 5 percent or more, while usually it would have experienced several. Possible increased volatility due to reduction in QE.
US earnings growth has been tepid in recent years due to the sluggish economic recovery. However, our expectation for economic growth to accelerate towards trend (2.5 – 3.0 percent) in 2014 should translate into an uptick in earnings growth (8 –10 percent). This should support attractive returns in equities (7–10 percent from current levels), but we caution investors that strong double digit returns are unlikely as P/E expansion will be challenged due to rising interest rates.
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Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.