The U.S economic outlook for 2016, according to all official U.S. economic forecasts, is for stronger growth. Unfortunately, there is more to consider when it comes to the U.S. economic outlook than economic output. Sadly, U.S. economic outlook isn’t the only thing on the rise: inflation, debt levels, interest rates, and market valuations are also increasing. The big question is…what does this mean for investors?
In late April, the Federal Reserve came out with an updated U.S. economic forecast for 2016 and 2017. The Fed reaffirmed that the federal funds rate (benchmark short-term interest rate) is in the correct range of 0.0% to 0.25%.
Interest rates may be low, but the markets will continue to struggle with coming higher interest rates. As a result, the Fed explained that it would monitor both realized and expected economic data as it related to employment and inflation.
What are the official conclusions? The Congressional Budget Office (CBO) forecasts that the U.S. economy will advance 2.9% this year after growing 2.1% in 2014. It also expects the U.S. economy to increase 2.9% in 2016.
Where will the majority of that growth come from? You. Growth is projected to come from a rise in consumer spending and fixed asset investment by businesses. Growth is not created equally. Consumer spending will account for 2.3% of the 2.9% growth domestic product (GDP) growth forecast this year. (Source: CBO, last accessed May 7, 2015.)
Solid U.S. economic growth will also translate into stronger hiring in the coming years which will send unemployment levels down from the current 5.5% to approximately 5.3% in 2017. The Federal Reserve sees even sunnier days ahead for the U.S. economy. It expects U.S. unemployment to settle in a range of 4.8% to 5.1% by the end of 2017. (Source: Federal Reserve, April 8, 2015.)
The CBO also expects inflation, as measured by the personal consumption index, to stay below the Federal Reserve’s target of two percent until 2017. Inflation currently stands at -0.1% which means prices are actually declining. (Source: BLS, April 17, 2015.)
That also means we can look forward to a sharp rise in inflation. The lack of any increase means the Federal Reserve will most likely postpone the Fed’s interest rate decision past the July and September 2015 meetings.
Interest Costs and Debt
One thing that doesn’t look all that promising is debt. At the end of 2014, public debt stood at $12.8 trillion or 74% of GDP. In spite of the so-called solid outlook for U.S. economic growth and inflation U.S. debt levels are expected to increase. (Source: CBO, January 26, 2015.)
Normally, you’d expect personal debt levels to decrease when the economy is chugging along. But, in this case, the opposite is true. The $12.8 trillion in debt, held by the public at the end of 2014 will pale in comparison to the projected $21.0+ trillion (79% of GDP) held by 2025.
What will accompany soaring debt levels? Interest rates.
The current rate on a three-month Treasury bill stands at 0.01%. Or, to round down a sliver, zero percent and zero return. The rate on a U.S. Treasury bill with a 10-year maturity has an interest rate of 2.12%. (Source: U.S. Treasury, last accessed May 7, 2015.)
Once again, the outlook remains grim for income starved investors. The CBO expects the interest rate on three-month Treasury bills to average just 0.2% in 2015 and then rise sharply to 1.2% in 2016. While that’s a significant increase, it’s merely returning to normal levels, an environment the market isn’t used to.
Interest rates are also expected to rise in the long-run. The 10-year Treasury note yields are expected to increase from their current rate of 2.12% to 3.4% by 2016, and increase to over 4.5% longer-term. The last time we saw 10-year notes yields of 4.5% was way back in August 2007 before the Great Recession.
The rise in Treasury rates will not be of any comfort for the U.S. government, since it translates into higher borrowing costs. It also means U.S. public debt will continue to rise. The CBO projects the average interest rate on debt to climb from 1.7% this year to 2.0% in 2016, and to 3.3% by the end of 2020.
The CBO also notes that debt levels are at historical levels. According to the most recent data, debt held by the public in 2014 was at its highest levels since 1950. As a percentage of GDP, public debt in 2014 totaled 74%; that’s twice the average levels between 1965 and 2014.
Just before the financial crisis in 2007, debt as a percentage of GDP was just 35%. But the Great Recession put a big dent in Federal coffers. Forecasts for the American economy in 2016 see U.S. public debt reaching 74% of GDP.
Federal obligations and increasing interest rates will significantly curb the U.S. economy in 2016 and 2017 and even further out. That’s because interest rates on debt are set to rise. On top of that, total U.S public debt is set to rise. As a result, the federal budget deficit will also widen.
What will that look like? An increase in debt and servicing costs cuts into government finances. National savings will fall and there will be limited investment into the U.S. economy. Budget cuts and shortfalls also means the Federal government will not be able to respond effectively or efficiently to future crises.
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What Does The Federal Reserve Say?
As we look ahead to the U.S economy in 2016, it’s important to look at the forecast of the Federal Reserve. Janet Yellen, Chair of the Federal Reserve, predicts the U.S. economy will expand anywhere from 2.3% to 2.7% in 2015. The Fed also forecasts the same range for 2016. (Source: Federal Reserve, April 8, 2015.)
While this is better than a few years ago, it’s still pretty underwhelming for the world’s biggest economy. In fact, the days of 3.0%+ annual growth may be a thing of the past. Between 1995 and 2014, the U.S. economy grew on average at 2.5%. But if you look at the data starting from 1965, U.S. GDP grew at an annual rate of 3.0%. (Source: FRED, last accessed May 7, 2015.)
Moreover, the most recent long-term outlooks suggest the U.S. economy will advance no faster than 1.8% to two percent annually. This despite the U.S. economy running at full employment and inflation hitting the long-term target of two percent. The new normal for U.S. economic growth will be much slower than in the past. (Source: Federal Reserve, April 8, 2015.)
Effects on Stocks and the Bond Market
As we head into 2016, short and long-term interest rates will be on the rise, as a result, the federal government will be trying to come to terms with higher debt levels. But U.S. budgets are not the only one going to be affected by higher interest rates. Stocks and bonds are also going to be negatively impacted by higher rates.
It’s no surprise that U.S. stocks are overvalued. As of March 31, 2015, the S&P 500 trades at 17 times forward earnings. According to JPMorgan, the 10-year forward earnings multiple average is 13.8 times. That means today’s valuations are approximately 23% above the 10-year valuation average. (Source: JPMorgan, March 31, 2015.)
Between March 2009, when the markets bottomed and May 2015, the S&P 500 has rallied 200%. What’s been fuelling stocks higher? Artificially low interest rates. Short-term interest rates were dragged from five percent in 2007 to zero percent in early 2014.
What will happen to the long-in-the-tooth bull market when short-term interest rates soar more than 500% from 0.2% to 1.2% as predicted by the CBO? Higher rates will cut into company incomes through higher interest expense costs; particularly those companies heavily reliant on short-term funding.
Despite nose bleed valuations and higher interest rates, investors will still want to see solid revenue and earnings growth. And no just as a result of cost cutting measures. But that seems unlikely. First quarter blended earnings are projected at just 0.1%. If that kind of growth persists in 2016, or should the blended earnings be negative, you can expect there to be some kind of sell off in 2016. (Source: FactSet, May 8, 2015.)
Then there’s the bond market. Bonds will also be negatively impacted by higher interest rates. In fact, 2016 could very well be the worst year for bonds in over 30 years. The rally in bonds began in 1981 when 10-year Treasury notes hit 16%. Today, interest rates are hovering at just over two percent.
Bond holders could be faced with large losses in 2016. For every one percent increase in interest rates, a 10-year Treasury note holder will lost nine percent. If 10-year Treasury notes move from their current yield of 2.21% to the forecasted 3.4% in 2016, prices will plunge by 11%.
Given the 2016 U.S. economic forecast, investors should consider their options when looking at stocks and bonds.