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The Year Ahead – 2019

December 14, 2018

Stock market jitters are making investors nervous.  We understand why.  The expansion is approaching its 10-year anniversary which makes it geriatric.  GDP growth overseas has slowed.   Home sales have been shrinking steadily for a year.  However, we believe the stock market’s fears are overblown.

For 2019 we expect:

  1. GDP growth of 2.8%.
  2. Inflation should be steady with the core CPI rising 2.3%.
  3. The Fed will boost the funds rate twice in 2019 to 2.75%.
  4. The stock market should reach a new record high level.
  5. Sustained rapid growth in investment spending will quicken productivity and boost the economy’s speed limit to 2.8% by the end of this decade.
  6. This expansion will not end in the foreseeable future.

To forecast GDP growth, we break it down into its major components – consumer spending, investment, trade, and government spending.

Consumer spending, which is about two-thirds of the GDP, is likely to grow 2.6% in 2019.   While the stock market has fluctuated wildly for two months consumer confidence has been unfazed.  Why?

Jobs.  The economy continues to crank out 190 thousand new jobs per month.  Job creation generates the income that allows us to spend.

Some economists note that consumer debt has climbed to a record high level.

But consumer income has also risen and, as a result, debt in relation to income is near a record low level.  Consumers are not saddled with excessive debt.

If we were, delinquency rates should have begun to climb.  That has not happened.

Bottom line – look for consumer spending to grow 2.6% in 2019.  Remember, consumers account for two-thirds of  GDP.

The  housing market has declined steadily throughout year.  While disquieting, we had a similar drop in 2014.  Ex Fed Chair Bernanke said that the Fed planned to slow its purchases of its U.S. Treasury bonds.  The markets panicked.  Long-term interest rates spiked and home sales got crushed.  But eventually reality sank in and sales rebounded.  We expected something like that to happen again.

Is the recent decline attributable to a drop-off in demand?  Or is it a supply constraint?  We argue it is primarily the latter.

The National Association of Realtors )NAR) reports that there is currently a 4.3-month supply of homes available for sale and that a 6.0-month supply is necessary for supply and demand to be in balance.  Hence, there is a considerable shortage of homes available for sale.  Realtors cannot sell what is not for sale.  If enough homeowners were to put their houses on the market so that there was 6.0-month supply, sales would be 5.8-6.0 million versus 5.2 million currently. Thus, the problem is largely a supply constraint.

Some economists contend that the combo of rising home prices and higher mortgage rates has made housing unaffordable.  That is not true for most potential home buyers.  The NAR publishes a housing affordability index which includes prices, mortgage rates, and consumer income which has been rising steadily.  This index tells us that consumers have 45% more income than is necessary to purchase a median-priced home.  In 2007 that same number was 14%.  Housing was expensive at that time.  That is not the case today.

On the demand side, the average length of time between listing a home and its sale is 33 days.  In 2011 the comparable figure was 95-100 days.  Clearly the demand for housing remains robust.

For builders the primary constraint seems to be a labor shortage.  They cannot find an adequate supply of workers.  That puts a lid on how many homes than can produce.  Our sense is that housing will climb about 4.0% next year, but that is not fast enough to alleviate the extensive housing shortage.

Investment spending is another 15% of the GDP pie.  Business confidence is soaring.  That is true for manufacturers, non-manufacturing firms, small businesses, and big businesses.  Small business confidence is particularly noteworthy since it has reached a 35-year high.  Why?  The tax cuts.  All measures of confidence surged immediately after the November 2016 election.  The combination of tax cuts, repatriation of overseas earnings at a favorable tax rate, and the elimination of unnecessary, overlapping, and confusing regulations has buoyed business optimism.

That confidence has, in turn, stimulated investment spending which surged in the first quarter of 2017 and continues to this day. While some economists suggest this is a short-term development triggered by the tax cuts, we do not share that view.  A reduced tax rate and further deregulation will spur investment spending for years to come.  Also, the 3.7% unemployment rate is the lowest in 50 years.  Labor shortages are extensive.  If firms cannot hire an adequate number of new workers, they might contemplate spending money on technology to make the company’s existing workers more productive.  This will provide further stimulus for investment.  Thus, we expect investment spending to grow 6.5% for the next several years.

Trade has gotten lots of attention recently.  All economists support the notion of free trade.  All countries benefit.  But free trade is not fair trade.  Not all countries play by the rules.  Some cheat.  The primary culprit is China which does not respect intellectual property rights, steals trade secrets, and forces companies who want to do business in China to share their technology.  The object of the trade negotiations is to encourage China to reform.

But Trump initially said he was concerned about the size of the trade deficit and wanted to shrink it.   To that end, he imposed steel and aluminum tariffs on our neighbors, friends, and allies as well as China.  They retaliated.  Suddenly a trade war was underway.

While all countries lose as the result of a trade war, not all countries lose equally.  As investors scoured the globe to find which countries might fare best in a trade war, their answer was the U.S.  After all, trade only represents about 10% of the U.S. economy, versus about 50% elsewhere.  As a result, money has poured into the U.S. stock and bond markets since January.  The dollar has climbed 9%.  Tariffs imposed by other countries will reduce growth of U.S. exports, but the flood of money into the U.S. by foreign firms  who start new businesses here and hire American workers will limit the damage.

That is not the case for emerging economies.  They generally import the raw materials required by their manufacturing sector.  But those commodities are all traded in dollars.  When the dollar rises, their cost of goods sold increases.  It becomes more difficult for them to compete in the global marketplace.  As a result, their currencies decline.  Their stock markets plunge.  Indeed, the emerging markets stock index has fallen 23% since February.  Slower GDP growth lies ahead.  In October the IMF lowered its projection of 2019 GDP growth for emerging economies by 0.3%.  Growth in China should slip to 6.5% this year, the slowest rate of expansion since 1990 with even slower growth expected in the years ahead.  This slower pace of growth outside U.S. borders – China in particular – is one factor weighing on the U.S. stock market.

As growth  prospects dim for these countries and the pain intensifies, there is increasing pressure on their leaders to strike a trade deal with the U.S.  Thus far that has happened with Mexico and Canada.  A deal with Europe seems close.  China not so much.  But if Trump broadens and further raises tariffs on Chinese goods at the end of this year the pressure on both sides will intensify.  We believe that by spring the U.S. and China will reach an agreement with both sides claiming victory.

Unfortunately, previously imposed tariffs on U.S. goods by China and other countries will reduce growth in U.S. exports, cause the trade gap to widen, and the trade component will subtract about 0.2% from U.S. GDP growth in 2019.

When we combine these GDP components, we come up with projected GDP growth for 2019 of 2.8%.

Our GDP forecast for the next several years differs from others because we expect rapid investment spending to continue for years, which will boost productivity growth and, eventually, raise our economic speed limit to 2.8%.  Most other economists expect investment growth to fade soon and potential growth to remain at 1.8%.

Nobody knows exactly what the economy’s potential growth rate is, but we estimate it by adding the growth rate of the labor force to growth in productivity.  If we know how many people are working and how efficient they are, we should be able to estimate how many goods and services they can produce.  In the 1990’s potential growth was believed to be 3.5%, consisting of 1.5% growth in the labor force and 2.0% growth in productivity.  The economy grew at that rate for a decade and we concluded that in the good times the economy should grow by at least 3.0%.  But in recent years potential growth rate has slipped to 1.8%.  The baby boomers are retiring, and labor force growth has slipped to 0.8%.  Productivity growth has  faded to 1.0% following a growth spurt triggered by the introduction of the internet in the mid-1990’s and the cloud and apps in the early 2000’s.

While GDP growth of 1.8% is disappointing, it does not have to remain there forever.  But to increase it we need to boost either growth in the labor force or growth in productivity.  Labor force growth is unlikely to accelerate because the baby boomers will continue to retire for another decade.  Fortunately, productivity growth is determined to a large extent by growth in investment.  Our bet is that sustained rapid growth in investment will boost productivity growth from 1.0% in recent years to 2.0%, and the economy’s potential growth rate will climb from 1.8% to 2.8%.  That means that the economy can grow at a steady 2.8% pace without triggering an upswing in inflation.

We estimate that the core inflation rate will edge upwards from 2.2% this year to 2.3% in 2019.

There are components, like housing, that will put upward pressure on the inflation rate.  Rents, which represent about one-third of the entire CPI index are growing by 3.3% which reflects the shortage of rental units.

But there are two factors that have kept inflation in check which are not widely discussed.

First, is the role of technology.  Whenever we buy anything, we shop first on Amazon and can find the lowest price anywhere in the world.  As a result, goods-producing firms in the U.S. have absolutely no pricing power.  In the past year prices of goods have risen  0.2%.  Prices of services have risen 2.9%.  This means that inflation is virtually non-existent for one-third of the economy.

Second, productivity growth is countering most of the faster growth in wages.  Given the tight labor market wage growth has accelerated from 2.0% to 3.0%.  Most economists worry that this will cause an upswing in inflation.  But they are looking at the wrong thing.  If employers pay their workers 3.0% higher wages because they are 3.0% more productive, they don’t care.  They are getting 3.0% more output and have no incentive to raise prices.  Workers have earned their fatter paychecks.  Thus, we are supposed to look at “unit labor costs” which are labor costs adjusted for the increase in productivity.  In the past year unit labor costs have risen 0.9%.  The Fed has a 2.0% inflation target.  As a result, the seemingly tight labor market is not putting upward pressure on the inflation rate.  If productivity continues to climb, it will help to keep the inflation rate in check.

If in 2019 we end up with 2.8% GDP growth and inflation is relatively steady at 2.3%, the Fed will be cautious about further rate hikes.  For years the Fed thought that a “neutral” funds rate was about 3.0%.  But recent speeches by Fed governors make it clear that the Fed is rethinking that objective and may lower it to 2.75%.  Given that the funds rate currently is 2.2%, that implies only two rate hikes in 2019.  The Fed is getting close to where it wants to be.

When will the expansion end?  We do not know, but probably not before 2022.  We want to see two things to happen before we call for a recession.

  1. The funds rate should be at least 5.0%.
  2. The yield curve must invert, meaning that short rates are higher than long rates.

We have found that the U.S. economy has never gone into recession until the funds rate has been above the 5.0% mark.  If the Fed raises the funds rate to 2.75% by the end of next year and leaves it there, a 5.0% funds rate will not happen for the foreseeable future.

We have also found that when the yield curve (which we define as the difference between the yield on the 10-year note and the funds rate) inverts, a recession follows within a year.  Today the 10-year note is 3.0%, the funds rate 2.2%, so the yield curve has a positive slope of 0.8%.  By the end of next year, we expect the funds rate to be 2.75% and the yield on the 10-year note to  be 3.4%.  The curve will have a positive spread of 0.65%.  By the end of 2019 (and for 2020 and 2021), we expect neither of our preconditions for recession to be met.   For this reason, we believe the expansion will continue at least until 2022.

We have described a very positive scenario.  Potential GDP growth rises from 1.8% to 2.8%.  Inflation remains steady at 2.3%.  The Fed raises rates only twice more and the funds rate peaks at 2.75%.  The stock market will climb to a record high level during 2019.  But for this to happen, investment spending must continue to grow rapidly, and productivity must sustain a 2.0% pace.

Stephen Slifer


Charleston, S.C.

The Year Ahead — 2018

December 8, 2017

It is impossible to overstate the importance of the corporate tax cuts that are on the verge of enactment.  Over the next few years the corporate tax cuts should accomplish the following:

  1. Raise the economic speed limit from 1.8% to 2.8%.
  2. Boost growth in wages from 1.4% to 3.5%
  3. Accelerate growth in our standard of living.
  4. Boost the inflation rate slightly from 1.8% to 2.3%
  5. Keep the Fed on track to raise rates slowly to the 3.0% mark but no higher.
  6. Propel the stock market to a record high level.
  7. Extend the expansion to 2022 or beyond.

Back in the 1990’s the economy grew at a 3 .5% rate and, as a result, we all came to believe that in the good times the U.S. economy should grow at a similar pace.  Since the current expansion began in June 2009 GDP growth has struggled to reach the 2.0% mark and economists endlessly point out how the current pace of expansion falls far short of growth registered at comparable periods of other business cycles.  The often-cited culprits are the Republicans, or the Democrats, or Obama, or the gridlock in Congress, or the Federal Reserve.  Or all the above.  Because growth is so anemic, the naysayers note that it would not take much of a shock to push the economy into recession.  They seem to live in constant fear that the next downturn is right around the corner.  But the pessimists are wrong.  The economy is alive and doing well, it is gathering momentum, and will continue to expand for many years to come.  We are in the midst of the longest expansion on record.

To understand why growth has been so slow relative to other business cycles we need only to look at what economists call “potential GDP growth” which is essentially the economy’s speed limit.  We cannot observe that particular number, but we can make a reasonable guesstimate by adding two numbers – the growth rate in the labor force and the growth rate in productivity.  After all, if we know how many people are working and how efficient they are, we can probably make a reasonable estimate of how many goods and services they can produce – which is what GDP is trying to measure.

Back in the 1990’s labor force growth was 1.5%, productivity growth was 2.0%.  Add them up and the economy’s speed limit 20 years ago was 3.5%.  The economy grew that quickly for a decade.  Not surprisingly, we have come to expect the economy to grow at a 3.5% pace in the good times which is why we are so frustrated by the 2.0% pace of the recent expansion.

But the economy today simply cannot grow at a 3.5% pace.  Labor force growth has slowed to 0.8%.  Why?  Because the baby boomers are retiring, and when they retire they leave the labor force.  Baby boomers will continue to retire for another decade.  Productivity growth has slowed to 1.0%.  Why?  Economists do not fully understand the reasons for this slowdown.  Our favorite explanation is that the internet came into existence in 1995.  In the early 2000’s the cloud and apps came along.  These technological advancements completely revolutionized the way that we communicate with each other.  As a result, productivity growth surged to 2.0%.  But nothing quite so revolutionary has occurred in recent years and productivity growth has slipped to 1.0%.  With labor force growth of 0.8% and productivity growth of 1.0%, the economic speed limit today is 1.8%.  Thus, today’s economy can expand at only about one half of the pace it registered during the decade of the 1990’s.  We are frustrated and disappointed.  Surely, we can do better than that!

To boost our economic speed limit, we have two choices – achieve faster growth in the labor force, or find some way to boost growth in productivity.  Because the baby boomers will continue to retire for another decade, we probably will not have much luck boosting growth in the labor force.  If we are going to raise the economic speed limit we must stimulate growth in productivity.

Corporate tax cuts to the rescue!

It is important to understand that productivity is closely tied to the pace of investment.  Investment spending collapsed in 2014 and did not grow for two years.  Part of the drop-off was tied to the collapse of oil prices.  When oil prices plunged from $104 per barrel to $25, drillers could no longer operate profitably 75% of the wells that were in operation at that time and they shut them down.  When they did that, they cut spending on oil drilling equipment and supplies.  They curtailed spending on oil exploration and research.  Investment spending in the oil sector was crushed.  More broadly, business leaders were frustrated by the political gridlock in Washington.  Why should they spend investment dollars when they have no idea what the economy might look like 1-, 2-, or 5-years down the road?  Investment spending ceased to grow for more than two years.  But oil prices are no longer at $25, they are at $57.  Now those same drillers can profitably operate many of the previously-closed wells.  Investment spending in the oil sector is on the rebound.

In November 2016 the American people elected Donald Trump as President.  Trump ran on a platform of creating jobs and boosting investment spending. He pledged both individual and corporate tax cuts.  He cut the corporate tax rate from 35% to 20%.  He is going to allow companies to repatriate earnings at a favorable 5.25% tax rate rather than 35%.  He is in the process of eliminating a wide range of confusing, overlapping, and unnecessary regulations.  He was going to “Make America Great Again”.  Within a month of the election many American companies announced that they were going to boost investment spending and create jobs.  The laundry list included sizeable job announcements by industry leaders like Walmart, Amazon, Sprint, Pizza Hut, even the on-line Chinese retail giant Alibaba.  Trump had not yet taken office!

Investment spending immediately began to rise.  First quarter growth jumped by 7.2%.  Second quarter was 6.7%.  Third quarter climbed 4.7%.  Fourth quarter growth is expected to be 5.5%.  After failing to grow for two years, investment spending has surged in 2017 to 6.0%.  Coincidence?  We are not fans of President Trump, but the timing of the investment spending acceleration is hard to dismiss.  Give credit where credit is due.  We expect investment spending to continue to climb at a 6.0% pace in 2018.

CEO’s say that they do not plan to use the tax cuts to boost investment spending.  Instead, they say they plan to increase shareholder dividends and buy back stock.  Nonsense.  The reality is that they have already begun to boost investment spending.  Big time.

Despite their rhetoric, corporate leaders today act as if the soon-to-be-enacted corporate tax cuts are going to boost growth in productivity, accelerate GDP growth, keep inflation in check, prevent the Fed from raising rates too sharply, propel the stock market to still higher record levels, and lengthen the current expansion by another five years.

Consider productivity growth.  In the past three years it has grown by 0.7%.  As investment spending has surged in 2017 productivity growth in the past year has quickened to 1.5%.  Coincidence?  We do not think so.  It is not hard to imagine that within a couple of years productivity growth might climb to the 2.0% mark.  That is our bet.

Now let’s re-calculate the economic speed limit.  Labor force growth of 0.8% combined with 2.0% growth in productivity raises the economy’s speed limit from 1.8% today to 2.8%.  That may not match the 3.5% growth rate registered in the 1990’s, but it is vastly improved over recent years.

Faster growth in the economy allows our standard of living to grow more quickly.  Economists typically measure standard of living growth by looking at real, after-tax, income per capita.  Take our income, subtract what we pay in taxes, adjust for inflation, and see what is left.  Today this measure of income is rising by 0.9%.  But if the economy grows 1.0% more quickly, that number will jump to 1.9%, which is slightly faster than the 1.6% trend rate of growth over the past 25 years.

Faster growth in productivity will also help to alleviate upward pressure on inflation.  At 4.1% the unemployment rate is below anybody’s estimate of the full-employment threshold.  As a result, labor shortages are becoming more apparent.  Wages are beginning to rise a bit more quickly.  The fear is that higher wages will cause firms to start raising prices, which will cause inflation to accelerate.  But perhaps less than you think because renewed growth in productivity can alleviate the impact of faster growth in wages.  Think of it this way.  If the firm you work for pays you 5.0% higher wages and you are no more productive, its wage costs have climbed by 5.0% and it might be tempted to raise prices to counter the higher labor costs.  But what if it pays you 5.0% higher wages because you are 5.0% more productive?  It does not care.  It is getting 5.0% more output.  Economists call wage pressures adjusted for productivity “unit labor costs”.

So, what is happening to “unit labor costs” currently?  In the past year compensation has risen 1.4%, productivity has risen 1.5%.  Thus, unit labor costs have declined 0.1%.  No wonder the seemingly tight labor market has not yet put upward pressure on the inflation rate!  The increase in wages has been countered by a commensurate increase in productivity.

But what about next year?  Wage pressures in recent quarters have begun to quicken.  We expect compensation in 2018 to rise 3.5%.  We expect productivity to climb to 2.0%.  Doing the subtraction implies that unit labor costs will rise 1.5%.  That is a faster rate of increase in unit labor costs than we saw this year, so there should be a bit more upward pressure on the inflation rate.  But the Fed has a 2.0% inflation target so an increase in ULC’s of 1.5% is perfectly consistent with its inflation objective.

Other things to consider when projecting the inflation rate for next year are the steady increase in recent months of commodity prices in general – not just oil.  Also, the shortage of apartment units is causing rents to climb by almost 3.5% which is a big deal because housing represents about one-third of the entire CPI.

The bottom line is that we expect the core CPI (which excludes the very volatile food and energy components) to increase 2.3% in 2018 after having risen 1.8% this year.  Last year was a little bit below the Fed’s 2.0% inflation target.  Next year should be a bit above target, but not enough to alarm Fed officials.

Putting all this together, we expect GDP growth to pick up to 2.8% (its potential growth rate) during the next couple of years.  Our standard of living will rise more quickly.  Our paychecks will get somewhat fatter.  Productivity will accelerate and thereby offset most of the increase in wages.  As a result, inflation in the years ahead should continue at a 2.3% pace which is roughly in line with the Fed’s target.

If that is the scenario that unfolds, the Fed should continue its gradual tightening until the funds rate reaches 3.0% by the middle of 2020.  That 3.0% rate is what the Fed believes is a neutral” rate which means that it is neither providing economic stimulus nor trying to slow down the economy.

So, when might this expansion end?  Historically the U.S. economy has never, ever, fallen into recession until the Fed has pushed the funds rate above that so-called neutral rate.  At the end of the most recent expansion in December 2007, the funds rate reached the 5.0% mark.


When might the Fed raise the funds rate to 5.0%?  We do not know!  By mid-2020 the funds rate has achieved a neutral rate of 3.0%.  If the economy is expanding at its potential pace of 2.8 it is not overheating.  The inflation rate should be 2.3% which would be just a shade above its 2.0% target.  Against that background, the Fed has no incentive to tighten further.  It should boost the funds rate to the 3.0% mark — but no higher.

When will this expansion end?  We do not know.  Because the funds rate will not reach the so-called neutral rate of 3.0% until mid-2020 it should last at least that long.  But in mid-2020 the Fed should have no reason to raise rates further.  This means that a 5.0% funds rate is nowhere in sight.  Could the expansion last until 2022?  2025?  Absolutely.  What we should be looking for are signs that the economy is overheating, and that inflation is moving substantially above the Fed’s 2.0% target.  Those two pieces are nowhere in sight.  The end of the expansion is likely to be least five years down the road.

This expansion is going in the history books as the longest expansion on record.  The current record-holder is the decade of the 1990’s which lasted exactly ten years.  The current expansion will reach that milestone in June 2019.  We are suggesting 2022 or even 2025 as likely end dates.  If the Federal Reserve can produce an expansion that lasts 13 years or longer, it certainly deserves high marks in our book.

All is well.  Enjoy the coming year.  Rock on!

Stephen Slifer


Charleston, S.C.



The Year Ahead — 2017

December 16, 2016

Policy changes enacted by President Trump and Congress in the first half of 2017 should:

  1. Raise the economic speed limit from 1.8% to 2.8%.
  2. Boost growth in wages from 3.0% to 4.0%
  3. Accelerate growth in our standard of living.
  4. Boost the inflation rate slightly from 2.3% to 2.7%
  5. Keep the Fed on track to raise rates slowly with a 1% funds rate likely by the end of 2017.
  6. Propel the stock market to a record high level.

The catalyst will be policy changes enacted in the first half of next year.

Political gridlock in Washington has so frustrated business leaders that they currently lack the will to invest.  Nonresidential investment spending has slipped from 8% growth a few years ago to 0%.  The 35% corporate tax rate encourages business leaders to move their corporate headquarters overseas to take advantage of corporate tax rates that average 23% elsewhere.  They are unwilling to bring overseas earnings back to the U.S. because it will be taxed twice – once in the country in which they do business and again in the U.S. if they bring those earnings home.  Large firms hire an army of attorneys to ensure they are in compliance with all 80,000 pages of Federal regulations.  And they are befuddled by a dysfunctional, expensive health care system which they are required by law to provide if they have more than 50 workers.


Because investment spending stimulates productivity the more money firms spend on the latest technology or the newest labor-saving device for the factory floor, the more efficient its workers are and the faster productivity grows.  The lack of investment has caused productivity growth to virtually disappear.  And slower growth in productivity is a major reason why the economic speed limit has slipped from 3.5% in the 1990’s to 1.8% today.


But the U.S. is under new management!

With a Republican President and Republican control of both the House and the Senate, much of Donald Trump’s agenda is likely to be enacted by midyear.  Specifically, we look for:

  1. A cut in individual tax rates.
  2. A cut in the corporate tax rate from 35% to 15%.
  3. A one-time chance for global firms to re-patriate corporate earnings at a very favorable 10% tax rate.
  4. Elimination of all unnecessary, needlessly complex, and overlapping regulations.
  5. The introduction of a simpler, less costly health insurance program consisting of tax-advantaged health savings accounts coupled with a high deductible health insurance plan.

If business leaders were discouraged by gridlock, action on any or all of the above should inspire confidence.  Our expectation is that this combination of policy changes will unleash a wave of investment spending over the next several years and boost its growth rate to 5%.  If firms re-ignite investment spending it is an almost sure bet that productivity will follow.

Faster growth in productivity will raise the economic speed limit.  That number can be estimated by adding the growth rate of the labor force to the growth rate of productivity.  If we know how many people are working and how efficient they are, we can estimate how many goods they can produce.  Today that speed limit is 1.8% — 0.8% growth in the labor force plus 1.0% growth in productivity.

Labor force growth has slowed to 0.8% as the baby boomers retire and exit the labor force.  Because the boomers will continue to retire for another decade it is unlikely that labor force growth will accelerate any time soon.

Productivity growth has fallen from a 2.0% pace in the 1990’s to about 1.0% and economists do not understand why.  Some suggest that it reflects the retiring baby boomers.  When a firm replaces someone who has been on the job 40 years and is very efficient with someone with less experience, it is likely that productivity growth will slow.  Perhaps there are measurement issues.  It is difficult to measure output and productivity in the service sector.  If it were measured more accurately productivity might grow more rapidly.  Or, perhaps, productivity got a onetime boost in the late 1990’s and early 2000’s by the introduction of the internet followed by the cloud and aps.  The bottom line is nobody knows.

Today’s speed limit today of 1.8% is far slower than the 3.0-3.5% we have come to expect in good times.

But what if the policy changes described above unleash a wave of investment spending and productivity growth accelerates to 2.0%?  Labor force growth of 0.8% plus productivity growth of 2.0% means that the economy’s speed limit will jump from 1.8% to 2.8%.  That brings with it a dizzying array of positive economic developments.


First, growth in our standard of living will accelerate by the 1.0% difference in those two growth rates.

Second, wages will grow more quickly.  If productivity accelerates a firm can afford to pay its employees higher wages.  If workers are 3% more productive the firm gets 3% more output.  Thus, workers have earned a 3% bigger paycheck.  In the past year worker compensation has risen 3.0%.  Next year, given the very tight labor market, we expect compensation to climb by 4.0%.

Third, faster growth in productivity helps to keep the inflation rate in check.  If firms pay workers 3% higher wages but they are no more productive, businesses owners will be inclined to raise prices to offset the higher labor costs.  The inflation rate will rise.  But what if firms pay their workers 3% higher wages because they are 3% more productive?  In this case there is no reason for that firm to raise prices and there will be no upward pressure on inflation.  Thus, to determine the upward pressure on inflation stemming from a tight labor market do not look solely at the faster growth in wages.  Instead, look at the growth rate of wages adjusted for the increase in productivity.  Economists call this “unit labor costs”.

In the past four quarters compensation has risen 3.0%.  Productivity has been unchanged.  Hence, unit labor costs have risen 3.0%.  In 2017 we expect worker compensation to increase 4.0%.  We also expect productivity to climb by 1.0%.  Thus, unit labor costs next year should once again increase 3.0%.  There will be no more upward bias to the inflation rate in 2017 caused a tight labor market than there was this year.  The faster growth of wages should be offset by a commensurate increase in productivity.

Finally, if the inflation rate holds fairly steady the Fed is likely to adhere to the modest path of increases in interest rates that it has described previously.

Specifically in the next two years we expect the following:


The GDP growth rate assumes 2.5% growth in consumer spending in each of the next two years.  The consumer is highly optimistic with confidence the highest in 13 years.  The stock market is at a record high level.  Consumer debt in relation to income is the lowest since the mid-1980’. The economy is generating 170 thousand jobs per month which produces the income necessary for consumers to maintain their pace of spending.  Interest rates may climb moderately but remain low by any historical standard.  And the price of gasoline is expected to remain low at about $2.25 per gallon.  Consumer spending should remain solid for the foreseeable future.

The housing outlook remains bright in large part because there is a shortage of single-family homes available for sale and an acute shortage of rental properties.  Housing remains affordable despite the modest pickup in the 30-year mortgage rate to 4.0% primarily because consumer income is also climbing. Builders are trying hard to boost the pace of production, but are having difficulty finding an adequate supply of skilled labor.  Thus, it appears that the demand for housing will continue to outstrip supply for at least another year.

Policy changes implemented in the first half of this year should sharply boost the pace of investment spending during the next couple of years.  Investment spending should also climb as oil production rebounds in response to the higher price of oil.  This sector was crushed in 2015 and the first half of this year as oil prices collapsed.  But higher oil prices in recent months have caused a moderate pickup in the pace of production.  Finally, corporate profits are rebounding after having been depressed by the oil sector for more than one year.  We expect corporate earnings to climb 10% in 2017.

Trump’s comments regarding trade are disturbing.  A wall between the U.S. and Mexico, high tariffs on goods imported from China, a tax on any U.S. company that chooses to re-locate overseas, and renegotiating NAFTA are all counterproductive.  Such insular policies would significantly hurt those who elected him.  Prices at Walmart, Target, and COSTCO could all jump by 15%.

When he talks about trade he invariably notes the jobs lost to Mexico and China as U.S. firms take advantage of lower wage rates.  However, the majority of those jobs were not lost because of trade agreements but as the result of technological innovation and are never coming back.  To the extent that factory jobs are heading overseas we would suggest that there is a better way to stem the tide — create a more business friendly economic environment in the United States.   Cut the corporate income tax rate.  Allow firms to repatriate their overseas earnings to the U.S. at a favorable tax rate.  Provide regulatory relief.  By doing these things firms will choose to stay in the U.S. and jobs will remain here.

In 2014 and 2015 the dollar rose more than 20% given the slowdown in the pace of economic activity in China.  Global investors sought the safety of and higher returns available in the U.S. stock and bond markets.  Slower grow in exports caused the trade component of GDP to subtract about 0.5% from GDP growth in 2014 and 2015.  Given faster U.S. GDP growth and higher interest rates in 2017 and 2018 we expect the dollar to appreciate another 5%, but that pales in comparison to the earlier run-up.  As a result the trade component should subtract 0.1% or so from GDP growth in each of the next two years.


Finally, government spending should be fairly steady in 2017 and 2018.  Trump has talked about a significant increase in defense spending.  However, defense spending is only about 15% of total federal government expenditures.  Defense spending will almost certainly will increase.  But 70% of government spending is on entitlements – Social Security, Medicare, Medicaid and the like.  If Trump follows the plan outlined by Paul Ryan and the House Republicans this past spring, entitlement spending should shrink and offset the increase in defense spending.

With 2.5% growth in consumer spending, 5% growth in investment spending, trade subtracting 0.1%, and government spending about unchanged, GDP growth should gradually climb to 2.6% by 2018.

If GDP growth gathers steam it will create a large number of new jobs which means that the unemployment rate will continue to fall – slowly.  Specifically, we expect it to decline from 4.6% today to 4.4% by the end of 2018.

As the unemployment rate dips farther below the full employment threshold of 5.0% it will be increasingly difficult for firms to find the skilled workers they require.  They will raise wages and offer more attractive benefits to attract the employees that they need.  Thus, we expect wage pressures to accelerate.  Specifically, look for worker compensation to increase from 3.0% this year to 4.0% in 2017.

As wages and worker compensation rise more quickly, one might expect the inflation rate to rise more quickly.  But we also expect a commensurate increase in productivity.  Hence, unit labor costs should increase 3.0% in 2017 which is exactly the same as in 2016.  There should be no upward pressure on the inflation rate caused by increasing tightness in the labor market.

There will, however, be upward pressure on the inflation rate from non-labor market sources.  Specifically, the extreme shortage of available housing will cause home prices and rents to rise more quickly.  That is important because shelter represents one-third of the entire CPI.  Rising health care premiums will boost the cost of medical care.

On balance, we expect the core CPI (excluding the volatile food and energy components) to increase 2.7% in both 2017 and 2018 versus 2.3% this year.  That represents a “moderate” pickup in the rate of inflation.

If GDP growth accelerates and wages rise more quickly, the Fed will not be concerned if the inflation rate accelerates moderately and should not deviate from its previously-described path of gradual increases in interest rates.  Specifically, we expect two rate hikes next year which will boost the funds rate to 1.0%, and three rate hikes in 2018 which will lift the funds rate to a still low level of 1.8%.  We believe that short-term interest rates are “neutral”, and the Fed is neither stimulating the economy nor trying to slow it down, when the funds rate is about 3.0%.  It will not reach that level until mid-2020.


Long-term interest rates will climb as the Fed continues to push short-term interest rates higher, and by a moderate increase in the inflation rate.  The yield on the 10-year note should climb from 2.4% today to 3.2% by the end of 2018.  The 30-year mortgage rate should climb from 3.9% to 5.0%.

When will the current expansion end?  Not until 2020 at the earliest.  The U.S. economy has never fallen into recession until the Fed has boosted the funds rate above its neutral level.  If that does not occur until mid-2020, that would be the earliest date for a possible recession.

If the expansion continues until mid-2020 it would go into the history books as the longest expansion on record.  The current record is the decade of the 1990‘s which lasted exactly 10 years.  By mid-2020 this expansion will have reached its eleventh birthday.  If the Fed can produce an expansion that lasts a record-breaking 11 years it is doing an excellent job.

In conclusion, we believe that regulatory changes likely to be implemented in the first half of next year will trigger an avalanche of investment spending which will:

  1. Raise the economic speed limit from 1.8% to 2.8%.
  2. Accelerate wage growth
  3. Boost the growth rate in our standard of living.
  4. Keep inflation in check.
  5. Keep the Fed on track to raise rates slowly..
  6. Propel the stock market to new highs.

It does not get much better than that.

Stephen Slifer


Charleston, SC

The Year Ahead – 2016

                                                                                                                                                            December 18, 2015

The economy should continue to chug along with GDP growth of 2.6% or so in 2016. But growth is uneven. Some sectors like consumer spending and housing are expanding nicely, but growth in manufacturing and trade is being curtailed by the combination of a sharp decline in oil prices and a stronger dollar. While 2.6% GDP growth is unimpressive it is adequate to produce jobs of 150-200 thousand per month which, in turn, will allow the unemployment rate to slip to 4.5% by the end of next year. That level is below anyone’s estimate of full employment which means that firms will need to raise wages to attract the increasingly scarce number of qualified workers. That, in turn, means that firms may also begin to raise prices to offset the higher labor costs. If that is the case the days of near-zero percent inflation will soon disappear. In an environment in which inflation is beginning to climb the Fed will continue its long journey of gradually increasing short-term interest rates. By yearend 2016 the federal funds rate will have risen to 1.25% which — while still low — is higher than the 0% rate that existed for the previous seven years. What all of this seems to portend is a good, but less than spectacular, year both for the economy and the stock market with no hint of recession for the foreseeable future.

Anything related to the consumer is doing just fine. And why not? Driven by the powerful combination of steady gains in the stock market and rising home prices, consumer net worth has climbed to a record high level. Consumers have very little debt and can easily afford to borrow more if they so choose. Interest rates remain low even as the Fed begins the very slow process of lifting short-term interest rates. The economy continues to crank out nearly 200 thousand jobs a month which boosts consumer income. And the collapse in gasoline prices during the past year means consumers spend one-half as much to fill the car’s gas tank today than they did one year ago. That is a recipe for a relatively robust 3.0% pace of consumer spending in 2016.

Ditto for the housing sector. The future for the next several years remains bright in part because of all the factors cited above but, in addition, for the first time since the recession younger adults are leaving their parents’ homes and venturing forth on their own. They presumably now have jobs and are confident they will still have jobs a year from now. As they take a giant step forward and embrace their future they need a place to live. That could be a house or an apartment. There can be little doubt that this explosion of young adults all searching for a place to live is boosting both home sales and the demand for rental properties. In fact, both types of housing are in short supply.

Household Formation

Builders are doing their best to step up the pace of production to satisfy this increased demand, but they are having a tough time finding an adequate supply of skilled workers to significantly boost the pace of construction. As a result, the housing sector will continue to expand and prices will move steadily higher in both 2016 and several years beyond.

Housing Starts Projected
Unfortunately, the outlook for manufacturing and trade is not nearly as rosy. Both sectors are struggling.

With respect to manufacturing and the investment spending portion of GDP, the precipitous slide in oil prices in the past year from $107 to $36 currently has caused drillers to cap 60% of the wells that were in operation at this time last year. They have cut spending on drilling equipment and services and curtailed exploration and research spending. That has caused a considerable hit to the investment component of GDP. But given that the energy experts expect oil prices to rise to about $50 next year our best guess is that, the bulk of the negative impact on GDP growth has already occurred. In fact, we expect investment spending to rise 4.5% in 2016.

The trade sector was hit hard in 2015 by two factors. First is the direct reduction in demand caused by the sharp growth slowdown in China. China is in the process of converting from an industrial-based economy to a more consumer driven model. In the process GDP growth has slipped from a double-digit pace a few years ago to 6.8% this year. Given that China is the second largest economy in the world (behind only the United States), a growth slowdown of that magnitude is going to have repercussions everywhere. In the U.S. the impact is relatively small because exports to China are only about 7.5% of the total. But for many ASEAN countries like Indonesia, Thailand, Malaysia, the Philippines, Vietnam, and Singapore, as well as Russia, Taiwan, and South Korea, the impact of slower growth in China has been far more troublesome.

China -- GDP Growth

But keep in mind that GDP growth in China has already slowed from a double-digit pace to 6.8%. The IMF expects growth to settle in between 6.0-6.3%. In our opinion, most of the slowdown in the U.S. economy caused by slower growth in China occurred this past year.

Second, the higher value of the dollar has imposed further damage on the trade sector. The dollar has risen 15% in the past year. As the dollar rises, U.S. goods become more expensive for foreigners to purchase, hence slower growth in exports. In fact, exports will shrunk about 7% this year.

Trade Deficit -- Exports

The increase in the dollar was caused in part by slow growth in China. During the summer the Shanghai Composite Index of Chinese stock prices plunged 40% and triggered a worldwide stock market selloff as investors feared GDP growth in China was on the brink of collapse. In times of turmoil investors seek the safety of dollar-denominated investments like U.S. stocks and bonds. That desire for dollar-denominated investments boosted the value of the dollar.

Going forward the dollar is likely to increase an additional 7% or so in 2016 for two reasons. First, 2.6% GDP growth in the U.S. outpaces growth elsewhere around the globe. That growth rate differential should tend to bolster the value of the dollar. Second, the Federal Reserve has begun to slowly raise short-term interest rates while central banks in Europe, Japan, and China are all moving in the opposite direction and trying to further stimulate the pace of economic activity. Thus, widening interest rate differentials should exacerbate the increase in the value of the dollar.

Trade-weighted dollar -- Projected

As we see it, consumer spending of about 3.0%, 4.5% growth in investment spending as oil prices rise slightly, and a modest drag on growth from the trade sector should result in moderate GDP growth for 2016 of 2.6%. While that outcome is truly unimpressive the benign overall result masks widely divergent movements amongst the various sectors. Consumer spending and housing are doing well. The manufacturing sector and trade have struggled throughout 2015, but the drag on GDP growth from each of those two sectors is expected to largely disappear in 2016.

GDP growth of 2.6% is rapid enough to generate almost 200 thousand new jobs every month for a while longer. Such an impressive pace of jobs creation will continue to push the unemployment rate lower. The official rate is currently 5.0% which is roughly in line with what most economists regard as “full employment”. At that level by definition everyone who wants a job has one. Even the broader measure that Fed Chair Yellen prefers will be at full employment by midyear.

Unemployment Rate -- Broad Projected

“Full employment” is an important concept because it means that employers will have an increasingly difficult time finding an adequate number of new workers. As a result, they will have to entice people to change jobs by offering higher wages and/or more attractive benefits. That, in turn, means that the firm’s cost of labor will increase. And given that labor costs are such an important part of a firm’s total spending, there is a good likelihood that businesses will raise prices to offset the impact of higher labor costs. Thus, the days of 0% inflation will soon end.

Our sense is that if oil prices level off inflation will soon rise from 0% currently to 2.6% or so by the end of next year. Given that the Fed has a 2.0% inflation objective a 2.6% pace is not bad, but inflation will have shifted from a pace that is far below target to a position that is slightly above it. That should be sufficient to keep the Fed in motion.

CPI -- Projected

The Fed finally ended the era of 0% interest rates on December 16. Rates had been at that level since December 2008. They have promised to raise rates slowly which is generally interpreted to mean that they will increase them only at every other FOMC meeting. Given that these meetings occur every six weeks that pace will cause rates to rise by about 1.0% per year which is far slower than the 2.0% pace that it has raised rates in the past.
How far do rates need to climb? Our sense is that a 3.5% federal funds rate should be roughly “neutral”. At that level the Fed is neither trying to stimulate the economy nor attempting to curtail the pace of economic activity. Economists reach that conclusion by looking at the level of the funds rate relative to the rate of inflation over a long period of time. During the past 50 years – in good times and bad – the funds rate has averaged about 1.5% higher than the rate of inflation. Hence, if the Fed wants its policy to be “neutral” it should probably put the funds rate 1.5% higher than the inflation rate. Given that it seeks a 2.0% rate of inflation, add the two together and one can conclude that a “neutral” funds rate should be about 3.5%. If the Fed tightens at the pace they have suggested, it will take until the end of 2018 for the funds rate to return to neutral.

Fed Funds Rate -- Projected

The final piece that is important is that the U.S. economy has never gone into recession until the Fed has pushed the funds rate above that so-called “neutral” rate. So if it takes until the end of 2018 for the funds rate to return to neutral, it is hard to imagine how the U.S. economy can dip into recession until 2019 at the earliest. Make no mistake we are not forecasting a recession in 2019. We are merely highlighting the fact that by that time short-term interest rates will have finally risen enough that they could begin to bite. For the first time in a decade we will have to pay close attention to the economic data for early warning signals that the economy may be starting to stumble.

Fed Funds Rate -- Peak

One final point. If this expansion lasts until June 2019 – which we think will happen – this will become the longest expansion on record. It will have surpassed the expansion of the 1990’s which lasted exactly 10 years. While everybody criticizes the Fed for being too tight or too easy, if it can produce a business expansion that lasts a decade we would suggest that it is doing a pretty good job. It is time to give praise where praise is due.

Stephen Slifer
Charleston, SC

The Year Ahead – 2015

December 19, 2014

GDP growth in the U.S. is poised to accelerate to 3.3% in 2015 as rapid jobs expansion, rising wages, steady improvement in the housing market, and falling oil prices provide ample stimulus.  At the same time, as oil prices level off and wage pressures begin to mount the inflation rate is expected to edge upwards from 1.8% currently to 2.8% in 2015 which is slightly above the Fed’s 2.0% target.  A pickup in the pace of economic activity, the relentless tightening of the labor market, and an uptick in inflation will cause the Fed to raise interest rates for the first time in eight years.  But given that the expected series of rate hikes is starting from 0%, it will take several years for them to reach a level that will have any meaningful impact on the pace of economic activity.  Thus, it is difficult to envision how the U.S. economy can slip into a recession sooner than 2018.

However, as the economy adjusts to a rising rate environment and to a sea change in the oil market, there will be considerable volatility in every market — stocks, bonds, currencies, and commodities — which will make it a very bumpy ride.

Employment. Perhaps the most positive factor contributing to this ratcheting upwards in the pace of economic activity is employment.  Monthly job gains have climbed to 225 thousand which is as good as it gets.  Jobs create income which becomes the fuel for a pickup in the pace of consumer spending.

Rapid hiring gains have caused the official unemployment rate to decline far more quickly than anyone expected to 5.8% which is approaching the 5.5% level that is generally associated with “full employment”.  At that level everyone who wants a job presumably has one.  But Fed Chairman Yellen has focused attention on a broader measure of unemployment which includes people who are unemployed as well as workers who are “underemployed”.  There are two types of underemployed workers — “discouraged workers” who have been without a job for so long that they have given up seeking employment and workers who have part time jobs but would like full time employment.  This broader measure of employment is currently 11.5% compared to 5.8% for the benchmark rate.  It is important to note that this broad measure is always higher than the official rate simply because it is a different (and broader) measure of unemployment.  Over the past 20 years this broad rate has averaged about 80% higher than the official rate.  Thus, if full employment for the official rate is 5.5%, then full employment for the broader rate should be about 10%.  As the labor market steadily tightens in the months ahead and employers have increasing difficulty finding skilled workers, many “discouraged workers” may once again seek and find employment, and some part-time workers may be offered full-time positions.  Thus, both rates of unemployment should continue to drop and approach their full employment thresholds by the middle of next year.

Housing. The all-important housing sector should continue to expand next year despite an expected modest increase in mortgage rates from 4.0% currently to about 4.75%.  This expected gain is the result of an on-going shortage of available housing.  Every year in the U.S. 1.3 million new households are formed.  Those people need some place to live.  It could be a single-family home or an apartment.  Builders have stepped up the pace of construction to about 1.0 million units but are encountering some difficulty finding skilled workers, challenges in attaining adequate financing, and a shortage of available lots.  Thus, housing will remain in short supply at least through the end of 2015.

New home sales have been rising steadily but the rate of increase remains modest.  This seems to reflect a shift in preference away from owning a home towards renting which is especially prevalent amongst younger adults.  Some of this may be a generational change whereby young people do not want to be tied down by home ownership.  It may also reflect difficulty in qualifying for a mortgage given the steady increase in home prices the past couple of years and the fact that many younger borrowers are encumbered by a considerable amount of student debt.  Given this distinct preference for renting, there is an acute shortage of available rental properties.   So while housing starts will undoubtedly continue to climb, the growth rate for multi-family construction is likely to be twice as fast as for single-family housing (45% vs. 20%) in 2015.

Oil. Rising oil prices have been a contributing factor to every major recession in the West since the mid-1970’s.  It is never the only factor causing these economic downturns, but it is invariably a contributing factor.  Similarly, our most impressive periods of sustained growth in the 1980’s and 1990’s were lubricated by falling oil prices.  Thus, it is logical to expect that the 50% drop in the price of crude oil since June will lead to a significant pickup in the pace of economic activity next year not just in the U.S. but around the globe – China, Japan, Germany, France, the U.K., Italy, and Canada.

Consumers will be able to spend money saved at the pump on other items.  At the same time consumer confidence will rise sharply.  An obvious beneficiary will be the auto industry as a surge in jobs and more income from falling gas prices will encourage consumers to buy a new car.  The agricultural sector which is very energy intensive will get a lift. That translates into lower food prices.  Airlines will experience a significant drop in the cost of jet fuel which eventually will filter through into lower ticket prices.  Portions of the manufacturing sector that are heavy users of petroleum based products – think plastic and chemicals — will also get a boost.

Inflation. With the dramatic decline in oil prices it is tempting to anticipate a substantially lower inflation rate next year.  But that would be a mistake.  The Energy Information Administration (EIA) expects crude oil prices to average $63 a barrel in 2014 compared to $55 today.  Thus, oil prices are likely to have reached their low point.

But two other items are likely to boost the inflation rate from 1.8% currently to 2.8% next year.  First, the extreme shortage of available rental units has caused rents to rise steadily.  They are now climbing at a 3.0% rate.  This is an important factor in any inflation forecast because housing accounts for one third of the entire CPI.

In addition, the steady tightening of the labor market should cause wages to rise more quickly in 2015.  If employers cannot find the skilled workers they need from the ranks of unemployed or underemployed workers, they will try to poach those employees from other firms by offering higher wages and/or more attractive benefits packages.  Given that wages represent two-thirds of a firm’s overall cost, higher wages are almost certain to be passed along to consumers in the form of higher prices.

Thus, it is fairly easily to envision a pickup in the CPI inflation rate in 2015 from 1.8% to 2.8%.

Federal Reserve. Like virtually everyone else we expect the Fed to begin raising short-term interest rates by about the middle of next year.  That is because the Fed has told us the two conditions that are required for it to initiate that process.  First, the Fed has said that it will not begin to raise rates until the unemployment rate reaches the full employment level.  As noted earlier, that should be achieved by the middle of next year.  The Fed has also said that it will not raise rates until the inflation rate has climbed to its 2.0% target rate.  That, too, should occur by midyear.  That is why virtually all economists expect the process of raising interest rates to begin at about that time.   Once underway, the Fed has promised that it will raise rates slowly.  As a result, we expect the funds rate to be at 1.2% by the end of next year.

But an increase in short rates from 0% to 1% will not do much to slow the pace of economic activity.  Indeed, rates will have to climb to about the 4% mark before they are likely to bite.  That level will not be achieved until the middle of 2017.  That is the level at which interest rates are generally regarded as having a “neutral” effect on the economy.  At levels below 4% the Fed is trying to stimulate economic activity.  At higher rates it is attempting to slow it down and short circuit an increase in inflation.  A gradual move from 0% to 1%, or 2%, or 3% does not reflect a tighter Fed policy stance.  Rather, those steady rate increases should be regarded as a progressively less accommodative posture.

It is important to note that the U.S. economy has never slipped into recession until such time as the Fed has pushed short rates above that so-called neutral threshold.  In the chart below periods of recession are indicated by the shaded areas in pink.  The circles represent the level of the funds rate when the economy went over the edge into recession.  In every single instance the Fed has had to push interest rates above the neutral rate to induce a recession.  So if it takes until mid-2017 for rates to get back to neutral, it is difficult to envision how the U.S. economy can fall into recession until 2018 at the earliest.  We are not forecasting a recession in that particular year, but for the first time since the recession we will have to watch carefully at that point in time for indications that the rate hikes are beginning to take their toll.

Thus, the overall economic environment for 2015 appears favorable with 3.3% GDP growth, a decline in the unemployment rate to 5.0% by yearend, and low oil prices that should average about $63 per barrel.  Interest rates will remain at historically low levels even with the moderate rate hikes that are anticipated.  The combination of robust economic activity, low oil prices, and still low interest rates should propel the stock market higher.

Volatility. While the overall economic outlook appears bright, it will be a year of transition on many fronts which implies considerable volatility in all markets – the stock market, bonds, commodities and currencies.

This is the first time that the Fed has raised short term interest rates in eight years.  We are going to be reminded of what that process feels like.  At the same time a potential increase in the inflation rate should impact bond yields.  All of this should lead to considerable volatility in the fixed income markets during the course of the year.

In the past six years all central banks have been acting in concert to push interest rates to record low levels.  But now the Fed and the Bank of England are poised to raise rates while the European Central Bank and the Bank of Japan seek additional stimulus and are inclined to further ease monetary policy.  This divergence in monetary policy amongst the world’s four largest central banks implies currency movements with the dollar and the pound sterling strengthening, while the Euro and the yen weaken.

The consequences of the unprecedented increase in the supply of oil and possible counter moves by OPEC countries should lead to wild fluctuations in the commodity markets.

As the GDP growth forecasts for the U.S., Europe, and Asia ebb and flow, and as interest rate expectations are revised accordingly, the stock market is virtually certain to have a wild year with 200-point daily changes occurring often.

At the end of next year it will be evident that 2015 was a very good year, but hang on to your hats as the year progresses.  It is going to be a wild ride.

Stephen Slifer


Charleston, SC

The Year Ahead — 2014

December 13, 2013


It is likely that 2014 will be the year when the economy finally emerges from its slump.  GDP growth should accelerate to 3.0% which would be a percentage point faster than in 2013.  The expansion will no longer be confined largely to housing but become more broad-based as all sectors of the economy — consumers, businesses, foreign trade, and government — contribute to the growth pickup.  Meanwhile, monetary policy will remain highly accommodative.  Long-term interest rates may rise somewhat, but the key federal funds rate will remain at 0% through mid-2015.  Against this background the stock market will continue to march upwards to even more lofty levels.  The unemployment rate will fall to 6.5% by yearend as younger people and those who are currently working part time will find full time positions more plentiful.  Given a very slow but steady increase in interest rates the expansion is likely to continue for another five years.

GDP Forecasts — 2014
2012 2013 2014
GDP 2.0% 2.0% 3.0%
Unemployment Rate 7.8% 7.1% 6.5%
Inflation Rate 1.9% 1.8% 1.9%
Fed Funds Rate 0.1% 0.1% 0.1%
10-year Note 1.70% 2.80% 3.25%
30-year Mortgage 3.40% 4.30% 4.75%

Consumer Spending

Consumers appear poised to spend at a somewhat faster pace in the coming year.  The rapid advance of the stock market and double-digit increases in home prices are bolstering both consumer attitudes and their wallets as net worth has soared to a record high level.

At the same time consumers have paid down considerable amounts of debt in the past five years, and their debt burden is very low in relation to income.  As a result, consumers have the ability to pick up their pace of spending if they so choose.

Some fear that the combination of rising mortgage rates and higher home prices might curtail growth of the rapidly expanding housing sector.  Such fears seem overblown.  While mortgage rates have recently climbed from 3.5% at midyear to 4.25%, those rates are the lowest since the 1960’s.  And while home prices have risen 13% in the past year, they remain 23% below the peak level they attained in 2006.

Thus, housing remains affordable although less so than it was at the beginning of the year.  The National Association of Realtors index on home affordability currently stands at 164 which means that consumers have 64% more income than is necessary to purchase a median-priced home.

Going forward demand will continue to outpace supply.  The Census Bureau reports that 1.3 million new households are formed every year.  Those families need a place to live.  But builders are currently producing only 900 thousand new homes.  They are being constrained by an inability to find adequate financing and/ or by a shortage of available skilled labor.  The excess demand for housing should push prices higher in 2014.

While currently about 200 thousand jobs are produced every month, a larger-than-normal number of those jobs are low paying positions in the retail and food and beverage industries.  Furthermore, many are part time positions.  As a result, income is climbing at a modest 2.0% pace which limits the consumer’s ability to spend any more quickly.

As job gains continue to outpace growth in the labor force the unemployment rate will fall from its current level of 7.0% to 6.5% by the end of next year.  With each passing month employers will increasingly have to rely on younger people to fill their hiring needs and they may choose to convert some of their part time positions to full time.  That is good news for the 16-24 year old age bracket where the unemployment rate currently is 14.0%.  Prior to the recession it was about 11.0%.  A stronger labor market would also be a welcome development for those people who hold several part time positions even though they would like full time employment.  Because of this continuing softness in the labor market the Federal Reserve will be justifiably slow in reversing the course of monetary policy.

As jobs growth accelerates and income rises more quickly, consumers are likely to step up their pace of spending.

Investment Spending

The economic outlook for corporate America also seems quite positive.  With stock prices at a record high level firms are able to issue additional stock to bolster their capital base or offer an initial public offering at a favorable price.  Corporate profits are at a record high level and growing at a healthy 5.6% pace.  Corporate borrowing rates are slightly higher than they were at midyear, but for all practical purposes are the lowest they have been in 50 years which makes it an attractive time for firms to borrow.  Meanwhile, banks are increasingly willing to make funds available to the corporate sector.  Commercial and industrial loans are currently climbing at an 8.0% pace.  Firms also have a record amount of cash on their books which they are anxious to deploy into higher-yielding assets.  Despite this seemingly favorable environment for corporate America, non-residential investment spending has been expanding at only about a 3.0% pace.

This damper on investment spending is undoubtedly impacted by the political gridlock in Washington.   Government spending is approved on a quarterly basis which makes it exceedingly difficult for government contractors to know what the future might bring.  There is a constant threat of exceeding the debt limit which could cause the U.S. Treasury to default on its debt and result in sharply higher interest rates.   The burden of compliance with existing legislation is onerous for small businesses.  And the current disarray in the implementation of Obamacare makes it exceedingly difficult for firms to determine the cost of health care benefits for their workers.  Under these conditions it is not surprising that many firms are reluctant to deploy their vast holdings of cash assets.

Having said that, a pickup in the pace of economic expansion next year, an increase in the debt limit for an extended period of time this coming January and adoption of a budget which will eliminate the possibility of another government shutdown should entice business owners to accelerate their pace of investment spending in 2014 to 6.8% from 3.0% in the current year.


The foreign trade sector of the economy should also contribute to GDP growth in this coming year for two different reasons.  First, the deficit for net exports has been steadily shrinking for the past two years as the result of new technology in the oil sector.  Hydraulic fracturing and horizontal drilling have unlocked supplies of natural gas and oil that were previously inaccessible.  As a result oil and gas production has increased dramatically in recent years and will continue to climb for at least another decade.  As a result, energy exports have been rising rapidly while energy imports are shrinking. By the end of this decade the U.S. is likely to be a net exporter of energy for the first time.

Second, growth overseas – Europe and Japan in particular — is expected to accelerate in 2014.  Europe is expected to finally end its two-year recession and expand at a moderate pace this coming year.  That turnaround is largely attributable to the European Central Bank’s pledge late last year to make funds available to any country that found itself in financial difficulty as long as that country was willing to commit to austerity measures that would reduce government spending.  An upswing in Europe is important because the European Union as a block is as big as the United States.

Similarly, Japan’s economy has been in a growth recession for 20 years but it is likely to step up the pace in 2014.  In this case the upswing is attributable to the Bank of Japan’s decision to pursue a quantitative easing strategy similar to what the Federal Reserve has been doing for the past five years.  That has bolstered both consumer and business confidence and triggered an astonishing 65% increase in the Japanese stock market in the past twelve months.  Faster economic expansion in Japan is important because it is the world’s third largest economy – behind the U.S. and China.  Faster growth in other regions around the globe should boost U.S. exports and contribute to a more rapid pace of GDP expansion in this country.

Government Spending

Government sector has been a significant drag on GDP growth for the past two years.  Federal government spending, defense spending in particular, has been falling primarily because the U.S. has been winding down its wars in Iraq and Afghanistan.  In addition, defense spending has been hit hard by the enforced spending cuts which went into effect on March 1.  This sharp reduction in federal government spending has reduced GDP growth by about 0.4% in each of the past two years.  This coming year government spending should be about unchanged and its drag on GDP growth will largely disappear.

When one combines a slight pickup in consumer spending, considerably faster investment, a continuing decline in the trade deficit, and reduced drag from the government sector, it is easy to envision 3.0% GDP growth in 2014.

Monetary Policy

The Federal Reserve will not take any action this coming year that could jeopardize the nascent pickup in the pace of economic expansion.  Their reluctance to do so is largely related to weakness in the labor market.  While the unemployment rate has fallen more quickly than anyone expected to 7.0%, the reality is that the labor market is weaker than the overall rate would suggest.  As noted earlier, the unemployment rate amongst 16-24 year olds is 14.0%.  Prior to the recession that rate stood at about 11.0%.  Many workers have been forced to take two or three part time jobs because no full time position is available.  Still others have been seeking employment for so long that they have simply given up looking for a job and have dropped out of the labor force.

While the Fed does not want to inhibit the pace of economic activity, that does not mean it will sit back and do nothing.  Its policy response will come in two phases.

Prior to 2008 Fed policy focused exclusively on short-term interest rates.  When the Fed wanted to slow the pace of economic activity it would push short rates higher.  When it wanted to speed things up it did the opposite.  Once Lehman Brothers collapsed in 2008 the Fed pushed short-term interest rates to 0% but the economy was still teetering on the brink of an outright depression.  It became apparent that the Fed needed to do something else to give the economy a jolt.

For the first time ever it decided to focus its attention on long-term interest rates and try to push them lower.  Its hope was to reduce Treasury bond yields, lower 30-year mortgage rates and, hopefully, revive the dormant housing sector.   It is important to understand that this was uncharted territory and it was not clear whether it would work.  From the time this policy was implemented in early 2009 long-term interest rates have fallen appreciably with mortgage rates reaching a record low level of 3.5% late last year.  As rates continued to slide the housing sector began a vigorous rebound which continues to this day.  Thus it appears that the Fed’s “quantitative easing” as it is now called has been relatively successful.

To push long rates lower the Fed buys a security and pays for it by placing the proceeds in the bank’s checking account at the Fed which is known as a “reserves” account.  Because the Fed has purchased so many bonds and mortgages, excess reserves in the banking system have grown from $2 billion in late 2008 to $2.3 trillion currently.  It is important to understand that the Fed continues to purchase $85 billion of such securities every single month.  Hence, monetary policy is continuously easing as the Fed injects more and more surplus reserves into the banking system.

Those surplus reserves represent funds available to the banking system to lend to consumers or businesses.  If consumers and businesses were suddenly inclined to borrow and simultaneously banks were willing to lend, the $2.3 trillion of excess reserves would fuel a spending spree the likes of which we have never seen before and which would be highly inflationary.  At some point the Fed must absorb that surplus liquidity from the banking system.  But before it can begin to drain some of the surplus liquidity it must first stop adding to bank reserves which is what the debate is about at the present time.

The Fed has indicated its intention to reduce its pace of bond purchases by the end of this year and stop purchases altogether by the middle of next year.  By taking that action the Fed is not “tightening”.  All it is really doing is slowing its pace of easing from $85 billion per month to some smaller amount, and then phasing it out entirely.  In the process of doing so, long-term interest rates may rise slightly by the end of 2014.

The increase in long rates will be limited because there is always a relationship between short-term rates and long-term rates.  The difference between the two is known as the “yield curve”.  It is difficult to find any period when long rates have been more than 3.5% higher than short rates.  So if the Fed holds the overnight funds rater at 0% the yield on the 10-year note is unlikely to rise beyond 3.25% rate.  The 30-year mortgage should not be more than 4.75%.

The next question is when the Federal Reserve will begin to raise the crucial federal funds rate which has been the traditional rate the Fed has used to implement monetary policy.  It has told us that it will not begin to do so until the unemployment rate reaches 6.5%.  Recent speeches by Fed officials suggest that it might soon lower that threshold to 6.0%.  According to our forecast, the unemployment rate will not hit that the 6.0% mark until mid-2015.

If the Fed begins to raise the funds rate at that point in time, history suggests that they would increase rates slowly but steadily, by perhaps 0.25% every six weeks.  At that pace it would take until mid-2017 to reach the 4.25% mark at which the funds rate is generally regarded as being “neutral”.

Finally, the U.S. economy has never fallen into recession until the Fed has pushed short-term interest rates far above the so-called “neutral” mark.  If that is the case and short rates do not return to neutral until mid-2017, it is difficult to imagine how the U.S. economy can dip into recession until 2018 at the earliest.


If during 2014 the economy expands at a 3.0% pace with all four sectors contributing to its growth and the Federal Reserve keeps short-term interest rates at 0% and allows long rates to rise only slightly, it should be a very good year.  By December of next year the unemployment rate should have declined to 6.5%.  Corporate profits will continue to rise.  The stock market will climb well beyond its current level.  And inflation will remain close to the Fed’s 2.0% objective.  Until the Fed becomes serious about slowing the pace of economy activity the odds on recession are near 0%.  The earliest date that outcome seems even remotely possible is 2018.

Stephen Slifer


Charleston, SC

The Year Ahead — 2013

December 14, 2012

The economic outlook for every year depends on fiscal policy.  But this year more than ever events in Washington are likely to overshadow decisions made on Main Street.

Confident Consumers

Consumers finally woke up to the potential negative consequences associated with the “fiscal cliff” as sentiment fell sharply in December.  Nevertheless, at 74.5 they seem to believe that the worst will be avoided and the economy will expand at a moderate pace in 2013.  They have ample justification for enthusiasm.

During the recession consumers lost 25% of their net worth as the stock market collapsed and home prices plunged.  But in the three and one-half years since the expansion ended, they have recovered the bulk of what they lost thanks to rising stock prices.  Now that home prices are finally beginning to turn upwards it is easy to imagine consumer net worth reaching a record high level sometime next year.

At the same time consumers have reduced debt and gone from a record high level of debt in relation to income at the start of the recession, to a debt to income ratio currently that is the lowest since 1980.   Consumers clearly have the ability to step up their pace of spending if they so choose.

Meanwhile mortgage rates have fallen to 3.4% and are headed lower as the Fed continues to purchase $40 billion per month of mortgage-backed securities.  By this time next year mortgage rates are likely to be at the 3.0% mark.  Combining record low mortgage rates with a 30% drop in home prices means that housing is more affordable than it has been in 40 years.

Most importantly, the housing sector has finally turned the corner.   The Census Bureau tells us that 1.3 million new households are formed every year and those people need a place to live – a house or an apartment.  Thus, housing starts must climb 1.3 million annually just to keep pace with population growth.  Unfortunately, housing starts have been rising at one-half that pace for the past five years.  Builders were hurt badly by the recession and have been reluctant to jump back into the market.  Even ones who were so inclined had difficulty finding financing.  So for five years demand has far exceeded supply.  As a consequence vacancy rates have plunged, shortages of available homes have begun to emerge (especially for homes valued under $250,000), rents have been rising, and home prices have begun to climb.  Construction of single-family homes and apartments will accelerate throughout 2013 as builders race to catch up with demand.

Given this housing shortage it is a sure bet that home prices will continue to climb.  After hitting bottom in January, home prices have been rising at a 7.0% annual rate.  This will not only encourage fence sitters to jump into the market to purchase homes, but fewer current homeowners will be “upside down” and owe more than their home is worth.  That implies fewer foreclosures and short sales which have depressed home prices for several years.

Business Bonanza

Business leaders in the U.S., like consumers, are relatively upbeat.  They have ample justification for such a view.  First, the stock market has been rising steadily since the expansion began in mid-2009.  As stock prices climb, CEO’s can issue additional shares of stock and thereby bolster the firm’s capital.

Because corporations cut costs so sharply during the recession and boosted productivity, profits have risen to a record level and continue to climb at a 6% annual rate.  As a result of this extraordinary growth in profits and relatively few investment opportunities, corporations have accumulated a mountain of cash.  If lucrative investment opportunities should arise, firms have ample cash to deploy.  If such opportunities do not materialize, CEO’s are likely to return some of that cash to investors in the form of a special dividend.

Meanwhile, borrowing rates for corporations are the lowest in 50 years.    Depending upon their credit rating firms can issue 20-year bonds at rates between 3.5-4.5%

Not only are interest rates low, credit is readily available.  Larger corporations can tap the commercial paper market at rates very close to 0%.  They might choose to issue bonds.  Or they might turn to banks which are finally making funds available to the business community.  Commercial and industrial loans have climbed 13% during the past year.

Investment Inhibited

Despite corporate leaders confidence, record profits, a pile of cash, the lowest borrowing rates in 50 years and credit readily available, investment spending has slowed steadily throughout 2012, and actually declined slightly in the third quarter.  Why?  Uncertainty.

Employment growth has been sluggish at about 150 thousand per month.  Many employers have postponed plans to hire additional workers.   Why?  Uncertainty.  Uncertainty about both the fiscal cliff and longer-term budget deficit and debt problems.

The “Fiscal Cliff” Folly

Given its unwillingness to raise taxes or significantly cut government spending prior to the election, Congress has created a nightmare.  A variety of tax rates will increase at yearend – individual and corporate income taxes, the payroll tax, and the alternative minimum tax amongst them.  Defense and nondefense spending will be chopped, unemployment benefits will shrink from 99 weeks to 26 weeks.  This combination of higher taxes and reduced government spending will reduce GDP by $640 billion in 2013 or roughly 4.0%.

To put that amount in context, the $787 billion fiscal stimulus bill passed in February 2009 was sufficiently large to turn around an economy that was threatening to slip from recession into an outright depression.  Given that stimulus package, GDP growth turned upwards within six months and the recession ended in June 2009.  If Congress does not act by yearend, the economy will encounter a powerful $640 billion headwind that will almost certainly push it back into recession.  If one believes the trend rate of GDP growth in 2013 might be 3.5%, a 4.0% headwind would push it back into recession.

Such an outcome would be catastrophic.  Consumer and business confidence would collapse as it becomes apparent that our lawmakers are paralyzed.  The stock market would plunge.  Net worth would shrink.  Jobs would be lost.  The unemployment rate would climb from 7.7% today to 9.0% or higher by the end of next year.

The difference between Republicans and Democrats regarding a possible solution to the fiscal cliff is centered on tax rates for individuals making more than $250,000.  Democrats insist on higher tax rates for those so-called wealthy individuals.  The Republicans are opposed.

While these differences are important, the reality is that Republicans and Democrats agree on many issues.  Nobody wants to see tax rates on middle or lower income wage earners increase.  Nobody wants to see the alternative minimum tax ensnare a larger group of individuals.  Nobody seems to think this is good time to sharply cut defense spending.  If the President and Congress agree to postpone those particular tax increases and the cuts in defense spending for another year, the impact of the cliff would be reduced from $640 billion to $265, and the negative impact on GDP would be sliced from 4.0% to 1.5%.  Re-doing the math, if the trend rate of GDP growth in 2013 is 3.5% a 1.5% headwind would reduce it, but to an acceptable rate of 2.0%.

It is not difficult to mitigate the negative impact of the cliff on GDP growth from 4.0% to 1.5%.  All that is necessary is willingness to compromise.

Longer-term Budget Busting and Debt Difficulties

Solving the fiscal cliff problem does nothing to resolve our longer-term budget and debt issues.  We simply kick the can down the road for another year.  Firms will remain reluctant to hire and invest.

There can be little doubt that the U.S has a longer-term budget deficit problem.  In each of the past four fiscal years the U.S. has had a budget deficit in excess of $1.0 trillion.  When a country has a budget deficit it spends more than it collects in taxes.  It must borrow the difference.  During that four year time frame the U.S. added more than $5.0 trillion to the national debt.

Budget deficits will shrink somewhat during the next couple of years as the economy recovers, but will climb again in the second half of the decade.  Why?  Because the baby boomers are beginning to retire.  They were born between 1946 and 1964.  If they work to age 67, they will retire between 2013 and 2031.  As they retire they collect Social Security benefits.  They become eligible for Medicare.  The ever increasing pool of retirees will steadily boost budget deficits through 2035.

As budget deficits soar, the Treasury will need to issue an equivalent amount of debt to finance them.  One way of assessing the debt problem is to look at the ratio of debt to GDP which essentially measures our ability to pay it back.  That ratio climbed from 35% prior to the recession to 75% today.  As the baby boomers retire that ratio will climb further to 186% of GDP by 2035.

Most economists believe a country will have difficulty financing its debt when its debt to GDP ratio reaches 90%.  At that level government borrowing is so pervasive that it sops up most of the funds available for investment.  There is little left over for the private sector.  As a result, both productivity and that country’s standard of living will grow more slowly.  At the same time foreign investors may question that country’s ability to repay its debt and shift their investments elsewhere.

A debt to GDP ratio of 186% is a serious problem.  It roughly equivalent to what Greece has today.  We do not want to go there!

To address this debt problem, President Obama appointed a bipartisan commission in February 2010 – 9 Republicans and 9 Democrats — to, essentially, fix everything.  It became known as the Simpson-Bowles commission.  Nobody expected them to reach an agreement.  But they did!  A majority of 11 members voted in favor of the commission’s recommendations which, essentially, raised taxes a little and cut spending a lot.  Here is a sampling of their recommendations:

Individual income taxes.  They proposed three tax brackets 8%, 14%, and 23% (compared to a top bracket of 39% today).  Eliminate most tax deductions.  This recommendation would boost individual income tax revenues despite the lower tax rates.

Corporate income taxes.  Lower the corporate tax rate to 26% (compared to 35% today).  Eliminate most corporate tax deductions.  As with individual income taxes, corporate tax revenues would rise despite the lower tax rate.

Defense and non-defense spending. Quickly cut spending to its pre-recession level.  Then allow it to grow at one-half the rate of inflation.  Equal percentage cuts to both the defense and non-defense categories.  Eliminate all congressional earmarks.

Social Security. Reduce benefits, particularly for high income individuals.  Gradually increase the retirement age from 67 to 68 years.  Increase the payroll tax maximum from $168,000 to $196,000.  These changes would make Social Security solvent for the next 75 years.

Medicare/Medicaid. Essentially, make us pay more for our health insurance coverage.  For Medigap policies the first $500 of expenditures would not be covered.  Insurance would only cover 50% of health care expenditures between $500 and $5,000.  Raise the retirement age for Medicare eligibility to 68.

If the plan were adopted in its entirety, the projected debt to GDP ratio would shrink from 186% in 2035 to 40%.  By adopting these measures the fiscal health of the U.S. would be restored within 25 years!  It can be done!  Eleven of the 18 commission members set aside political differences and voted in favor of the recommendations because it was the right thing to do for the country.  It would put us on a course of fiscal responsibility for the first time in years.

But President Obama did not accept the recommendations because they cut entitlement spending too sharply.  Republicans complained that they raised taxes too much.  In the end, the commission’s recommendations were not adopted.  But because of its bipartisan support in late 2010, the Simpson-Bowles findings are being used as a blueprint for the budget negotiations that are taking place as we speak.  Our sense is that, following the election, both parties are more willing to negotiate.  Our operating assumption is that the negative impact of the fiscal cliff will be reduced from 4.0% to 1.5%, and that by the spring a plan resembling Simpson-Bowles will pass Congress.

If that is the case we expect GDP growth to quicken from 2.0% in 2012 to 2.7% in 2013.  The unemployment rate will decline from 7.7% to 7.1%.  Inflation will be steady at about 2.0%.  The Federal Reserve will keep the funds rate at 0% throughout the year.  And long-term rates will decline by about 0.4% which would put the yield on the 10-year note at 1.3% and the 30-year mortgage rate at 3.0% by yearend 2013.

If the economic scenario next year is remotely close to what has just been described and, simultaneously, we solve our longer-term budget deficit and debt issues, it will be a fantastic year!

Stephen Slifer


Charleston, SC

The Year Ahead Outlook — 2012

December 16, 2011

As 2011 comes to a close the economy appears to be emerging from the doldrums and is on track to significantly improve its performance in 2012.  Last year the economy got hammered early in the year by civil unrest in many North African countries which boosted gasoline prices and curtailed spending, and then by the tsunami in Japan which interrupted the supply chain.  These events reduced first half 2011 GDP growth to a snail’s pace.   But as the year progressed, consumer and business spending quickened and the notion of a double-dip was pushed into the background.  Barring any other political or natural disasters the economy seems likely to register GDP growth of about 3.0% in 2012.  That puts us squarely amongst a relatively small group of optimists.  Our view is predicated on what we believe are favorable developments for consumers, businesses, and housing which – combined – represent about 75% of our economy.  If the pace of economic activity accelerates to the extent we expect, the economy should finally begin to produce a respectable number of jobs each month, and the unemployment rate will begin a more noticeable downtrend.  Finally, the stock market will almost certainly continue to be buffeted by every tidbit of news about debt problems in Greece, Italy, and perhaps elsewhere in Europe.  While the U.S. economy is not immune to a European debt default, the fears of contagion similar to what happened following the collapse of Lehman Brothers in 2008 appear to be exaggerated because our banks and corporations currently have much stronger balance sheets than they did a few years ago.  If all of the above is reasonably accurate, we will be quite content by this time next year.  Specifically, we look for the following:

  1. GDP growth should be 3.0% this year versus 1.9% in 2011.
  2. The economy will soon start producing 210 thousand jobs per month, and the unemployment rate will end this year at 7.6%.
  3. Inflation will remain relatively subdued at 2.4%.
  4. Problems in Europe will not derail the U.S. economy.

Consumer spending.  Most measures of confidence suggest that consumers remain nervous, but their spending has not wavered.  Consumer expenditures in the third quarter grew at an acceptable 2.5% pace, and fourth quarter growth seems equally rapid.


 And why not?  At the beginning of the recession consumers were grossly overextended.  When the bottom fell out they got scared and paid down debt every single month for two years.  But in recent months consumers have once again begun to take on additional debt.  They would not be doing that unless they were comfortable with the amount of debt that they owe.  Think of it this way.  If someone took $100 from his or her paycheck each week for two years and used it to pay down debt, they would eventually become comfortable with the amount of debt they owe.  At that point they could then take the $100 and actually spend it.  That is exactly what is happening.  This behavioral shift should provide considerable support to the economy in 2012.  Remember, consumers are two-thirds of the GDP pie!


 Investment spending.  Investment spending has been the fastest growing sector of the economy since this expansion began in mid-2009, and it is showing no sign of slowing down. 


 What are they spending their money on?  Technology.   Why?  Because money spent on technology boosts productivity which, in turn, enhances profitability.  So far that game plan has worked wonders.  Corporate profits today are at record high levels. 


Many of those profits are still sitting around on corporate balance sheets in the form of cash – in checking accounts, Treasury bills, and CD’s.  Like profits, corporate cash holdings are also at a record high level.  What those instruments have in common is that they yield less than 1.0%.  But a CEO cannot keep a significant portion of the firm’s assets in cash for long.  Investors did not buy that company’s stock to be content with a 1.0% return.  They are looking for 8.0-10.0% or more.  As we go forward some of that cash will almost certainly be spent on basic research to develop a new product, on more technology, or even buying the competition – all of which will bolster GDP growth.

 This positive view of corporate spending in 2012 is reinforced by a steady increase in the backlog of orders.  Each month our factories receive orders, manufacture something, and then ship those manufactured goods elsewhere.  If what is coming in the front door exceeds what is going out the back door, the backlog of orders continues to climb.  Indeed, it has been rising steadily for almost two years.  If that pile of orders keeps getting higher, how do firms respond?  They increase production – which is exactly what GDP is all about.


Some firms complain that they cannot get money from banks because lending standards are so tight.  While that used to be true, it is changing rapidly.  In the early part of 2011 bank lending to businesses began to turn upwards.  Such loans are currently expanding at a robust 8.7% pace which is accelerating with each passing month.  Another headwind bites the dust.


Housing.  For the economy to gather momentum during 2012 the housing sector must emerge from the doldrums.  We all know that home prices have fallen by about 30%, and more than two million construction jobs have been lost since its peak in 2006.  Typically in the early stages of a recovery the housing sector leads the way and construction employment rises rapidly.  This cycle has obviously been different.  But at some point the housing sector will turn, and that turning point is likely to occur in 2012. 


While the drop in home prices has been troublesome for the home owner, for a home buyer the drop in prices represents an opportunity.  Combining a 30% drop in home prices with a 4.0% mortgage rate, we find that housing is more affordable today than it has been in more than 40 years.  Thus, the fundamentals for housing going forward appear surprisingly strong.

  One other thought to keep in mind is that the Census Bureau tells us that there are 1.3 million new households formed every year.   The home ownership rate in this country is 65%.  If two-thirds of those new households require housing, then builders need to be constructing about 900 thousand new homes each year.  Currently, they are building 400 thousand.  Once the rebound arrives, presumably by spring, the housing sector can easily double or triple from where it is today.  At that point construction employment can easily rise by 20 thousand per month — it is currently falling by about 10 thousand.


Employment.  The other piece of the equation for stronger growth in 2012 is jobs.  The November unemployment rate fell 0.4% to 8.6% which is a step in the right direction.  By the end of 2012 we anticipate a further drop to 7.6% which remains well above the full-employment threshold of 5.0% — the level at which (presumably) everyone who wants a job has one. Unfortunately, it is hard to imagine a set of circumstances under which the unemployment rate can return to that desired level sooner than mid-2015.  That trajectory is based on an assumption that monthly job gains climb to 210 thousand per month versus about 160 thousand currently.  While that is achievable, you have to remember that our forecast is more optimistic than that of many other economists.  If they are right it will take even longer.


Why are we reasonably optimistic that jobs growth will accelerate?  Three reasons.  First, as noted above, if the housing sector responds to the favorable fundamentals, construction employment can easily add 20 thousand to the job gains each month versus the current decline of about 10 thousand.  That will boost the monthly reading by 30 thousand. 

Second, state and local governments have shed nearly 700 thousand jobs since the demise of Lehman Brothers in September 2008.  Why?  Because as the economy collapsed, tax revenues plunged.   The only way states could produce a balanced budget – which most are required by law to do – was to sharply curtail expenses.  Thus, thousands of teachers, police, and firefighters lost their jobs.  But as the economy gathers momentum, tax revenues should rebound.  As a result, it will be easier for these government entities to produce a balanced budget without further job cuts.  Given that state and local government jobs are currently falling by 20 thousand each month, a return to no change would boost overall employment gains by an additional 20 thousand. 

 Finally, if construction and government hiring improves in response to faster GDP growth, the pace of job creation in other sectors of the economy should quicken as well.

 Europe.  The market is buffeted almost daily by news about the debt problems in Greece, Italy, and elsewhere.  There are clearly long term problems that must be addressed as these countries attempt to stimulate growth and simultaneously lay the groundwork for spending cuts down the road to shrink their bloated budget deficits.   The biggest problem for 2012 would be if the European economy were to slip into recession.  However, the recently released forecast by the European Union calls for GDP growth of 0.5% next year with virtually no growth early in the year and a gradual pickup in the second half.  The IMF forecast is similar.  If, as we expect, GDP growth in the U.S. is surprisingly robust, then growth in Europe is likely to surprise on the upside as well.  Thus, the chance that any European country will default on its debt in 2012 is remote.

But it is important for us to remember that even in the event of a hiccup in Europe, the U.S. banking system and corporate America are well positioned to withstand a temporary setback.  One measure of the health of the banking system is the ratio of total assets to cash which is basically a leverage ratio.   If banks make loans and do not increase cash commensurately, this ratio climbs which means that the banking system is more highly leveraged and its appetite for risk has risen.  Over the past 35 years that ratio has averaged about 13.  In the mid-1990’s when times were good banks made a large number of loans, many of them mortgages.   By 2007 that ratio had climbed to 37.  Then the bottom fell out.  Many of those loans went sour, and banks had to scramble for cash to stay afloat.  As a result, this leverage ratio fell dramatically.  Today it stands at a near record low level of 7.5.  It is basically where it was in the mid-1970’s.  The point of all this is that the banking system today is well positioned to withstand any potential liquidity problem triggered by a default somewhere in Europe.


The same thing is true of corporations in the United States.  Corporate cash holdings are at a record high level.  While difficulties in Europe will clearly rattle the markets, the fears, in our opinion, are greatly exaggerated.


There is always the possibility that unanticipated events will change the outcome (much like what happened in 2011), but from where we sit the economy seems poised to finally shift into a higher gear during 2012 as the housing sector emerges from its slump, the economy begins to produce a significant number of new jobs, state and local governments stop laying off workers, and bankers begin to loosen up on their purse strings.  It’s about time.

 Stephen D. Slifer


Charleston, SC

The Year Ahead — 2011

December 14, 2011

(Almost) As Good As It Gets

This is the time of the year when economists reveal their expectations for growth in the upcoming year.  Our best guess is that 2011 will look quite different from 2010 as the economy shifts into high gear.  Specifically, we look for the following:

  1. GDP growth should be 4.0% this year versus 2.7% in 2010.
  2. The economy will soon start producing 250 thousand jobs per month, and the unemployment rate will end this year at 8.7%.
  3. Inflation will remain subdued with core inflation averaging 1.1%.
  4. The Fed will leave rates unchanged throughout 2011.

Indeed, the economy in 2011 will be impressive.  While the unemployment rate will remain elevated, it will at least begin a steady decline which should bolster confidence.

When talking about the economy it is best to break it up into its major components.  Let’s start with the consumer.  Consumer spending is critical because it represents about two-thirds of GDP.  So goes the consumer, so goes the economy.  At the beginning of the recession consumers were saddled with debt payments which surged to 14.0% of income.  But in the past two years they have been paying down debt with a vengeance.  Mortgages, credit card debt and car loans have declined almost every month.  As a result, that ratio has plunged to about 12.0%.  How much farther must it fall before consumers are “comfortable” with their debt burden?  Over the past 30 years that ratio has averaged 11.5%, so perhaps one could argue that represents a comfortable amount of debt.  If so, we will get there by midyear.

In recent months employment has begun to increase, people are working longer hours, and hourly earnings have been climbing.  The net result of all this is that weekly earnings are growing at nearly the same pace that they were climbing prior to the recession.

If income is rising and consumers are becoming more comfortable with their debt burden, then it stands to reason that their pace of spending on goods and services of all sorts (including housing) will accelerate as we move throughout 2011.

How about the businessman and the outlook for investment spending?  During the recession firms laid off eight million workers.  Once the recession ended corporate America began to invest heavily in information technology and any type of productivity-enhancing equipment.  Indeed, spending on technology has grown at a 15% pace since the recession ended in June 2009.  It is by far the fastest growing sector of the economy.  Productivity growth has surged.  As a result, firms made a lot of money!  Corporate profits today are back to where they were prior to the recession.

Because of the rebound in profits, corporations have socked away unprecedented amounts of cash.  Funds slopping around in checking accounts, time deposits, and U.S. Treasury securities have climbed $350 billion in the past year and are at a record high level.  This cash is not going to sit there for long.  Corporations will be looking for investment opportunities.  Much of it will be spent on technology.  More cash might be spent gobbling up a rival or paying down debt, but both of those events are likely to propel the stock market higher.

The one missing ingredient during 2010 was jobs.  But the employment situation now seems brighter.  In response to demand, firms have had to step up production.  Rather than hire new workers they have, for the most part, chosen to hire temps and work existing employees longer hours as evidenced by the steady increase in the workweek which is now almost back to its pre-recession level.  Between health care benefits, vacation time, pensions and 401 (k) plans, it is expensive to hire permanent employees.

But now firms have pushed that string about as far as it can go and they need to hire additional bodies.  Think of it this way.  If GDP is rising at a 2.5% pace, and productivity is also rising at 2.5%, then the economy can grow at that rate forever without the need for additional hiring.  Firms can produce everything that they need to produce with their existing headcount.  But if, as expected, GDP growth quickens to 4.0% and, simultaneously, productivity growth slows to 1.0%, then the gap must be filled by employment growth of the difference, or 3.0%.  If you work through the math that means that monthly employment gains could quickly climb to 250 thousand per month. Over the most recent three month period, payroll employment has on average risen 107 thousand.  If we soon begin to see monthly gains of 250 thousand, more people will be working which means faster growth in income, a pickup in spending, consumer and business confidence will soar, the unemployment rate will – at long last – establish a steady downtrend, and corporate profits will climb further.  In short, we will have the beginnings of a virtuous economic cycle.

If we begin to see employment gains of the magnitude suggested, the unemployment rate should decline to 8.7% by the end of 2011.  That is a lot higher than where it ought to be, but at least it will have started to move in the right direction.  At 250 thousand jobs a month it will take years to replace the eight million jobs lost during the recession.

What about inflation?  If we start to see steady GDP growth of 4.0%, won’t inflation soon come roaring back?  Probably not.  The Fed expects the inflation rate to remain in check for the foreseeable future primarily because of “slack” in the economy.  There are two types of slack to which they are referring.

First, with the current unemployment rate at 9.8% when it should be at 5.0%, there are lots of available workers for every job.  Thus, there is a lot of “slack” in the labor market.  That competition amongst workers will ensure that wage pressures remain in check.  But what is really important to an economist is a concept called “unit labor costs” which is basically labor costs adjusted for the change in productivity.  For example, if I pay you 3.0% higher wages, you might think that my costs have risen by 3.0%.  But what if you are 3.0% more productive?  I pay you 3.0% more money but I get 3.0% more output, so I really don’t care.  In this case, “unit labor costs” are unchanged.  As shown in the chart below, unit labor costs continue to decline.  As a result, we do not expect any upward pressure on the inflation rate stemming from labor costs this year.  That is important because wages represent about two-thirds of a firms overall cost of production.

The other type of “slack” in the economy comes from utilization rates in the industrial sector.  Once capacity utilization climbs to about 80%, we typically see a somewhat higher rate of inflation.  At that point the economy is running so hot that firms are able to push through price hikes.  However, the utilization rate in the manufacturing sector today is 72.7%.  Factory output typically slows in the second year of expansion.  If so, then capacity utilization will remain well below the 80% danger level throughout 2011.

Between the slack in the labor market and a low utilization rate, it is hard to see inflationary pressures emerging for some time to come.  As a result, we expect the core inflation rate this year to be 1.1% versus 0.6% in 2010.

If you are in the Fed’s seat, what do you do?  Currently, the Fed believes GDP growth in 2011 will be in a range from 3.0-3.6% (versus our projected 4.0% pace) and the unemployment rate will end the year at the 9.0% mark (compared to our 8.7% forecast).  It is actively trying to stimulate the economy by purchasing $600 billion of longer-dated U.S. Treasury securities between now and midyear in an attempt to push long-term interest rates lower.  Our guess is that the yield on the 10-year Treasury note will not dip much below its current level of 2.5%, which means that the 30-year mortgage rate will remain at about 4.25% — which happens to be a record low level.

Eventually the Fed will have to get interest rates back to “neutral” which means that the funds rate will need to climb from its current level of around 0% to about 4.5%.  But given the slack in the labor market and the low utilization rate, there is no need for the Fed to begin tightening until sometime in 2012.  Thus, our expectation is that the funds rate will remain in a range from 0-0.25% throughout this year, but 2012 will be a different story.

If this is the world that evolves – GDP growth accelerates to 4.0%, we start cranking out 250 thousand or more jobs a month, the unemployment rate remains high but begins a steady decline, the inflation rate remains in check because of that slack in the economy, and the Fed leaves the funds rate at 0-0.25% for the entire year – we are all going to be fairly happy campers.

As with any forecast there are always risks.  But just keep in mind that the world is very different now than it was in 2008.  The global economy has pulled out of its slump and is gathering momentum.  Financial firms are not nearly as highly leveraged as they were at the beginning of the recession.  Consumers and corporations have been aggressively paying down debt.  Corporations have accumulated an unprecedented amount of cash.  The global economy, the U.S. in particular, is far better positioned to withstand difficulties should they arise in 2011 than it was a couple of years ago.

Stephen Slifer


Charleston, SC

The Year Ahead – 2010

January 4, 2010

A Year of Transition and Healing

It is that time of the year when economists gaze deeply into their (somewhat hazy) crystal balls to provide a glimpse into the future.  So here we go:

The economy will grow at a rate of 2.5-3.0% in 2010.

  1. The unemployment rate will end the year at about 9.5%.
  2. Inflation will remain subdued with core inflation averaging 1.5-2.0%.
  3. The Fed will leave interest rates unchanged for the entire year.

At this time last year the consumer was overcome by fear – the stock market was plunging, financial institutions were failing, property values were falling, and confidence was collapsing.  But policy actions by the Fed, the White House, and Congress saved the day.  By early spring the stock market had turned upwards, confidence began to climb, GDP rose in the third quarter with more growth expected in the fourth quarter.  The worst is behind us.  Having said that, economic headwinds will curtail growth during 2010.

The biggest challenge for the consumer is debt.  As shown in the chart below, consumers piled on debt far in excess of their ability to pay it back for 30 years.  And why not?  The stock market was rising steadily and adding to wealth.  Home prices marched relentlessly upwards.  Mortgages were readily available with no down payment.  The only other time in our history when spending was so out of control was in the 1920’s.  Then came the depression, and we spent the next 15 years paying down debt.  While no two periods are exactly alike, the current debt problem is sufficiently large that consumers should be in debt paydown mode for years to come.

A second obstacle for the consumer is the loss of wealth.  Those same two assets that rose so sharply for 30 years – house prices and the stock market – suddenly turned south.  Home prices fell 20-25%.  The stock market lost more than half its value.  Consumer net worth fell 25%.  With the stock market rally it has recovered to some extent but is still 15% below the peak level attained in 2007.  Retirement plans have been postponed.  Retirees have been forced back into the job market.  For years Americans had no need to save because gains in the stock market and home values were effectively doing the saving for them.  That is no longer the case.  As a result, our savings rate – the amount we tuck away into savings each week from our paycheck — had been hovering around zero per cent for years.  But now it has rebounded to the 4% mark as we try to recover our lost net worth.  The problem for 2010 is that every dollar we save is one less dollar that gets spent.

Third, there is the issue of credit availability.  Banks have been stung by losses on their holdings of mortgage debt and credit card debt.  They are under considerable pressure from the Fed to raise capital.  In addition, they will have to pay the FDIC three years worth of deposit insurance premiums by the end of this year.  Not surprisingly, banks are not anxious to lend.  And when they do so it is only to the most creditworthy borrowers.  They have tightened their lending standards by requiring larger down payments and higher credit ratings.  Many seemingly creditworthy borrowers are being turned away.  This inability to attain credit is having the biggest negative impact on consumers and small businesses.  Larger businesses have been relatively successful in tapping the credit markets for funds.  Banks are catching most of the heat for the fact that loans are not growing, and some of that criticism is justified.  But, as described above, consumers and small businesses are currently more inclined to pay down debt than add to it.  Whether the problem is on the demand side or the lending side is irrelevant.  Without loan growth, the economy is not going to grow quickly.

Finally, there is the issue of the 10.0% unemployment rate.  Unemployed workers do not have a paycheck.  To make ends meet they dip into savings.  But how much savings do they have?  Three months?  Six months?  When the savings runs out they cannot pay the bills.  They may lose the house to foreclosure.  They can no longer pay the credit card bills.  The car gets repossessed.  The moderate pace of economic activity expected this year will not generate sufficient jobs to bring the unemployment rate down quickly.  Most likely it will still be 9.5% at yearend, and 8.0% by the end of 2011.  To the extent workers are unemployed and without income, their spending will be limited.  Even those workers with jobs will spend cautiously because of a fear that their job could be the next to go.

Most jobs are created by small businesses.  But right now there is considerable uncertainty about the outlook for health care and taxes.  Will small businesses be required to provide health care?  How much will they have to pay?  What will happen with taxes?  Remember, the Bush tax cuts are scheduled to end on December 31 of this year.  What new taxes lie in store?  Until this uncertainly is resolved small business hiring is likely to be modest.

What about inflation?  The Fed keeps talking about “considerable slack” in the economy which will keep inflation in check.  Part of what they are referring to is the very high, 10% unemployment rate.  Most economists believe that full employment is achieved when that rate is about 5.0%.  At that level everybody who wants a job presumably has one.  As the unemployment approaches the 5.0% mark, wage pressures emerge which are ultimately passed through to consumers in the form of higher prices.  But even if the economy produces 250,000 jobs per month, it will take five years for that to happen.

The other factor the Fed cites is the low level of factory utilization.  That rate is currently 68.4% and rising slowly.  When the economy is humming that rate will be 80.0%, at which point businesses find that they have the ability to raise prices and inflation arises.  But, once again, it may take five years for that to occur.  Thus, the Fed is relatively confident that inflationary pressures will remain subdued for some time to come.

Given the “considerable slack” describe above, the best bet is that the Fed remains on the sidelines in 2010 and leaves short-term interest rates at 0%.  But during the past year the Fed has purchased all sorts of mortgage securities and credit card debt to provide necessary liquidity.  That action is potentially inflationary.  Eventually the Fed must reign in those outstanding reserve balances.  But when?  If they move too quickly they run the risk of dumping the economy back into recession.  If they proceed too slowly they run the risk of igniting inflation.  For now, the Fed has the luxury of being able to proceed cautiously.  But if investors begin to worry about inflation, the Fed could be forced into action sooner than it anticipates.

Make no mistake, the economy will expand in 2010, and 2.5-3.0% is an acceptable pace.  And very soon the economy will begin to create jobs.  Those are good things.  But the economic headwinds described above can only abate with time.  Thus, 2010 is probably best characterized as a year of transition and healing with low inflation and low interest rates.