Economic Review 4Q 2014
Of the major global economies, the US continues to be one of the strongest with the end of QE in October, 2014 and the prospect for the Fed to raise rates in mid-2015. As the Fed normalizes interest rates in 2015, the USD should strengthen. On a relative basis, the US economy is stronger than others such as Europe which is now in recession. Japan is also technically in recession. Since mid-2014, commodity prices have been under pressure and risk asset spreads widened during the quarter.
US banks have strong liquidity and good asset quality. With expected higher interest rates, bank net interest margins will increase. If these factors hold up, financials should continue to be a well performing sector.
Event risk as a result of shareholder activism, financial engineering and limited growth is beginning to impact certain sectors. The energy sector has continued to weaken since mid-2014.
Geopolitical risks remained elevated during 4Q2014 and are expected to linger throughout 2015. The quarter ended with increased volatility in December, 2014. Further volatility and uncertainty is expected through 2015 as the Fed begins to raise rates. The release of better than expected US economic data also reinforced the fear that the Fed will begin raising rates.
Falling oil and commodity prices were the dominant theme during 4Q2014. Lower yields, falling inflation and flattening of the yield curve for maturities greater than 5 years all contributed to poor performance across risk sectors.
Yields on securities in the 1-5 year part of the yield curve rose in December and spreads widened in response to increasing Fed Funds Rate expectations.
U.S. Federal Reserve
The Federal Open Market Committee (FOMC) minutes (December 16-17, 2014) increased expectations that interest rate hikes will begin in June 2015 as the unemployment rate continues to fall, consumer confidence grows and core inflation falls. Fed officials also noted the geopolitical and economic risks globally. The FOMC noted that the international situation could represent some downside risks to US economic and employment activity. Key concerns include deflationary pressures abroad. The US dollar has surged as the ECB has aggressively eased. Negative interest rates in Europe, oil price collapse and geopolitical tensions have spurred capital flows to the US seeking safety in US Treasuries.
At its December meeting, the FOMC updated its economic projections and interest rate forecasts. For 2015, the committee maintained its GDP forecasts, but lowered its unemployment rate and inflation projections. Because it reduced its inflation expectations, the committee lowered its 2015 rate expectations, although Fed Chair Janet Yellen continued to advise that mid-2015 would be an appropriate time to raise interest rates.
Additional guidance is expected from the Fed’s meetings on January 27-28 and March 17-18, 2015. Several top Fed officials expect that they will start raising rates by mid-2015. The Fed predicts that the US economy may grow at 2.6% - 3% in 2015. The unemployment rate is expected to fall to 5.2%-5.3%. CPI in 2015 is expected at 1.0%- 1.6% which is below the 2% Fed target.
Geopolitical tensions in Ukraine and Syria, fears of Ebola spreading and plunging oil prices are creating investor anxiety and will continue to generate market volatility resulting in continued flows to U.S. Treasuries as a safe haven.
U.S. Interest Rates
The Fed ended its asset purchase program in October, 2014. Federal-funds futures (CME data), reflect a 23% probability that the Fed will raise rates at the June 2015 meeting. The probability of a rate increase in July 2015 is 48%. Investors see a 56% chance of a rate increase by September and an 84% chance by December 2015.
For now, the Fed Funds target range remains at 0%-0.25%. LIBOR yields ended the year slightly higher with three-month Libor at 0.255% and the one-year at 0.628%.
U.S. Treasury bill yields rose heading into year-end. Three-month yields ended the month at 0.04% and six-month yields at 0.12%.
During the quarter the U.S. Treasury yield curve between two- and five-year maturities flattened significantly, by 21 basis points (bps), with the yield of the two-year note increasing 10 bps to 0.67% and the yield of the five-year note decreasing 11 bps to 1.65%.
The U.S. Treasury market was volatile during the quarter as early in the quarter, risk aversion briefly drove yields down (prices up) with the 10-year U.S. Treasury (UST) hitting 1.87%. Yield spreads widened with plummeting oil prices and heightened geopolitical risks, largely ignoring strong U.S. GDP and economic data. The plunge in oil prices helped consumer spending and consumer confidence but created volatility in the markets. Yield spreads widened on oil-dependent industries and countries.
Headline inflation fell as energy prices plunged, while core inflation measures held steady. The Consumer Price Index (CPI) slid 0.13% per month on average, down from an average decline of 0.01% in the third quarter. The Personal Consumption Expenditures (PCE) Index fell 0.06% per month in Q4, below the 0.04% Q3 average. Core inflation estimates, which exclude food and energy, were more resilient, with Core CPI up 0.14% on average, from 0.08% in the prior quarter, and core PCE up 0.09%, just below the 0.10% Q3 average.
Jobs and Unemployment
Employers added 2.95 million jobs in 2014 yet the US Labor-force participation rate was only 62.7% in December.
Nonfarm payrolls rose a seasonally adjusted 252,000 in December. The unemployment rate decline to 5.6% is attributed to people that stopped looking for jobs. Once people leave the workforce, they are no longer counted as unemployed. About 8.7 million Americans have not been able to find work. Wages were stagnant with average hourly earnings for private-sector workers at $24.57 and the average workweek held steady at 34.6 hours in December. Over the past year, hourly earnings are up a mere 1.7%, barely ahead of inflation’s 1.3% rate.
Consumer spending rose 0.4% per month on average in October and November, up from its 0.3% monthly average in Q3. Aided by strong auto sales, retail sales improved, climbing 0.6% on average in October and November. Consumer confidence uniformly strengthened in the fourth quarter. The University of Michigan consumer survey rose to 89.8 in the fourth quarter from 83.0 and the Conference Board measure of consumer confidence increased to 93.6 from 90.9. Both measures are at post-recession highs.
Manufacturing indices were marginally better in the fourth quarter, although they softened going into December.
The national ISM survey averaged 57.7 in Q4, up slightly from 57.6 in the prior quarter. Regional surveys were mixed in the fourth quarter: the Chicago and Philadelphia surveys improved while New York, Dallas and Richmond softened.
Housing indicators were mixed in Q4. In October and November, new home sales averaged a seasonally adjusted annual rate of 442,000, up from 434,000 in Q3; housing starts averaged an annualized rate of 1.037 million in October and November, up from 1.03 million, and building permits averaged 1.072 million, up from 1.03 million. Less strong were existing home sales, which averaged an annualized rate of 5.09 million, down from 5.12 million in Q3, and the pending home sales index, which averaged 104.4, down from 105.3.