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Economic Outlook | Spring 2016

Market Jitters Unlikely to Derail Economy

from Anthony Chan, PhD, Chief Economist for Chase

SUMMARY

Although investors rang in the New Year with an attack of nerves, America’s “real economy” appears little affected by these market jitters. The U.S. economy remains among the healthiest in the developed world, on the same slow-but-steady growth trajectory that has characterized its recovery since the Great Recession. While there are legitimate causes for concern—such as falling oil prices, rising interest rates and slowing growth in China—none appear powerful enough to knock us off our present course. The risk of the U.S. economy falling back into recession remains quite low, at no more than 25%. Let’s address these concerns one by one.

Pros and cons of cheap oil

Of all the concerns unnerving investors, none received more headlines than the collapse in oil prices. From its highs above $100 per barrel in 2014, the cost of Brent crude (the most common oil benchmark) dipped below $30 in the early days of this year. While these price levels may present a hazard to oil-based economies like Saudi Arabia and Russia, the United States remains a net oil consumer—even with the phenomenal growth of U.S. production due to fracking and other new sources. For a mixed economy like ours, falling oil prices are, on the whole, a good thing.

Our oil import bill dropped from about $174 billion in 2014 to about $82 billion last year. This represents a significant cost savings for the U.S. economy. A gallon of regular gasoline has fallen more than 50% from $3.70 to $1.77, on average. This will put more than $193 billion of savings back into the pockets of U.S. households, if such prices are maintained over a year’s time.

This is the equivalent of a sizable middle-class tax cut going to every U.S. household that owns a car. While energy-intensive businesses like trucking and airlines also benefit, this windfall needs to be balanced against job losses in the energy sector and reductions in capital spending by U.S. energy companies, which fell 50% last year and could fall another 25% in 2016.

The economists at J.P. Morgan compared the pros and cons of falling oil prices, and found that overall the positives substantially outweigh the negatives. We forecast this will add 0.3% to our GDP this year—which, in an era of about 2.0% annual growth, makes it a significant contributor to our national prosperity.

The other concern posed by falling oil prices is whether it is an early signal of a global economic slowdown. We think this fear is unfounded. The most recent estimates (compiled by Oil Market Intelligence) reveal that world oil demand grew by 2.0% on a year-over-year basis through December 2015. That is the fastest rate of growth in four years. It shows that the collapse in oil prices is supply-driven, and that the world economy is doing much better than feared. It may not be as robust as we would like, but it’s still growing at a healthy pace.

Furthermore, we believe oil prices are due for a rebound because of declining production. U.S. oil production has already fallen from 9.7 to 9.2 million barrels per day. Non-OPEC countries, including the United States, are expected to cut back as much as another 700,000 barrels this year. Even OPEC countries may very well end up cutting production. This will more than compensate for new production from Iran, which is expected to be in the range of 500,000 to 1,000,000 barrels per day.

Second thoughts at the Fed

Investors are also concerned that the Federal Reserve could derail the U.S. economic recovery by raising interest rates too aggressively. The first rate hike of 0.25% took place in December 2015, and the Fed’s internal projections last year suggested it would raise rates four more times in 2016.

We think this is unlikely to occur. The Fed has been very sensitive to the tentative nature of this domestic recovery. It will not hesitate to adjust its strategy to make sure the U.S. economy doesn’t fall back into recession. Remember, it delayed last year’s long-announced rate hike until its last meeting in December because of global market turbulence. It is unlikely to move too quickly in the face of another round of global turbulence. So we expect no more than one or two interest rate hikes by the Fed this year.

Investors should feel comfortable modestly extending the duration of their bond portfolios. Long-term interest rates are unlikely to soar in the face of a hesitant Fed. Core inflation remains under control. The Bank of Japan has already eased policy further by introducing negative interest rates on some bank reserves. We are also hearing signals from the European Central Bank and the People’s Bank of China that they are leaning toward additional monetary stimulus. The U.S. Federal Reserve and the Bank of England may both find that the easing moves of other central banks will enable them to raise rates more slowly.

Managing change in China

Finally, let’s talk about China. Investors have been concerned about the prospect of slower growth in the Chinese economy, and more recently by its falling currency. It’s important to keep these concerns in perspective. The latest GDP figures from China show that the economy grew at a rate of 6.8% in the fourth quarter of 2015 and 6.9% for the entire year. Yes, this fell short of the announced 7% target, but it was still more than 2½ times the growth rate of the U.S. economy and many more times the rate of the European Union and Japan.

There are other signs of a continuing robust economy, too. In 2015, China created 14 million new jobs—well above its announced target of 10 million. While China’s vaunted manufacturing powerhouse has slowed down, its service sector is growing at double-digit rates. Services now account for more than half of the Chinese economy.

China’s currency, the yuan, fell a little more than 5% against the U.S. dollar in 2015. This, too, is actually a sign that the Chinese economy is maturing. In November, China achieved its long-time goal of seeing the yuan designated a world reserve currency (starting later this year) alongside the dollar, the euro, the pound and the yen. It also announced in December 2015 that it would no longer maintain a tight peg with the dollar, but rather benchmark the yuan against a global basket of currencies of its major trading partners. Measured against this basket, the index has remained relatively stable, fluctuating between 99 and 101 since its inception.

We are confident China will find a solution to its current economic challenges. The Chinese government has lowered interest rates six times since 2014, reduced taxes, eliminated regulations, lowered down payments on mortgages and loosened its banking system to stimulate the economy. We expect further major initiatives to be announced and for China to maintain a growth target of approximately 6.5% over the next several years.

Overcoming the fear factor

So why, then, did the U.S. stock market get off to its worst start of any year in history? Some blame forced liquidations by sovereign wealth funds, a $7.2 trillion market, as many of the oil-producing countries holding these funds had to sell assets to cover the shortfall from lower revenues.

Closer to home, we believe the market is reacting less to economic fundamentals than to what John Maynard Keynes famously called its “animal spirits.” The U.S. economy remains healthy. Growth is steady, albeit modest. Unemployment is down and labor markets are tightening. The civilian labor force grew by nearly 850,000 since last June. Even if China were to go into a recession (which is unlikely) and cut its demand for U.S. exports by 10%, it would reduce our real GDP by less than 0.1%.

Two external factors are exacerbating these market fears: terrorism and the U.S. election. Our research shows that consumer confidence and equity markets suffer temporarily after every major terrorist incident. And the early stages of an election cycle are typically marked by harsh, negative rhetoric. As the campaign advances and the field narrows down, candidates generally move back toward the center. Although it may happen less this year than in other elections, this should still become a stabilizing factor for the financial markets.

WHAT THIS MEANS TO YOU

We continue to see opportunities in the stock market. Prices have come down in some long-favored sectors like technology and healthcare, where attractive valuations can be found selectively. Financials could benefit from rising interest rates, although perhaps less than the market anticipates if the Fed cuts back on its pace of rate hikes. While it may not seem very exciting advice to investors who are suffering through a string of sell-offs, we continue to believe that a patient, globally diversified approach remains the right thing to do and will pay off for investors over time.

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