WEEKLY ECONOMIC COMMENTARY

posted 12/5/2013 in Investments

Highlights

  • LPL Financial Research forecasts economic growth, as measured by real GDP, to accelerate from the 2% pace of recent years to 3% in 2014.
  • Global GDP growth is also likely to accelerate in 2014.
  • Given our forecast for the economy, we expect the Fed to begin tapering its bond-buying program in the first half of 2014 and exit the program altogether by the end of the year.

Economic Outlook 2014: Accelerating Global Growth


LPL Financial Research forecasts economic growth, as measured by real gross domestic product
(GDP), to accelerate from the 2% pace of recent years to 3% in 2014. This marks our first
above-consensus annual forecast on GDP in many years. As of mid-November 2013, the
Bloomberg-tracked consensus estimate by economists for 2014 is 2.6%. If achieved, the 3% pace of
GDP growth in 2014 would be the best performance for the U.S. economy since 2005, when the
economy posted a 3.4% growth rate. While a strong growth rate in comparison to the past 10 years, the 3% growth rate would simply equal the average pace of real GDP growth since the end of WWII. Global GDP growth is also likely to accelerate in 2014. Economists' consensus forecast expects a pickup from around 3% in 2013 to 3.6% in 2014. Beyond the United States, the major contributors to this growth rate are also likely to enjoy a better pace of growth in 2014:

  • Europe will likely eke out a modest gain in GDP after emerging from a double-dip recession in 2013.
  • China's growth should stabilize in the coming year after slowing during the last few years.
  • Japan will likely record its third consecutive year of GDP growth for the first time since the mid-2000s.

If the U.S. economy grows at our expected 3% pace in 2014, it will be the end of year six of the twelfth economic expansion since the end of WWII. The current recovery is already the sixth longest expansion and would only have to last until at least mid-2014 to become the fifth longest.


The current economic expansion has already lasted 54 months, and in 2014, may surpass the average expansion since the end of WWII, which is 58 months. Looking back over the past 50 years, the average expansion has been 71 months. On that basis, the current recovery has another two years to go (2014 and 2015) just to get to "average."The best comparison, however, may be the three economic expansions since the end of the inflationary 1970s, a period that has seen the transformation of the U.S. economy from a domestically focused, manufacturing economy to a more export-heavy, service-based economy.

In general, this economic structure is less prone to inventory swings that drove the shorter boom/bust cycles of the past. On average, the last three expansions -- the ones that began in 1982, 1991, and 2001 -- lasted 95 months, or roughly eight years. Using those three expansions as the standard, the current economic expansion is merely at its midpoint. The rather tepid pace of this expansion relative to prior expansions that lasted this long also supports the idea that we are close to the middle of the expansion, rather than the end.


Small Risk of Recession
Most, but not all, recoveries end when the imbalances within the economy that have built up over time grow too big to sustain. Examples of these imbalances can include overinvestment in housing or technology, excessive consumption, or too much debt, among others. Currently few, if any, material imbalances have begun to emerge, as the economy continues to struggle to normalize after the Great Recession of 2008-09, the worst economic downturn since the Great Depression of the 1930s. In fact, the strength in the forward-looking economic data captured in the Index of Leading Economic Indicators suggests just a small chance (10-15%) of a recession over the next few years.


While these data suggest low odds of recession in the United States in the next few years, a recession is not completely out of the question. For example, a major mistake by policymakers (fiscal or monetary) at home or abroad could cause a recession. In addition, a geopolitical event, such as a terrorist attack that disrupted economic activity over a wide area for a long period of time would likely lead to a recession, as would a large-scale natural disaster. Finally, a sharp and swift spike higher in consumer energy prices -- similar to what the U.S. economy experienced in the early 1970s and mid-2000s -- would also raise the odds of recession.


Drags on Growth Fading


Several factors have caused the current expansion to be lackluster, even after such a severe recession.

Major components of GDP -- government spending, business spending on equipment and buildings,
and consumer investment in housing -- have badly lagged the average post-WWII expansion and
have acted as a drag on economic growth in the United States. The factors that contributed to the weakness in recent years include strained balance sheets, poor business confidence that contributed to a weak labor market, banks' unwillingness to lend after billions of losses in the housing bust, and a weak global economic backdrop comprised of a lingering recession in Europe and a slowdown in China and other emerging markets. Fortunately, most of these uncertainties should fade in 2014.


In addition, growth in 2013 was stifled by tax increases and spending cuts that added a material drag to the economy. The impact of the sequester, the fiscal cliff, and defense cuts reverberated
throughout the economy in 2013, and these should fade quickly in early 2014, especially if Congresscan come together to offset, or at least dampen, the sequester that is set to hit the economy on January 15, 2014. On balance, government spending should be less of a drag on growth in the next four years than it was in the first four of the expansion, when government spending added to growth in only three of 16 quarters. In 2011, 2012, and the first three quarters of 2013, weakness in government spending (federal, state, and local) subtracted about 0.5% each year from GDP growth.


Just adding that 0.5% back to GDP in 2014 would, in addition to better global growth, result in +1%
and help the U.S. economy achieve 3% growth in 2014.


However, some drags may remain, including:

  • The impact of the Affordable Care Act;
  • The increased regulatory burden in the financial sector and its impact on bank lending and loan growth;
  • The long-term outlook for the federal budget; and
  • The mid-term elections in Congress.

While these may keep growth from rising to 4% or above, we see the decreasing impact of drags as a positive for growth in 2014.
 
Yellen Enters as Fed Exits


Given our forecast for the economy, we expect the Fed to begin tapering its bond-buying program in the first half of 2014 and exit the program altogether by the end of the year. Therefore, 2014 is likely to mark a year of transition for the Fed in many ways -- the immediate impact being a less direct role in the markets. After tapering its bond buying, we expect the Fed to remain on the sidelines and keep short-term interest rates near zero well into 2015.


We expect the current Vice Chairwoman of the Fed, Janet Yellen, to succeed Ben Bernanke on
January 31, 2014, as Chairwoman of the Fed and the Fed's policymaking arm, the Federal Open
Market Committee (FOMC). While this may have little impact on the decision to taper quantitative easing (QE) in 2014, it is a very significant change as it relates to the long-term balance of policy between the Fed's dual policy goals of full employment and low-and-stable inflation. The Fed has been focused primarily on inflation over the past three decades. Chairman Volker brought inflation down from the double digits in the early 1980s, then Chairman Greenspan continued that legacy and helped keep inflation stable in the 1990s, and then Chairman Bernanke sought to avoid deflation, or falling prices, in the late 2000s. The change in leadership at the Fed may mark a longer-term shift in focus toward improving employment. This may mean short-term rates remain low for an extended period while longer-term rates rise -- not just in 2014, but for years to come.


Yellen's credibility, and that of the Fed itself, are on the line as the Fed exits its direct role in the
markets. Increasingly, emphasis will be on the guidance the FOMC provides as it contemplates
increasing interest rates in future years.
  
 
 
IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to
provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.


The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.


The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System, is
charged under the United States law with overseeing the nation's open market operations (i.e., the Fed's buying and selling of U.S. Treasury securities).


Gross Domestic Product (GDP) is the monetary value of all the finished goods and services
produced within a country's borders in a specific time period, though GDP is usually calculated on
an annual basis. It includes all of private and public consumption, government outlays,
investments and exports less imports that occur within a defined territory.


Quantitative easing is a government monetary policy occasionally used to increase the money
supply by buying government securities or other securities from the market. Quantitative easing
increases the money supply by flooding financial institutions with capital in an effort to promote
increased lending and liquidity.


Stock investing involves risk including loss of principal.
The Index of Leading Economic Indicators (LEI) is an economic variable, such as private-sector
wages, that tends to show the direction of future economic activity.
This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent
investment advisor, please note that LPL Financial is not an affiliate of and makes no
representation with respect to such entity.


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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
 
The financial consultants of Wealth Management are registered representatives with and Securities are offered through LPL Financial. Member FINRA/SIPC. Insurance products offered through LPL Financial or its licensed affiliates.
 
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