Economic Forecast: “2014: The Sequel”

By KC Mathews, CFA | Mar 10, 2014

This year our economic theme draws a parallel between a movie sequel and the economic environment. While this may seem like an unlikely correlation, we believe 2014 will be a compelling extension of 2013’s economic story. Much like any movie sequel, this year’s economy will include a similar cast, an extension of the original plot, and a potential surprise or twist as the economic show comes to a close.

Cast of Characters

We think there will be four leading characters, all of whom have played significant roles over the last five years.

Let’s start with the Federal Reserve, which has experienced a significant change in leadership, but perhaps not a change in strategy. In January, former Federal Open Market Committee (FOMC) Chair Ben Bernanke transitioned from our “leading man” to our “leaving man,” effectively passing the torch to our new “leading lady,” Janet Yellen. While FOMC Chair Yellen has not been in the spotlight much before now, she is highly respected and will be charged with the significant task of unwinding the QE program. She is considered to be “dovish,” in that it’s likely she will promote monetary policies to maintain low interest rates. We also believe she will be accommodative for the short-term, thus continuing stimulus for 2014 and perhaps beyond. There is no doubt she will play an influential part in our economy and financial markets this year and for the foreseeable future.

Our next character is the consumer, who has had a tumultuous road the past few years. From dealing with high unemployment and wage stagnation to bearing the repercussions of lower home values and stock prices, the consumer endured what most likely felt like a few long rounds with Rocky. However, the consumer is resilient, and like any good Rocky sequel, has come back fighting. They have reduced their debt, repaired their balance sheets, home values are recovering and investments are significantly higher than what we have seen since 2008.

The result is that the consumer is now in a much better place to consume, or spend, which is an extremely important driver to GDP growth as their activity makes up almost 70 percent of that calculation. Business, which includes both corporate America and small business, is our next character. In 2012, we had many conversations with business owners, and the sentiment was clear – even though they had restored their balance sheets and had significant cash reserves, they were grappling with uncertainty and were simply not ready to make business investments at that time.

However, fast-forward to late 2013, and the conversation changed completely. Business owners expressed just the opposite and are now looking at ways to expand or invest in their businesses through actions such as adding personnel, purchasing new equipment, buying new facilities, etc. And when asked about the primary drivers, the overwhelming response was aggregate demand. Business was good and warranted spending.

Our last character in this sequel is Washington, or our politicians. Last year started with a potential fiscal cliff and ended with a 16-day government shutdown in the fourth quarter. This year the debt ceiling has already been extended until March 2015. As expected, this passed quickly and quietly as both parties sought to avoid further conflict. After suffering brand damage following the 2013 shutdown, neither party wanted to risk being blamed for another shutdown in an election year. The next big event will be the mid-term elections, but given it is late in the year, it’s unlikely it will impact our forecast.

The Plot

The next question is how do we see our economic story unfolding from here? Specifically, what lies ahead for our economy? While many factors are improving, we do anticipate a continued period of subdued economic growth, approximately 2.4 percent average GDP growth, for the next few years. Part of our theme from 2013, “The Policy Basin,” is still intact. We expect monetary and fiscal policy, public debt and our demographics to continue to haunt the economy in 2014, which will prevent us from exceeding that three percent GDP growth mark.

From a monetary policy perspective, quantitative easing (QE) is a very powerful tool that quite possibly saved the US from a deflationary period. As stimulus occurred, the market moved in lock step, steadily rising with the bond purchase program. QE has also kept interest rates low and bolstered housing prices, all of which have given a boost to consumer confidence and sentiment.

However, as most agree, if used for too long, this program could have serious side effects. The challenge now will be to unwind this program in a way that will not be disruptive to the financial markets, but rather allow this upward glide pattern for growth to continue; we believe the Fed will be able to successfully maneuver this through a staggered tapering.

Another positive factor contributing to our moderate growth projection is that the fiscal challenges federal and state governments have experienced since 2008 are diminishing.

State and local governments may be a shining star in 2014. Belts were tightened, staffs were reduced and swift cost-cutting action was taken at the onset of the Great Recession, which is paying off nicely now. We also expect spending increases in state and local governments, as they will receive a boost in property, sales and other tax revenue in 2014 because of the consumers’ enhanced ability to spend. This has been validated by these entities as well, as 43 of the 50 states have indicated that they intend to spend more in 2014 than they have the past few years.

Finally, the employment landscape is improving as well. Over the past several years, US workers have struggled with longer periods of unemployment, which in some cases has led to diminished skills and enthusiasm as well as a rise in the marginally employed. However, we believe better economic growth in 2014 will help close some of those negative gaps and generate close to 200,000 additional jobs per month, which is up from an average of 185,000 per month last year.

How will the story end?

So what does this all mean? Herein lies our surprise ending. While most sequels may not be as good as the original, we anticipate that this year’s economic story will actually be better than last year, and perhaps even better than the last five years.

First, we anticipate GDP growth of 2.7 percent, which would be a significant improvement over the 1.9 percent gain in 2013. We also anticipate better economic growth, yet we are not calling for another 30 percent return in the equity market, which could be seen as a slight twist to the story. Rather, we are forecasting positive returns, with an anticipated eight to 15 percent increase in the S&P 500. We also expect longer-term yields to rise and are forecasting that the 10-year treasury will land at 3.50 percent to 3.75 percent by year-end. Finally, we expect unemployment to move down to 6.0 percent by the end of the year, which is down from 6.7 percent at the close of 2013.

This economic story might not be a blockbuster, but it is a sequel that will be better than the shows we have seen in the last five years. We believe it will be a positive year with good storylines for consumers and businesses, and if managed correctly, for investors as well.