Economists are paid to pretend they understand ... things so that people will think that the world isn't riding a wild horse, when in fact it is. - Mark Helprin

The Timex stock market. It takes a licking and keeps on ticking. To wit, the Dow dropped from 17,279 on September 19 to 16,461 on October 22 – a 4.7% decline in a little over four weeks that totally eradicated the market’s gain for the year to that point. No problem. Over the ensuing six weeks the Dow rallied over 9% to a new all-time record high. But then it gave back almost 5% over the next seven trading days. No sweat, for the venerable index soared almost 6% over the following six sessions to another record high of 18,083 on the day after Christmas. Yes, Dow Jones, there is a Santa Claus.

The rarefied air proved to be too much again as the market fell back slightly over the last few days of 2014. The net gain for the year (excluding dividend reinvestment) was 7.52%, which definitely qualifies as not too shabby at all in a world of moribund inflation. But hold the phone because stock returns during the year paled in comparison to the returns from long-term Treasury bonds. The nearest Treasury bond futures contract enjoyed a price gain of 12.7% as yields fell during a year in which the vast majority of prognosticators was calling for exactly the opposite. Nothing new about that.

Among the losers during 2014 were a host of commodity prices. The Commodity Research Bureau Index plunged 17.9% for the year. The carnage was widespread in industrial commodities but the energy sector was hit hardest. West Texas Intermediate Crude Oil reached a peak over $110 per barrel in June before plummeting over 50% by the end of 2014 as OPEC steadfastly refused to cut production in order to support crude prices.

Speaking of losers, the Vanderbilt football team managed to eke out only three wins during the season and two of those were against lower division opponents. As a result, the offensive and defensive coordinators were sacked. The no longer lovable but still losing Chicago Cubs also effected a coaching change as they lured the successful manager of the Tampa Bay Rays, Joe Madden, to the North Side. Good luck with that. All of these machinations will probably end up being as useful as rearranging the deck chairs on the Titanic.

The economy began 2014 with a thud as first quarter real GDP fell 2.6%. Like the stock market, however, the economy snapped back from the skid and finished the year in a sprint. Second quarter growth was a stout 4.6% and the third quarter turned in a sparkling 5.0% gain led by an increase in personal consumption spending (apparently mostly on the new iPhone). Fourth quarter data has yet to be reported but another above trend result is anticipated.

Much of the improvement in the previously becalmed recovery has emanated from employment growth. Unemployment claims, a leading indicator of employment conditions, fell from 339,000 at the start of the year to less than 300,000 by the end of 2014. That level has been associated in the past with monthly jobs growth above the trend growth rate of the labor force. Heretofore, the decline in the unemployment rate was largely attributable to a decline in the labor force participation rate. In other words, frustrated job seekers gave up looking for new jobs.

The better news on the employment front, however, has been tempered by what appears to be a “profitless prosperity” in that wage gains have remained relatively paltry. The latest data show a 1.7% year-over-year gain in average wages. That is not materially better than the rate of inflation so it is questionable if consumer spending can continue at a pace sufficient to sustain above trend growth in real GDP unless there is greater improvement in wage growth in the months ahead.

For many years (alas, a great many) these pages have included references to what we call the “virtuous cycle” (as opposed to the “vicious cycle” known all too well by many, especially Commodores and Cubs fans). The virtuous cycle begins with jobs growth that leads to an increase in disposable income. The higher disposable income leads to gains in consumer spending that, in turn, results in higher production levels and, eventually, even greater jobs growth. This is the sweet spot of any economic expansion and it appears to have finally taken hold last year.

Once the virtuous cycle gets underway, it tends to be self-perpetuating. Ultimately the cycle can lead to either cost push and/or demand pull inflationary pressures. That is the point where the Fed takes the punch bowl away before the party gets going too good. Rising interest rates eventually signal the death knell of the cycle and a slowdown or recession ensues.

At present we are experiencing real GDP growth rates well above the long-term trend. Considered alone that might prompt the party poopers at the Fed to become more stingy about supplying liquidity to the financial system. In fact, the central bank has moved to reduce liquidity growth by eliminating its program of buying fixed income securities in the open market. They have done so, however, in a manner designed to avoid putting upward pressure on interest rates.

There has been much speculation in the media about when the Fed might begin to raise interest rates and much discussion within the Fed itself on the same topic. Most pundits, moreover, now believe that any upward pressure on rates will occur later in 2015 if at all this year. One of the supporting factors for this is the fact that the rate of inflation is well below the Fed’s target of 2%. No doubt the aforementioned collapse in commodity prices and meager wage growth are also important considerations influencing the central bank’s policy decisions.

Hence, the virtuous cycle would appear to have plenty of life left in it. As Lee Corso might say, however, “Not so fast my friend.” While the Fed historically has been the agent of undoing for the virtuous cycle, there are other factors that can have an impact and these are known as “exogenous variables” (which can largely be characterized as “things that go bump in the night”). These are sometimes referred to as Black Swans – unusual events that can disrupt financial markets and, hence, economic growth.

While the U.S. recovery at long last seems to be gaining momentum, the rest of the world’s economy is struggling. Japan and Russia are in recessions and Europe is battling substantial deflationary forces. In the past, the U.S. economy has often been the locomotive that pulls the rest of the world along with it and that may very well happen again.

For it to happen, the Timex market needs to keep on ticking. While the Dow and S&P 500 established new all-time highs late last year, the collective world stock market, ex the U.S. components, finished well below the peak set in 2007.Credit spreads have been widening and the precious metals have recently gained ground despite the blood bath in other commodities. This, along with the dollar’s ascent of late, is indicative of a flight to safety – risk aversion by the world’s investors. The hope is that those seeking to avoid risk will be proved wrong and the virtuous cycle will remain intact and lead the rest of the world out of the doldrums. The coming year should prove to be very interesting, indeed.

 

Weaver C. Barksdale, CFA