2014 – A Look Ahead

Flying back from Rwanda earlier this week gave me hours (33 to be exact) of time to reflect on many things. When I completed notes from my meetings in Kigali, I spent some time looking ahead to next year and what we as investors might expect. While I’m usually optimistic, the logical conclusion seems to be pointing considerably more negative than positive. Odds are for a slow-down, maybe even the ‘R’ word.

We are now 54 months into recovery since the Great Recession. The average length of recoveries since WWII is a little over 60 months. This one has been on the bottom of the heap from a growth standpoint. Averaging just 2%, job growth and capital investment have been and remain sub-par. The ability of government to provide stimulus is waning and in fact set to become a potentially large drag on the economy as Federal spending cuts are set to go deeper this year and the Federal Reserve must begin tapering QE3 soon.

On the fiscal side of the government the Congress seems to be operating surprisingly well lately in bipartisan fashion. But the ideological realities will once again rear their ugly heads in February. Democrats remain just as reticent to cut entitlement spending as Republicans are to raise taxes. The next round of spending cuts from sequestration are draconian compared to this year’s cuts. Government spending, no matter how inefficient, is a stimulant to the economy. Given the current weakness government and additional cuts or tax hikes will certainly have an impact.

On the monetary side, Janet Yellen is due to take over as the new Fed chair at the end of January. She is expected to emphasize the job creation side of the dual mandate over inflation prevention. This path suggest a smoother and slower tapering of the fiscal stimulus of QE3, but increases the possibility for inflation. Ms. Yellen also leans more toward the ideas that bubbles are increasingly a reality and that the threat of failure of one large financial institution can still bring down the financial system. Only greater regulation can help to prevent this threat.

Interest rates are due to rise as the Fed begins its tapering and if inflation picks up. Higher interest rates will not be good news for the housing market. Rising mortgage rates will reduce the number of prospective buyers, particularly those who have been impacted by slowing growth of personal incomes – that’s the mid and lower classes.

Bloomberg’s chief economist Rich Yamarone points out that “housing starts were 883,000 in August, lower than the 919,000 in May and 1,005,000 in March. Existing home sales were 5.12 million, lower than the 5.39 million units in July and August, while new home sales totaled 421,000 in August, down from a 454,000 pace in June. Pending home sales have fallen for five consecutive months, and are 2.2% lower than a year ago.”

The driver of the US economy is the consumer and very little other than government incentives have gone his and her way since the Great Recession. Average hourly earnings have increased by 2.2% over the last 12 months, but only 1.3% when adjusted for inflation. And if the money isn’t coming in consumers can’t spend as much argues Yamorone.

He points out that there’s a little known rule of thumb in the economics world: when the annual growth rate of several economic indicators falls below 2 percent, the macro economy eventually slides into recession. Currently several of these statistics are flashing warning signals: real GDP (1.6%), real disposable personal incomes (2%), real consumer spending (1.7%), and real final sales of domestic product (1.6%).

Yamarone continues, “These are the broadest measures, possessing exceptional recession predicting abilities. The explanation for this is simple: like riding a bicycle, if you don’t pedal, you tip over. And when the tier one indicators don’t advance by a 2 percent pace, the economy grinds to a halt amid softer employment, incomes, and spending.”

Anecdotal conversations with people from all over the country and the world lately have revealed the same stories. Investors and businessmen are locked in what seems to be a conservative growth mode. They are investing, but not with the kind of vigor that stimulates significant economic growth and employment. Scanning scheduled and probable events in the coming 12 months or so don’t reveal significant bright spots for optimism.