And the bond market, save high-yield securities, shook off fears of a great rotation out of fixed-income instruments after a three-decade plus bull market and gave investors a nice positive, inflation-beating return.
 
Moreover, few see much to worry about for 2015, despite an economic recovery now long-of-tooth at some 5½ years. Not with last week’s upward revision of third-quarter GDP growth to 5%. And yet inflation seems under control, with much of Wall Street believing that disinflationary winds and slowing economic growth in much of the global economy will keep goods and commodity price increases in check.
 
Most expect the Fed to raise the short-term federal-funds rate starting at midyear at a measured, decorous pace of 25 basis points (0.25 percentage point) per meeting, not enough to squelch good times ahead.
 
This conviction is only confirmed by the recent Fed median forecast of the fed-funds rate hitting 1.125% and 2.5% by year-end 2015 and 2016, respectively. Otherwise U.S. 10-year bonds wouldn’t currently be trading at a yield of 2.25%. Clearly, inflation with the current core consumer price index reading of 1.7% is expected to be quiescent for years to come.
 
Only adding to current investor complacency is the 40-plus percent drop in crude-oil prices for the year. Sure the oil price collapse caused a short-term paroxysm in stock and bond prices. But then cooler heads prevailed. The benefits to U.S. consumers of cheaper prices at the pump and to Corporate America from lower input prices clearly trump any dislocations in the junk bond markets and in oil-producers’ financial results.
 
Rick Rieder, BlackRock’s chief investment officer, who oversees some $690 billion in fixed-income assets, depicts the slide in energy prices as a fortuitous and powerful instance of “synthetic fiscal stimulus” for both U.S. consumption and employment. The current decline, if sustained, could drop the U.S. unemployment rate of 5.8% to below 5.5% next year all by itself, he opined to Barron’s.
 
Yet he sees little chance of the economy overheating as a result and a surge of inflation catching the Fed by surprise. Inflation will remain muted due to cheap energy and technological breakthroughs such as Internet retailing, which through improved price discovery keeps prices of goods and services from rising unduly.
 
Such an environment will be good for stocks next year, he opines. Corporate profit margins figure to remain lush from the improved productivity and efficiency afforded by technology and from continued cheap financing costs. On the latter score, Rieder sees little chance of a surge in longer-term bond yields, the true pivot point of the economy. Long rates will be held down for some time by the flood of baby-boomer retirees increasingly seeking yield instruments, the drag of low bond rates around the world, and the liquidity provided by loosening monetary policies in Japan, the European Union, and elsewhere around the globe.
 
PERHAPS SUCH OPTIMISM is well founded, particularly during a period of holiday good cheer.

But we feel compelled to offer up a counter-narrative. First, one shouldn’t forget some of the warnings issued in the last year or so by the so-called secular stagnation crowd. Their core insight is that the economy can’t grow as quickly as during much of the post-World War II period when GDP growth averaged over 3% annually. About the best that can be expected is 2% growth.
 
And that reduced figure is important to keep in mind in light of the blowout third-quarter increase of 5% and the expectation of continued 3% GDP growth over the next two years. Just maybe the economy is currently running too hot, well above its proper air speed, rather than merely playing catchup to recover some lost economic potential. If the former is the case, the aerodynamic force of surging inflation could soon start popping the rivets of a high-balling U.S. economy.
 
The secular stagnation argument revolves around several common-sensical observations. Most important are U.S. demographics. Growth in the working age population is slowing to under 0.5% annually from a rate that cycled as high as 1.8% in the ’70s when the baby-boom generation and, more specifically, women were streaming into the job market. So these days and over the next two decades there will be fewer new worker bees joining the workforce and, consequently, less honey produced.
 
Of course a surge in productivity, or hourly output per worker, could compensate for this shortfall in labor force growth. But the news isn’t great on this score either. For the bulk of the post-World-War II period, productivity added an average of 1.5% or more to annual GDP growth, but that number in recent years has shrunk to well under 1%, despite the ballyhooed advances in robotics, cloud computing, big data, digital media, and artificial intelligence.
 
Nobody is quite sure why this is the case. Maybe workers are wasting more time on social media and entertainment sites. As plausible as any explanation is one offered in a recent report by David Kelly and Hannah Anderson at JPMorgan Asset Management. Among other things, they surmise, “this decline probably reflects the movement of employment from the manufacturing sector (which has always had strong productivity growth) to the service sector (where productivity growth is harder to achieve).”
 
KEY TO THE FEDERAL RESERVE’S maintenance of its zero-bound, short-term interest-rate regime even after six years, is the conviction that great slack still exists in the U.S. labor market. Invariably cited is the decline in the U.S. Civilian Labor Force Participation rate, which from 2000 to November 2014 descended from around 67% to 62.8% of the U.S. population either gainfully employed or actively job-hunting.
 
But this attrition seems more secular than the cyclical result of the 2007-09 Great Recession. For one thing, the rate had been dropping well before that downturn.
 
Likewise most of the 400 basis point drop can be ascribed to baby-boomer retirements, a surge in the number of Americans on federal disability (which has become a blue-collar worker welfare program that has been widely abused) and young people and older workers opting for further education and training instead of work. JPMorgan’s Kelly and Anderson likewise point out that Americans with criminal records of some kind have jumped from 13% of the population in 1991 to 22% in 2012, according to government statistics.
 
These folks typically can’t find work even if they try, once background checks turn up their past legal troubles. The point of all this analysis of the participation rate is that it’s unlikely that most of the absentees will ever return to the job market.
 
James Paulsen, chief investment strategist of Wells Capital Management, is concerned that the fast-disappearing slack in the labor markets will give way next year to strong wage growth and its evil cousin, inflation. He sees signs of such a surge in wage growth in the steep fall in the unemployment rate over the past two years and the rise in average hourly earnings of production and non-supervisory employees, which jumped from a 1.28% increase in October 2013 to a 2.48% rate this August before tailing off.
 
Paulsen examined past instances of the onset of Fed-tightening going back to 1955 and found that in every case stock price/earnings ratios dropped. In many cases, the tightening came early enough in the economic cycle that profit growth more than compensated for the multiple contraction, allowing stock prices to continue to rise.
 
Yet this time around, he opines that Fed tightening is occurring so late in the recovery cycle, with profit margins at elevated levels, that 2015 will prove a difficult, volatile year for the stock market.
 
“Stock prices may well be flat for 2015, but I see the likelihood of a nasty, gut-check fall of 15% to 20% in the market sometime next year,” he observes. “The Fed’s current mind-set is likely to fall apart, and the central bank will be forced to tighten faster and far more aggressively than Wall Street currently expects.”
 
A retired investment manager of our acquaintance sees disquieting parallels between today’s credit cycle and that of 2004. Fed tightening in 2004 began in June and proceeded at a leisurely pace of 17 target price hikes at 25 basis points each over the next two years boosting the fed-fund rate from 1% to 5.25%. In the meantime, excesses in the financial system built up, coming to full efflorescence in the 2007-09 global credit crisis.
 
This time around, he points out, the unemployment rate is virtually the same as it was six months before the 2004 tightening began while the core consumer price index, at 1.1%, was even lower than the current reading of 1.7%. So there’s considerable danger that the Fed will again find itself woefully behind the curve six months from now, when most expect the current tightening cycle to commence.
 
Are investment bubbles developing today similar to those begotten during the Naughts due to overly complacent monetary policy and a fixation on disinflation to the exclusion of manifestations of financial market overexuberance? Absolutely, says our friend. He airily ticks off stocks and bonds all across the risk spectrum. Trouble impends, maybe sooner than later, for all manner of U.S. financial markets.
 
We can only hope such predictions don’t come to pass and positive momentum in the economic cycle and financial prices rule the day. And by the way, Happy New Year.