We all know of Aesop’s fable The Tortoise and the Hare—a story of two unequal opponents who agree to a race. The outcome appears to be obvious, but in a surprising twist, the ever-so-diligent tortoise perseveres and wins the race. The moral of the story is: slow and steady wins the race.
Historically the U.S. economy has been more hare-like. So what has changed? When did our economy go from consistently growing more than 3 percent annually to a tortoise-like economy with growth less than 2.5 percent? For example, from 1955 to 2005, the U.S. average real Gross Domestic Product (GDP) was 3.4 percent. Fast-forward to the period from 2005 to 2015 and real GDP averaged a paltry 1.5 percent, leaving economists wondering what happened.
To answer this question, we investigated two economic variables that drive potential GDP: labor force growth and productivity gains.
Data Source: Bureau of Economic Analysis
Labor force growth
In economics, potential output refers to the highest level of real GDP (output) that can be sustained over the long term. Year-to-year actual GDP may vary from potential GDP; this is called the output gap. Forecasting potential GDP should be relatively easy, as the formula is simply labor force‡ growth plus productivity gains.
Labor force growth has changed throughout the years and is influenced by several factors. In the 1960s and 1970s labor force growth changed due to population growth, the baby boomer generation reached working age and more women were working outside the home and entering the labor force. However, the significant labor force growth rate increase of the 70s will not be repeated anytime soon. One reason is that most baby boomers have more siblings than children, and labor force growth is partly a function of population growth.
The second variable is productivity, or the efficiency of production. According to the Bureau of Labor Statistics, productivity change in the non-farm business sector from 2007-2014 was only 1.3 percent.
Debate among economists: What drives productivity?
- Capital accumulation or…
- accelerating technical progress in high-tech industries plus the resulting investment in information technology
One common theme between both theories is that investment is critical to any growth theory. Therefore monitoring measures of human capital and research and development expenditures is necessary. We believe we will continue to see exciting new technologies developed in the future, but caution that even though new technology is introduced, the lack of adoption to these new technologies can be limiting to productivity. Therefore, we don’t see productivity gains spiking higher in the near future.
So as the fable goes, the tortoise never gives up—it is patient and persistent, and wins the race. This is a great parallel to the U.S. economy in 2016 and perhaps beyond. Our economy has been slow-growing since the Great Recession in 2009 and has continued on that path to real GDP of 1.5 percent in 2013, 2.4 percent in 2014 and near 2.4 percent last year.
I expect our economy to continue to grow at a slow and steady pace in 2016 with real GDP in the range of 2 percent to 2.2 percent. This is in part due to several tailwinds and a few headwinds.
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. The Federal Reserve Chairperson, 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.
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.
Data Source: Bureau of Labor Statistics
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 the 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 U.S. 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 their 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.
Data source: U.S. Census Bureau
Not everything outside of the U.S. 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 2.0 percent range. This may not sound like much, but remember in 2014 they grew at a 0.8 percent pace and last year at 1.5 percent.
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 that non-manufacturing data is solidly in growth territory, albeit trending south. 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 United States.
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 United States, and as we mentioned, China is slowing. It will have an impact on other emerging markets as well as on the United States 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 United States.
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 percent and 2.2 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 percent.
The moral to our economic story is slow and steady won’t be all bad on a relative basis. Our economy expanding at an approximate 2.1 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.
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K.C. Mathews joined UMB in 2002. As executive vice president and chief investment officer, Mr. Mathews is responsible for the development, execution and oversight of UMB’s investment strategy. He is chairman of the Trust Investment, Asset Allocation and Trust Policy Committees. Mr. Mathews has more than 20 years of diverse experience in the investment industry. Prior to joining UMB, he served as vice president and manager of the portfolio management group at Bank of Oklahoma for nine years. Mr. Mathews earned a bachelor’s degree from the University of Minnesota and a master’s degree in business administration from the University of Notre Dame. Mr. Mathews attended the ABA National Trust School at Northwestern University and is a Chartered Financial Analyst and member of the CFA Institute. He is past president of the Kansas City CFA Society and a past president of the Oklahoma Society of Financial Analysts.
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