Water Cooler Wisdom

September 30, 2014

Nothing is private anymore: celebrity photos are leaked across the Internet, everyone knows that Ben Bernanke was unable to refinance his mortgage and we can even follow professional football players’ misconduct. This technology, which allows us to follow the economy more closely than ever, shows that our economy is growing. Over the last quarter, the economy grew 4.6% and it is poised to continue this growth in the long run.

Here is what we expect: the US economy will continue to grow in the short and long term, interest rates will eventually rise (which is a good thing!), and you will be able to manage your money more effectively in a stable U.S. economy.

The economy is ready for strong short-run growth.

During the third quarter 2014, we saw attractive returns and valuations (see Returns and Valuations). In the chart, you’ll notice how different size equity asset classes performed over various timeframes. Over the past twenty years, the value stocks cost more per dollar of earnings than the average for companies of all sizes (large-, medium- and small-cap). Large cap growth stocks are trading at the largest discount below their historic price-to-earnings ratio of all domestic asset classes (around 14% lower).

One thing that is unique in our current economic climate is that while high stock prices are historically met with high interest rates, this is currently not the case with a prime rate at 3.25%. We expect that interest rates will start to rise in appropriate measure to stock prices.

Interest Rates are poised to rise.

As Ben Bernanke found out, mortgage loans are scarce. Without long-run inflation and the associated rising interest rates, banks do not have the incentive to make mortgage loans more available at this time. Mortgage rates and average payments are well below the historic averages. Average mortgage payments are 13.4% of household incomes, compared to the historic average of 20.4%. Household debt is low, while household net worth is at an all-time high of $82 trillion. However, interest rates will eventually increase, which will create more space for loans.

Despite concerns that high interest rates will kill consumer spending, they will likely increase the availability of loans. If households maintain high levels of investment in interest-bearing assets, they may benefit from an increase in interest rates as well, especially since household assets often have a shorter duration than their liabilities

The Fed and others expect low long-run growth.

The Federal Reserve’s numbers (from September 18, 2014) paint a rosy picture for future growth that agrees with the promising trajectory represented in our data. The Fed’s recent GDP projections align with the majority of economic expert opinions and everything seems set for the last Treasury purchase to be in October 2014. However, it does anticipate some level of intervention until 2016 to manage fed funds rate adjustments to a long-run equilibrium of 3.75%. It anticipates inflation for 2014 at 1.6% but it is already at 1.7%. J.P. Morgan expects the Fed’s projection of 1.9% inflation to be reached in 2015 rather than in 2016.

U.S. growth in exports is largely due to rising demand for U.S. shale gas and improved capital spending that prepares us to increase consumption over the next year or so. Manufacturing momentum explains how the US economy is growing relative to the rest of the world (see Manufacturing Momentum. The growth over the last couple of years, along with future higher interest rates, does have some negative implications for investing abroad in the short run, and the strengthening dollar will disguise return on international stocks. For example, Europe is in a second recession and signs of recovery will be eaten up by exchange rates, especially if our domestic economy is more productive than theirs.

Inflation is low and cash holdings are high.

The Consumer Price Index (CPI) is at 1.7%, considerably below the historic average of 4.1%. Low inflation contributes to significantly higher levels of cash holdings, which is around 11 trillion US dollars, because the value of the dollar feels pretty much the same month-to-month, and perhaps because future implications from Money Market fund regulations has investors questioning the stability of cash-equivalent investments. It is important to remember that a more diversified portfolio with less cash holdings has delivered higher average annual and cumulative returns over the last decade (see Asset Class Returns).

Conclusion

So what should we conclude? Invest broadly and confidently, prepare for growth, and don’t be surprised by increases in interest rates or inflation that typically coincide with economic success.

 

Katherine Brown is a Research Associate at Castle Rock Investment Company with a Master’s degree in Global Finance, Trade, and Economic Integration from the University of Denver. She can be reached at Katherine@castlerockinvesting.com.