The U.S. economic recovery is intact and we feel that the stage has been set for GDP growth to ramp up toward the 3% level in 2015, from an expected 2.3% in 2014. Sustained employment gains coupled with an unemployment rate below 6% are supporting both consumer confidence and the willingness to spend. Corporate optimism, like consumer sentiment, is riding high and companies have been sitting on big cash balances for years. Based on recent corporate manager surveys, we believe we are likely at the point in this cycle where companies have the confidence to loosen their purse strings, which would be highly supportive of both continuing job creation and a pick-up in capital spending. We see unemployment, which sits at a six-year low of 5.8% to continue its downward trend, with a year-end 2015 target of 5.5%. Although there are pros and cons to recent plunging oil prices, statistics support the view that lower energy prices will be a net positive both here in the U.S. and for the global economy. The massive drop in crude prices, while a headwind to energy companies, has been a holiday gift to consumers whose spending makes up over 70% of the U.S. GDP.
We expect to see stark divergences in the global growth landscape, which will translate into greater policy divergences as we move through 2015. The Eurozone has been experiencing weakness, which we believe is more likely to be a mid-cycle slowdown than a double dip back into recession. However, the region’s lack of banking and fiscal integration continues to hinder the European Central Bank’s (ECB) ability to spur broad-based growth despite several rounds of bond purchases. ECB President Mario Draghi has been very vocal about his willingness to expand the ECB’s asset purchase program into broader Quantitative Easing (QE) if growth and inflation remain weak. Policy initiatives coupled with the weakening of the Euro, making exports more competitive abroad, should help fuel a slight acceleration of growth in 2015.
Japan has re-entered a mild recession after having been unable to regain economic traction on the heels of its consumption tax hike in April. The Bank of Japan has expanded its QE program and the Yen has weakened which should help the export sector of the economy going into next year. Additionally, the drop in energy prices is a plus for the Japanese consumer and the delay of an additional consumption tax hike slated for April of 2015 should help Japan return to positive growth in 2015.
China continues to face a balancing act between maintaining a sufficient level of growth to support its labor force while advancing an array of structural reforms to deal with their housing and credit market issues. We have seen deceleration in China’s economic growth over a series of years to below 7.5% in 2014, and we expect this trend to continue. Our single point estimate for China’s growth in 2015 is 7%, still what we would describe as a soft landing scenario. China’s slowing growth led their central bank, the People’s Bank of China (PBOC), to make a surprise rate cut in November 2014, their first in over two years. This was a broader-based response than the targeted liquidity moves we’ve recently seen from policymakers, such as cuts in reserve ratios for selected banks and liquidity injections into the banking system to free up cash for lending. We expect to see continued flexibility in how China manages its economy which will likely include additional PBOC easing in 2015 in an effort to achieve their desired growth.
Amongst the BRIC emerging economies, only India looks poised for a significant upturn in economic growth. We’ve discussed China in the preceding paragraph and both Brazil and Russia will be impacted by natural resource issues. India, under the leadership of the pro-business Modi administration, has seen a gradual ramp up in economic growth, which we expect to continue through 2015. The country needs substantial reform in areas like taxation, regulation and labor laws to really spur business investment. But India appears to be a bright spot for 2015. The Emerging Markets, as a whole, are expected to show a slight economic improvement in 2015, but as we pointed out earlier, there will be great divergences, particularly between those who are resource producers and those who are resource users.
The Fed has set the stage for the beginning of rate normalization in 2015. The FOMC comments regarding the bullish assessment of the U.S. economy and transitory impact from oil price volatility have led many to assume that the Fed’s “lift off” on rates will come in June of 2015. However, Fed Chair Janet Yellen made it clear that any ultimate move by the Fed was going to be data dependent. If oil prices remain highly depressed, the inflation side of the Fed’s dual mandate will remain well below their 2% target and heighten deflationary fears. Additionally, we believe that the Fed would like to see evidence of faster wage growth before raising rates. Thus, we see the potential for the initial increase in rates to be pushed out into the third quarter when the Fed may feel they have sufficient evidence that the economy is ready to stand on its own. Regardless of the timing of the first raise, we anticipate two measured moves before year end 2015 with the Fed Funds rate rising to 0.75%, a level that we see as highly supportive of growth.
As we pointed out in our 2014 Outlook, history has shown us that you can’t determine how long a bull market will run based on time alone. Given our forecast for close to 3% GDP growth here in the U.S., we believe that corporate profits will advance by about 8% and we feel that this will be sufficient to extend the bull run in stocks. Despite our expectation for the Fed to begin normalizing rates, the rate rise should indicate strength in the economy and, therefore, not be interpreted too negatively by the equity markets. However, we would expect to see increased volatility in the markets. Also, we’re anticipating some contraction in P/E multiples as the Fed moves toward and through its initial rate hike. Therefore, we expect the S&P 500 to rise only moderately to the 2100-2150 level in 2015.
Bonds were the surprise of 2014 with rates falling to unanticipated levels. The Fed’s telegraphing of its intended rate hikes for 2015 leads us to forecast an upward trend in rates in 2015. But with very benign inflation and an outlook for moderate growth, we don’t expect the 10-year Treasury to move beyond the 3% level. This scenario would allow core intermediate bonds to offer very low single-digit returns.
Based on our 2015 Outlook we believe that 1) stocks are fairly valued and should be held in line with strategic allocations, 2) large-cap multinationals run some earnings risk from the anticipated strength in the dollar, 3) small- and mid-cap stocks could be the beneficiaries of domestic growth without the level of currency exposure of multinationals, 4) international stocks look cheap based on historic relative valuations and could be poised to outperform if central bank policy measures have any success, 5) with the anticipated divergences in the economic performance of emerging market countries, active versus passive management of investments should be employed and 6) a moderate amount of short-duration bonds should be owned alongside core bond holdings as a defensive measure.
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