Wall Street's Best Minds

FRIDAY, DECEMBER 20, 2013

U.S. Economy May Be "Only Game in Town"

By DIANA CHOYLEVA

An economist with a global perspective argues that the U.S. will stand tall in 2014 on a relative basis.


Editor's Note: Diana Choyleva is head of macroeconomic research at Lombard Street Research, a London-based macroeconomic forecasting firm.


Renewed U.S. competitiveness in an improved economy is likely to spur a business investment-led economic recovery in 2014.

More of what America consumes will be produced at home. The U.S. is best placed to outperform, with GDP growth accelerating to 3%-4%.

But it won't be the global locomotive of the past. With poor growth prospects elsewhere, global capital will flow into the U.S., pushing up the dollar and lifting U.S. asset prices.

Good news is still at a premium in the global economy. But America's outlook for 2014 is decidedly positive. The U.S. economy has made tremendous progress correcting its underlying imbalances, well beyond the claims of some commentators that it has merely been 'printing money'. The U.S. recovery is set to take output growth well above trend to average 3%-4% over the next few years. It will be a production-led recovery, not a consumer-led recovery i.e. America will import less of what it consumes.

Growth should also prove durable, as inflation will not be a concern for some time. The economy continues to have significant spare capacity, while faster GDP growth could also pull up the economy's potential growth rate

Energy prices and the U.S. dollar will exert downward pressure on inflation, thanks to shale fracking and America's relative-growth outperformance. Subdued inflation is likely to keep policy rates ultra low for some time. Importantly, even when the Fed decides to raise interest rates in response to a sustained revival in growth, this will not derail the economy because it is no longer plagued by excessive levels of debt.

The dramatic fiscal squeeze, which the OECD estimates at 2.7% of GDP, was the main drag on growth in 2013. This was the biggest annual budget tightening since WWII and comes on the back of four years of continuous fiscal retrenchment

The fact that private demand expanded strongly enough to outweigh tight fiscal policy in 2013 by itself bodes well for 2014, when the fiscal tightening is set to be much less. The budget deal reached in Washington would mean not only even less fiscal tightening in 2014 than assumed before but importantly also reduced concern about U.S. political dysfunction. It removes one of the main risks to our growth forecast for 2014. The other risks are a premature rise in bond yields and weak global growth undermining business confidence.


Reshored to the U.S.


The U.S. dollar is now competitive, crucially against the Chinese yuan and the other Asian currencies. Relatively cheaper labour and energy place the U.S. – the second-largest manufacturer in the world – in a great position in a world of deficient consumer demand. The U.S. is likely to see a much lesser rate of off-shoring production and a rising wave of reshoring. This trend has only just begun.

The fortuitous development of cheaper shale energy in the U.S. is not to be underestimated either. Natural gas from shale is much cheaper in terms of oil equivalent and the incentives to develop it are huge. This major U.S. energy transformation should ensure not only cheaper energy but also a strong flow of capital spending into improving the distribution infrastructure.

America has expertise in many manufacturing industries, which means investment-led growth shouldn't take long to take hold. U.S. firms will not only have the incentives to invest, but they are flush with cash and are able to invest. The main threat is the tax incentives that encourage firms to keep their cash abroad. But the structural forces described above should provide a substantial impetus to investment irrespective of whether firms bring their cash back or decide to finance their expansion plans with low-cost debt. Most of the other potential uses of the large corporate financial surplus, such as dividends, share buybacks, M&A activity, will also be positive for U.S. domestic demand.


A durable economic revival


But investment-driven recoveries can fizzle out if they substitute capital for labor and firms hog the resulting productivity gains. However, both reshoring and shale energy argue for investment in new production capacity, not substitution of capital for labor

So this investment-led boom should translate into higher employment and wages, spilling over into higher-consumer spending. A production-led recovery is also much less susceptible to weakness in the rest of the world.

Broad-based growth, above the economy's noninflationary-growth rate, has a much better chance of lasting if it starts when the economy is operating with slack. There is considerable uncertainty about the level of existing slack in the economy and the extent to which the global financial crisis damaged the economy's underlying supply potential. But our assessment is that plenty of slack remains, which must be used up before demand-pull inflationary pressures build. We also share the Fed's optimism that stronger growth could pull potential growth higher, meaning it takes even longer to eliminate slack in the economy.

Given continued weakness in the rest of the world, the U.S. dollar should also strengthen, which will further dampen inflationary pressures. Meanwhile, shale fracking will keep energy prices down. But while inflation isn't an immediate concern for policymakers, the Fed might eventually worry about asset-price bubbles. U.S. real assets look the most attractive investment in 2014, with further potential upside from Chinese capital inflows. This will present the Fed with a difficult dilemma, but not until 2015. In 2014, it will stick with its labor-market centric 'forward guidance'.


Wage inflation to coexist with subdued CPI inflation


Untangling the labor market story is crucial. The U.S. participation rate has plunged, to reach its lowest level since 1978. Productivity growth has slowed but remains robust. Our estimates, given official population forecasts, suggest the participation rate will not rise dramatically in coming years.

This is a worrying development as it would leave a large part of the U.S. population out of the labor force. Even more worrying, the share of long-term unemployed workers has been extraordinarily high in this cycle. If we count those people as unemployable, the participation rate would plunge to an alarmingly low level and the unemployment rate would fall to a level not far off the economy's underlying noninflationary rate of unemployment.

If the current situation is one of potential workers not being willing to work at the currently offered wages rather than being unemployable because they've been out of the labor force for too long, wage inflation has to rise to induce them back into the labor force. A production-led recovery in the context of weak global-consumer demand and a historically high U.S. profit share suggests wage inflation could coexist with subdued CPI inflation as firms take the hit in profit margins. In fact, this will ensure the growth revival will be sustainable even if the U.S. dollar rises to erode U.S. competitiveness.


Monetary tightening will to take time, but won't tank growth when it comes


On-balance, the considerations above suggest that while the Fed will wind down its asset-purchase program fully in 2014, it is unlikely to hike the policy rate. The Fed will want to be sure the recovery is entrenched. And when the Fed does raise interest rates it shouldn't cause growth to collapse because the U.S. economy has eliminated the excesses of the previous boom.

The U.S. housing market was where the crisis began, but the adjustment there is now complete. House prices are rising and the backlog of unsold homes is falling. Substantial downpayments required for a mortgage are an inhibition for buyers, but the demographics relative to current housing supply are positive, affordability is high and easy money has made rentals very profitable. U.S. housing should be a buoyant area over the next couple of years, both in terms of rising investment and the wealth effect on households.

The U.S. household-debt crisis is now also over. Households have lowered their debt to a sustainable level relative to their income even if interest rates return to 'normal'. They may still need to raise their savings rate but cheaper shale energy should provide a big boost to real incomes over time and the investment recovery should fuel employment and wage growth. U.S. banks have also returned to health, increasing their capital buffers, boosting profits and improving their net-charge-off rates. They are now willing to lend, which together with QE has pushed real broad money growth to rates consistent with above-trend growth.

The last remaining adjustment is to stop public debt from rising further. But the public sector deleveraging has been under way for some time now. Moreover, on current fiscal plans the primary budget deficit will be brought back to a level consistent with stable public debt by end of 2014. Strong growth will help to lower the public debt-to-output ratio over the next few years.


U.S. asset prices and the dollar set to gain


The global recovery from the financial crisis has been uneven. The U.S. is the only major economy that has adjusted fully and looks like the only 'game in town'. The export-led growth model has always relied on the U.S. as the "consumer of first resort." But this no longer works because the U.S. real exchange rate is at its lowest since WWII. As a result, the export-led emerging markets' will not be buoyed by strong U.S. growth, while all emerging markets will be vulnerable to higher-U.S. bond yields.

Lacking domestic sources of strength, the euro area will continue to stagnate, with the risk that deflationary pressures in the periphery spread to the core. Meanwhile, Japan will continue to scoop demand out of the rest of the world, with its Abenomics-led competitive devaluation also stealing growth from the future.

This suggests global capital will flow to the U.S., pushing up the dollar. It is more likely to flow into real assets, with the U.S. housing market doing particularly well. But at the same time the continued global-savings glut and Japan's drive-through Abenomics to push Japanese investors to seek interest-bearing returns abroad suggest the natural cyclical upswing of Treasury yields could be later and slower than has happened in the past.

While Treasury yields are likely to flat-line for now, they should be more volatile. Ultimately, Chinese financial sector reforms, now underway, could be a decisive factor pushing Treasury yields up. These reforms include proposals to remove controls on private-sector capital outflows from the country. 

The outflows have been large even with the controls. Take them away and a tidal wave is likelyunless the authorities partly reimpose them. But Chinese investors will be seeking real assetshouses in San Francisco, farm land in Tennessee, stocks and shares not interest-bearing assets. Chinese financial reforms have the potential to rewrite the story for U.S. and global financial markets.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved


December 20, 2013 5:44 pm

2014: the year the world got back to normal?

The outlook for savers, borrowers and investors for 2014 is largely about figuring out where the interest rate – the puck – is heading, and how fast.
 
Bank of England governor Mark Carney – like Gretzky, a Canadian and a fan of ice hockeyattempted to show where the puck might be going earlier this year by instituting the policy known as forward guidance, which links future increases in rates to specific economic conditions such as employment levels. However, the policy has suffered a fate that would be familiar to many Canadians: it has been overshadowed by events in the US.
 
The US central bank spent $1tn buying mortgage-backed securities and Treasury bonds in 2013. The scale of that activity – even after a $10bn a month reduction to take effect in January 2014dwarfs anything the UK central bank is doing.

The end of extraordinary monetary policy doesn’t mean interest rates are about to rise. Of the 22 City institutions polled regularly by the Treasury, just twoSantander and Bank of Americathink that the Bank of England’s base rate will rise to 0.75 per cent by the end of 2014.

But markets have already started to price in the impact of dearer money. A year ago, (UK commercial bank liability spot curve) five-year (what) stood at 1.03 per centthis week it was 1.86 per cent. The yield on 10-year government bonds or gilts has risen to 3.09 per cent now, from 1.88 per cent a year ago.
 
 
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Savings

 

 
Savers have been the most obvious victims of ultra-low interest rates, and this year has been one of the worst on record for cash savers, writes Elaine Moore. Higher-rate taxpayers currently need to find returns of at least 3.5 per cent to keep pace with inflation, but even the best five-year fixed account, from Shawbrook Bank, pays just 3.2 per cent.
 
But things are set to look a little brighter in 2014, even if the Bank’s base rate is still 0.5 per cent at the end of 2014. The government’s decision to scale back its Funding for Lending Scheme could mean that high Street lenders start paying a premium for cash deposits next year, which could boost longer-term fixed accounts in particular.

Other nuggets of good news: the limit for cash Isas will rise to £5,940 in April, and National Savings & Investments has been provided with a higher funding target, which means that the state-backed savings institutions is less likely to continue cutting rates and withdrawing popular accounts.
 
One savings trend unlikely to end is the growing consumer appetite for alternative investments. Crowdfunding websites in the UK attracted nearly £1bn in 2013 and next year the sector will be regulated by the Financial Conduct Authority. Some analysts say formal regulation will be the mechanism that finally propels crowdfunding into the mainstream.
 
 
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Mortgages


The flip side of higher savings rates is higher mortgage rates. But while borrowing costs might rise, the variety and size of mortgages available looks set to improve as the housing market continues to gather momentum, writes Thomas Hale.

The conclusion of the residential part of the Funding for Lending Scheme means that certain residential lenders will, from January, no longer have access to cheap government funding.
 
The scheme has helped lenders, many of them cautious in a post-financial crisis world, to lower their rates by granting them access to cheap funding which increased in direct proportion to their lending.

A rejuvenated residential housing market is now providing increasingly competitive rates. Thanks in part to funding for lending, lenders have started to offer a wide range of large mortgages – which require larger deposits and are less risky. Competition has helped to drive down rates, with rates of less than 2 per cent available on a number of seven-figure loans.

Despite this, many have predicted that the end of the Funding for Lending Scheme will trigger a rise in rates in 2014, and that current offerings are as good as it gets”.
 
According to Simon Gammon, a mortgage broker at Knight Frank Finance, more people are asking the question: “If rates go up, how long have I got?”

“In terms of our clients, we are seeing a very high take-up on five-year plus fixed rates,” he said.

The prospect of higher rates has spurred remortgaging. Mr Gammon added that although remortgaging has typically made up about 20 per cent of Knight Frank Finance’s business over the past five years, it has represented about 50 per cent over the past nine months.

However, just as Funding for Lending ends, the second phase of Help to Buy will start in earnest. Several more lenders are expected join, helping to make the market for 95 per cent loan-to-value (LTV) mortgages more competitive. Rising house prices will encourage more high-LTV lending outside Help to Buy; Yorkshire Building Society recently undercut Help to Buy lenders with its own 95 per cent mortgages.
 
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Investments

 

Trading hub


 
The prospect of dearer money, coupled with the gradual withdrawal of monetary stimulus in the US, means investors should approach 2014 with some caution, writes Lucy Warwick-Ching.
 
“The troubled legacy of the financial crisis runs deep and the burden of debt left in its wake suggest there will be no return to the boom years in 2014 or for some time to come,” says Alan Higgins, chief investment officer at Coutts. “The new norm is likely to be one of low growth, subdued inflation and low interest rates.”

Fund managers are also voicing concerns that the reining in of quantitative easing will weigh heavily on investor sentiment in the UK and across the pond.
 
“It is difficult to predict the full effects of tapering of QE and investors will be watching the US closely for any signs of economic slowdown which could cause markets to overreact in the short term,” says Adrian Lowcock, senior investment manager at Hargreaves Lansdown.

But QE tapering hasn’t damped the mood for some. Research from Redmayne-Bentley’s internal broker survey revealed that 86 per cent of its brokers expect the FTSE 100 to break through the 7,000-point barrier and continue to climb in 2014.

There is also a degree of unanimity among fund managers regarding the outlook for investment next year. Most believe the economic recovery in developed nations, continuing low interest rates and the rotation away from bonds would all help prolong the current bull market in shares, which will also benefit from above-average economic growth in the US and stabilisation in the eurozone and China.

There is more debate about valuations, which some feel have become stretched in the US especially. Emerging market shares are cheaper, which some feel makes them compelling. “While 2013 was the year to own developed world equities and avoid everything in the emerging world next year we think it could be the year of the Asian equity; a continuation of Japan’s stock market renaissance and return to favour in ‘emerging’ Asian equities,” says Tom Becket at PSigma.

Closer to home, managers believe UK small-cap equities – which have been rampant since 2009 – could continue to perform well. “The universe provides exposure to faster-growth companies, where there is a greater prospect of mergers and acquisitions,” says Jonathan Jackson, head of equities at stockbroker Killik. “Further attractions include the strong IPO pipeline and the ability to invest Aim shares within an Isa.”

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Pensions


Rising market interest rates are good news for those approaching retirement, since gilt yields form the basis for annuity rates and drawdown limits. But more importantly, the winds of structural change will continue to blow through the retirement market in 2014, writes Josephine Cumbo, as policy makers switch focus to improving outcomes for millions beginning to save for workplace pensions.

Having laid the foundations for automatic enrolment, which has seen 2.2m signed into company pensions in the past 15 months, the government will now push to raise standards in the schemes widely used by these new savers.

Improving member outcomes is at the heart of many recent consultations and studies on Defined Contribution schemes,” says Zoë Lynch, a partner at Sackers, the legal firm.

“We are expecting further news on capping charges, governance, default funds and the planned audit of legacy schemes following the Office of Fair Trading’s market study published in September 2013.”

As AE rolls out to tens of thousands of medium-sized employers this year, the government is expected to introduce a charge cap to protect these new savers, of between 0.75 and 1 per cent.
 
“The government is united on the need to act quickly to protect consumers,” says the Department for Work and Pensions.

“We will be publishing our response to the consultation in due course. This is an important and complex consultation which requires our proper consideration to ensure we get it right.”

The government will also face further pressure to intervene in the £12bn-a-year annuity market, beset by accusations of profiteering. Any action will be guided by the findings of a 12-month thematic review of the annuity market by the Financial Conduct Authority, due in February.
 
“We must sort out the current annuity mess if the image and reputation of pensions is to be maintained,” says Malcolm McLean, a consultant with Barnett Waddingham, the actuarial consultants.

Both legislators and regulators will also be urged to take stronger action to tackle pensions liberation fraud, where savers are being misled into believing they can take cash from their funds before age 55, without tax consequences.

“If HM Revenue & Customs and The Pensions Regulator do not respond with rigour to the systemic problems in the current framework then there is the real potential for the problem to get worse in 2014, not better,” said Margaret Snowdon director with JLT Employee Benefits.
 
Meanwhile, changes are afoot for savers with larger pension funds. In April, the lifetime allowance will fall from £1.5m to £1.25m and the annual allowance from £50,000 to £40,000.

Action can be taken to protect pensions against the reduction in the allowance, but this action needs to be taken before April 6 2014,” said Andy James, head of retirement planning at Towry, the wealth managers.
 
 
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Regulation

FCA logo
 
The UK got not one but two new financial regulators during 2013, writes Jonathan Eley. The old Financial Services Authority was disbanded and in its place came the Financial Conduct Authority and the Prudential Regulatory Authority.
 
The FCA had a busy year and 2014 will see even more activity. For the FCA, the biggest change will come in April when it takes over the regulation of consumer credit from the Office of Fair Trading.
 
This will add anything up to 45,000 more companies to the 27,000 it already supervises. Its likely stance on “payday lenders has attracted the most attention, but consumer credit also includes credit cards, scorecards, personal loans and other forms of unsecured credit.
 
Next year will also see the results of probes into the annuity market (early February), the cash savings market, price comparison websites and “add-oninsurance such as travel insurance, breakdown cover and legal protection. Two major pieces of financial regulation will come into force in 2014. One is the
mortgage market review, which takes effect from April. The same month sees the start of what some have dubbedRDR 2” – a general ban (but with some exceptions) on commission payments from financial product providers to execution-only distribution platforms.
 
Many smaller distributors, including the Share Centre, Alliance Trust and Charles Stanley Direct, have already switched to cleanfund classesones that do not pay commission to any intermediaryahead of this deadline, and introduced separate charges for their own services. But two of the largest players, Hargreaves Lansdown and Fidelity, have yet to announce their full pricing structures for the new regime. They are likely to do so early in the new year.
 
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What does the fox say?

 
No, not the surprise YouTube hit from Norwegian duo Ylvis – but the more serious matter of FTSE100 predictions made by the semi-tame foxes that frequent former FT Money columnist Kevin Goldstein-Jackson’s back garden.
 
He writes: The canines have a past forecasting record that stands up to the City’s best. Predictions are made by laying out identically sized pieces of sliced chicken, marked from –15 per cent to 15 per cent. The foxes gobble all the chicken, but the first piece taken is deemed to be the prediction.
Last year, the fox ate the 2 per cent slice first, then the 3 per cent one in quick succession – so it may have been indicating 23 per cent since this was the easiest way to indicate a figure not actually in the line. The FTSE was up 10.2 per cent year-to-date at the time of writing.

To avoid any such doubt this year, I extended the potential range of outcomes by adding more chicken. The pieces ranged from 25 per cent to minus 25 per cent.

A small young fox sat watching from a safe distance while the chicken pieces were laid in line and the competition rules were explained. Once I’d gone back indoors, it ate the minus 17 per cent piece first. So that’s the prediction for 2014.

 

Copyright The Financial Times Limited 2013.