Monday, July 28, 2014

US Economy Fails to Gather Momentum Despite Fed Largesse

The International Monetary Fund (IMF) recently cut its forecast for 2014 US GDP growth, from 2% to 1.7%, while maintaining its 3% estimate for 2015. If the IMF’s 2014 forecast proves accurate, it will be the second consecutive year of weaker growth after the US economy expanded at a rate of 2.8% in 2012 and 1.9% in 2013. Since the Fed began its most recent round of quantitative easing, or QE, at the end of 2012, US economic growth has not improved. Sure, we could blame the sequestration in 2013 and a rough winter for the contraction in the 1st quarter, but that seems little too convenient. Bear in mind that the current asset purchase program is the Fed’s third outright QE program and we also had Operation Twist, in which the Fed simultaneously sold shorter maturity bonds while buying longer dated issues. Since Lehman Brothers collapsed in the fall of 2008, the Fed has expanded its balance sheet by nearly $3.5 trillion, with approximately 40% of the increase occurring over the last 19 months. Yet 2014 will be the ninth consecutive year in which US GDP has grown less than 3% and this year is likely to be the sixth year during that stretch in which it has it has grown less than 2%. If the US economy does indeed grow 1.7% this year and 4% next year, which we think highly unlikely, the 10 years from 2006-2015 would be the worst 10-year stretch for the US economy since the 10 years ended in 1954.


From the 10-years ended in 1955 through the 10-years ended in 2008, median and average rolling 10-year growth rates were always in the 2-4% range and rather consistently in the low-to-upper 3% range. From the 10-years ended in 1984 through the 10-years ended in 2006, the average growth rate was never less than 3% and the median never less than 3.5%. However, over the 10-years through 2015, using the 2014 and 2015 growth assumptions above, the median and average growth rates would be just 1.9% and 1.6%, respectively. Even if you eliminate 2008 and 2009, when the economy contracted, the median and average growth rates from 2006 through 2015 would be just 2.2% and 2.4%, respectively.
The credit crisis, incoherent fiscal policy, structural changes in labor markets, and shifting demographics has taken an enormous toll on the US economy. Unfortunately, aside from the credit crisis, the Fed is not equipped to deal with any of these issues. Therefore, it shouldn’t be surprising that QE has had little effect on the real economy. However, it has had a significant impact on investors’ appetite for risk, as the Fed’s purchases of Treasury and mortgage-backed securities have pushed yield starved investors into far riskier asset classes. So while the Fed has failed to re-inflate the US economy, it has succeeded at inflating financial assets, leaving most asset classes significantly overvalued. As a result, returns on stocks and bonds are likely to be far below long-term historical averages over the next three to five years.