No need to tear up the script yet on the 2016 outlook, despite the weakest ever first-week start to the year for US equity markets. We’ll give the global markets some time to get over their latest jitters—worrying about crude oil, China and “world growth”—before altering the forecast.
It’s the start of a new year and traditionally the time for a look at what might happen next over the course of the coming year. More than the economy and more than the outlook, it is the speed of interest rate normalization that remains our focus for 2016. Fed policy regarding future rate hikes should be on autopilot—unthinking, unblinking. The economy is normal, having finally reached full employment in 2015, but short-term interest rates are not normal. No other Federal Reserve in the last several decades has tried to hold down rates so long after a recession.
We reviewed our outlook made this time last year, always with a bias to the optimistic side of life, and back then we expected the Fed to raise rates four times: in March, June, September and December. They ended up doing so just once: on December 16, 2015. Why did we have such a bold Fed call? It wasn’t ours. We borrowed it from what we thought the FOMC (Federal Open Market Committee) forecasts indicated at the December 2014 meeting. The December 2014 Fed meeting forecasts said if unemployment was 5.2 to 5.3 percent at the end of 2015 (it’s 5.0) then the Fed funds rate should be 1.25 percent, which meant a March 2015 liftoff. That was the median forecast. But even a solid-majority 13 of 17 thought 1.0 percent, which meant a June 2015 liftoff. We got one in neither March nor June, and September was scuttled for a launch date because of the “markets”.
As for the outlook, based on how the Fed measures growth, fourth-quarter to fourth-quarter, we forecast real GDP (gross domestic product) will increase 2.6 percent in 2016. This is what counts for optimism anymore, with 2.6 percent being a little better than 2.5 percent in both 2013 and 2014, and growth of perhaps 2.2 percent in 2015 with one quarter of reporting left to go. Whenever we are asked why the economy is so slow, 2-percent something real growth, we always think back to those leaked Fed economic staff forecasts prepared for the June 2015 FOMC meeting. Don’t ask the technical reason why growth might be slower in the USA—be it lagging productivity, “healing” in the aftermath of the Great Recession, demographics, whatever—the staff of professional economists at the Fed think the economy can “grow” only 1.7 percent; that’s what the economy’s potential growth is, so anything above that is pure gravy—meaning we are, you are, actually doing quite well if real GDP growth is 2 percent.
There are some risks out there. Consumer spending has been doing most of the heavy lifting in 2015, and that might not quite be the case for 2016. There will likely be fewer new consumers now with the unemployment rate at 5.0 percent full employment; new payroll jobs creation will slow from the current rapid year-to-year (YOY) pace of 2.6 million, or 1.9 percent. The spending bump from the Oil Crash Effect on lowering gasoline prices to $2/gallon has probably come and gone. Low oil prices are now a negative for growth. The newspaper headlines over the formerly high-flying oil industry are not very friendly and worry the stock market by saying that 30 percent of these companies could go bankrupt with crude oil at $20/gallon. Mining and oil and gas drilling is just 15 percent of total industrial production in the US but accounted for almost half of pre-oil crash 2014’s 4.6-percent rise in total production.
Another couple of risks that we see for 2016 are that companies have made all the catchup investment in equipment that they need for the next couple of years, and so future growth will be slower. This is natural in the seventh year of an economic expansion. More troubling is the outright decline in US exports of goods to the rest of the world. Factory floors are not humming with as much activity. Manufacturing industrial production is running just 0.8 percent YOY this year.
Despite these risks, we still expect the US economy to go its own way from the rest of the world in 2016. Consumers drive the economy, accounting for two-thirds of economic growth, and they are confident about the future. No need for policymakers to tiptoe around cautiously in the “aftermath of the Great Recession and financial crisis”. Get on with it. Rates are 0.50 percent now, and we look forward to four more rate hikes in 2016 to 1.5 percent.
We can talk about seeing four rate hikes in 2016 based on our confidence in the strength of the US expansion. Other commentators insist the rest of the world cannot withstand four US rate hikes. We aren’t sure just what their concerns are. The dollar is unlikely to get that much of a further boost from rising US interest rates, as a “gradual” move of 100 basis points per year is already discounted. Most of the hot money flows, those going into emerging-market stocks and bonds, have already left. Investment inflows into commodity production will stop completely now that China’s demand has been satisfied. Rising US interest rates will have no effect on the commodity boom-bust cycle, now obviously in the hard down, bust direction at the moment.
More important to the world outlook than the US interest rate cycle is that 800-pound gorilla in the room: China. China contributes 30 percent to world growth, and its economy ran 6.9 percent in 2015. But the risks of a Chinese hard landing, as some fear, are overblown. China and the US will lead the way and keep world growth faster than 3 percent, as many countries attempt to deal with the overcapacity problems in many commodities that China once needed in great abundance. Many countries overinvested in raw-materials production, not realizing, perhaps, that China’s demand was a bubble, a bubble bigger than the US housing bubble from 2004 to 2006. There was a limit to how many refrigerators, TVs, air conditioners that US and European consumers could buy. Now China is transitioning away from industrial production to a more services-oriented economy, so they no longer need ever-increasing amounts of materials to make their factories churn out products for the rest of the world. That was a bubble. China’s own production of iron and steel—that capacity needs to be cut by a third by 2020. Those cutbacks don’t bode well for those countries exporting raw materials to China.
The supply cutbacks foreseen in China’s new five-year plan frankly will mean job losses for some workers who will need to be retrained, but this does not mean that China’s growth will go off the rails. We find the government’s official forecast that real GDP will average 6.5 percent annually through 2020 as being completely credible. We were never suckered in by the fears of global investment managers, who are counting the number of lighted floors in Shanghai skyscrapers each night to fine-tune their forecasts. Many China observers from the outside looking in worry that reduced power consumption and a decline in railway traffic mean the forecasts for 6.5 percent GDP are much too high. This pessimism ignores that services have added a lot to China’s growth the last two years. It is true that there have been reductions in activity in many industries—thinking of aluminum, chemicals, iron and steel—and this has led to a reduction in power consumption. Rail traffic is down, but railways account for about 15 percent of the country’s transportation infrastructure. We think the 6-percent-plus GDP growth forecasts are basically okay. The sky is not going to fall, as the Chinese say, and the world will not skip a beat if growth falls below 6 percent for a quarter or two.
Our conclusion is that the ever-changing world is fine and that global growth will remain above 3 percent the next couple of years, as many nations adjust to the global commodities bust. Four rate hikes from the Federal Reserve in 2016 will not dent the outlook. Growth may be more L-shaped in 2016 and into 2017, and we aren’t quite sure where the bottom of the L is, perhaps, but this does not mean growth will not return to a faster 4-percent pace a few years from now. The world has changed from the global financial market crisis of 1998, when America, the euro area and Japan accounted for 65 percent of the world economy, and now today their share is down to 45 percent. Our bet is on the faster emerging-market nations to fuel the global economy in the future. We remain confident in the world economy’s potential.