A familiar year-end ritual for economists, policymakers, and financial firms is to issue their forecasts for the year ahead. In reviewing these recent and often-voluminous projections, we are struck by the tight clustering of forecasts. Does this imply the risks to the outlook are low or that investors should stand pat?
As management consultant John Masters once said:
You have to recognize that every out front maneuver is going to be lonely. But if you feel entirely comfortable, then youre not far enough ahead to do any good. That warm sense of everything going well is usually the body temperature at the center of the herd. Only if youre far enough ahead to be at risk do you have a chance for large rewards.
The consensus the center of the herd as captured by reports such as the Blue Chip Survey of economists places GDP growth for 2016 (Q4 over Q4) in a 2.4-2.6% range, which includes the updated Federal Reserve projection of 2.4%, shown in the table below. Similarly, the consensus on 2016 inflation is in the 1.5-1.8% range, again nicely bracketing the Feds outlook.
This salutary outlook, on the heels of 2015 GDP growth of about 2.1% and inflation of 0.4% (1.4% core inflation), anticipates relative stability in the dollar and oil prices, little if any push on prices from wage growth, small net global effects on the domestic economy, and overall stability in longer-term expectations regarding domestic and international policies that will govern underlying growth and inflation.
Rather than produce yet another set of forecasts, we think we can be of greatest service to our clients by staying out of the weeds and focusing on the broad areas where the surprises are likely to emerge.
As the table below indicates, the median projection of the Federal Reserves FOMC members for the federal funds rate target at the end of 2016 is 1.4%.
With the current target range at 0.25-0.5%, this implies approximately three increases in the range at roughly quarterly intervals of 25-50 basis points each. Fed chief Janet Yellen has repeatedly emphasized that the increases will be slow, gradual, and data dependent. The Feds rationale is that by communicating policy plans and projections in some detail, market adjustments to their deliberate approach will be smooth with a minimum of confusion and accompanying volatility.
Well, it COULD unfold this way, but history suggests otherwise. Here are the major risks we foresee.
- There is an election coming and the Fed is under attack in campaigns on the far left and right. In the past, such political pressures have led the Fed to slow its policy responses to incoming data, particularly in those instances when the data are pointing to the need to raise rates. If and when the markets begin to sense this, volatility will increase and the smooth policy path envisioned will evaporate. The Fed is trying its best to convince all that it will focus on inflation; that said, the public and the politicians will be focusing on GDP growth and unemployment. The implications are clear.
- From a global perspective, the Fed envisions a convergence between U.S. and European growth as monetary policies diverge U.S. tightening, Europe easing, or standing pat. Such a configuration would maintain upward pressure on the dollar. With the appreciation of the dollar over the past 18 months or so likely to subtract 0.5-0.7% from GDP growth in 2016 and hold down inflation, additional dollar appreciation would undermine the Feds economic forecast and accompanying policy plans.
- The gradual slide in inflation expectations has followed the slide in actual inflation and led many toward negative views on gold for months. Yet, with the 10-year Treasury note trading around 2.3%, real, inflation-adjusted returns remain at low or even negative levels. Something has to give: If policymakers appear to be dragging their feet as wage pressures build, the economy picks up some steam, or the approaching election suggests even less policy discipline going forward, duck!
Members of Congress have been congratulating themselves for weeks after passing the Consolidated Appropriations Act of 2016, particularly its Section Q, Protecting Americans from Tax Hikes. A demonstration of rare bipartisanship? Hardly! This grab bag of more defense spending and tax cuts for corporations, which Republicans wanted, and more spending on programs for the working poor and no adjustment in entitlements, which the Democrats wanted, coupled with a relaxation or elimination of various curbs and caps on spending, added about $160 billion to the 2016 budget deficit and nearly $700 billion to the deficits over the next decade. No pain, no gain!
A year ago, who would have predicted that House Speaker John Boehner would be out, Paul Ryan would be in, and talk about entitlement programs would be entirely absent from campaign rhetoric. But legislators bought budgetary peace over the next 12-24 months at considerable cost.
- Going forward, re-establishing spending curbs, even weak ones, will not be easy.
- With both parties concerned about domestic and global security, relevant spending will rise, perhaps significantly.
- With Democratic presidential contender Bernie Sanders dragging Hillary Clinton to the left on domestic social spending (e.g., an entitlement program for college tuition), and the Republicans inevitably having to move toward the center to have a chance at winning the White House and holding on to the Senate, fiscal discipline will find few proponents. (And support for austerity in Europe will continue to erode.) The market consequences of such developments should not be underestimated or ignored.
Wages and Employment
Most forecasters, taking note of the slowing in average monthly job growth from 260,000 in 2014 to 210,000 in 2015, are looking for additional moderation in 2016, perhaps averaging 150,000 to 160,000 each month. What is less clear is whether such slowing reflects an anticipated moderation of the demand for workers or a continuing slowing in labor force participation (supply). Here too we see some risks relative to the consensus:
- Minimal layoffs, indicated by the drop in initial claims for unemployment insurance, and increases in job postings suggest demand increasing relative to supply.
- Wage growth and its distribution across sectors, shown in the Morgan Stanley diffusion index below, coupled with ongoing increases in the minimum wage, suggest wage growth heading toward 3% will attract more attention as the year unfolds.
Many market observers and participants typically view demographics as an interesting curiosity relevant to some degree over the longer run, but largely irrelevant over the short to intermediate run, say 6-12 months. Given our usual focus on investment strategies for the longer run, and thus underlying forces and trends, as opposed to shorter-run and difficult-to-anticipate forces, we call your attention to the recent report from the highly regarded Pew Research Center:
Sure, we all know Boomers are more likely to vote in elections than Millennials. But, and its an important but, Millennials are doing an increasing share of the voting in economic and financial markets; we think this perspective is suggestive of more rather than less volatility over the next 12-24 months.
What Does It All Mean?
Cross-currents abound political, economic, and global what else is new! While we will, of course, be monitoring developments carefully, here is how we see it now.
As the year begins, we see the risks as asymmetric and concentrated in the second half of the year. More specifically, risks are tilted toward more volatility, reflecting the tensions between and among a fiscal policy drifting on autopilot, a monetary policy pursuing a narrow path forward, building wage pressures, a strong dollar, and domestic and global demand pressures. Slow, steady, and smooth, the outlook embedded in the consensus and Fed forecasts, and the accompanying stand pat investment strategy it supports, will not avoid or manage the risks ahead.
Therefore, it is important to include precious metals and rare coins in an investment portfolio. The risks on the horizon could produce a dark and stormy market where protective assets will help insure an overall portfolio. Uncertainty produces turmoil, and a properly balanced portfolio will help navigate whatever 2016 brings.