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 That the rest of the world, China, Japan and Europe will all see
weakness will only reinforce the attraction of dollar assets, which
will benefit particularly from the easy monetary conditions.
The risk is that policymakers and investors underestimate U.S.
economic strength, setting the stage for an equity market downdraft
if the Fed is forced to raise interest rates sooner than
anticipated.
It has been a time of gifts for the United States, with the economy
expanding at a 5 percent clip in the third quarter, the best showing
since 2003. Particularly encouraging was the nearly 9 percent
expansion in business investment, a sign that corporations are
encouraged about prospects.
Consumer spending grew, too, and should continue to expand given the
effect on wallets of the quite rapid fall in the price of oil - down
nearly 50 percent on some measures since June. The effect of cheaper
energy is being felt more powerfully now than in the third quarter
and will be more powerful yet in 2015.
That helps to explain why U.S. stocks are trading very near their
all-time highs in inflation-adjusted terms, as does the stance of
the Federal Reserve, whose projections and overall message after its
last rate-setting meeting in December were far more downbeat than
the data released since then.
The fall in oil prices could drive core inflation, already well
below Fed targets, lower yet next year. That could convince a
Federal Open Market Committee, which will have a more dovish lineup
in 2015, to wait longer before raising rates.
“A zero percent rate policy in the face of the latest 6 percent
trend in nominal gross domestic product is likely a case of playing
with fire for even the most dovish Fed in recent memory,” David
Rosenberg, strategist at Gluskin, Sheff in Toronto, wrote in a note
to clients.
Investors in equities are generally thrilled when policymakers take
risks with over-heating, though they are often not so happy once the
corrective steps are taken. All of this argues for a continued rise
in the dollar in the early stages of 2015, and strong relative
performance from riskier U.S. assets like equities and
higher-yielding debt.
1987 ALL OVER AGAIN?
As a market phenomenon, all of this is self-sustaining. Good data,
good profits and easy monetary policy drive gains in the stock
market, which in turn forces less-convinced investors from the
sidelines.
The impact from cheaper energy is strong and will get stronger. U.S.
growth will be as much as 0.5 percentage point higher than otherwise
next year as a result, according to the International Monetary Fund,
and as much as 0.6 percentage point in 2016. To look for a
historical parallel, oil prices fell even more sharply in 1985 and
1986, setting the stage for a multi-year economic expansion.
“As is the case now, most analysts were underestimating how well the
economy was going to do as 1986 drew to a close - that 1987 was
going to be a real breakout year for growth, bond yields, the Fed,
and stock market volatility,” Rosenberg wrote.
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It is, of course, impossible to foresee a major market correction.
But a scenario in which the Fed hikes sooner than expected next
year, and gives off signs it will raise rates more rapidly than
anticipated, is one that would also figure a great deal of downward
volatility.
This is not the only way it could play out. The Fed may well be
justified in waiting, or it could easily bring the market along with
it as it edges toward hikes in the first three months of 2015.
The price of oil could also be telling us that things globally are
weak enough to justify a longer delay in policy normalization by the
Fed.
Much of the fall in oil prices is due to plentiful supply, both as a
result of the application of new technology in the United States and
older suppliers like Libya coming back online after political
dislocation.
The IMF, however, estimates that 20-35 percent of the fall is due to
decreasing demand, which in and of itself is a warning signal.
Copper, a base metal used heavily in industry and which often moves
in tandem with global growth, recently touched four-and-a-half-year
lows and is down about 18 percent this year. That may foreshadow
weaker conditions in Europe and China, which could hurt U.S. growth
and outweigh the benefit of cheaper oil.
Meanwhile, the party in U.S. risky assets looks set to continue, and
with few good alternative choices elsewhere, investors, as ever,
will be forced to pile in.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@gmail.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by Dan Grebler)
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