Monday, January 12, 2015

Guest Post: Year End Economic Commentary by Dorothy Jaworski

2014’s Biggest Surprise
It never fails.  The markets provide us with completely unexpected surprises and leave us scrambling to update our projections for rates and economic growth.  And so it was in the latter part of 2014.  Oil prices began a massive plunge, down 46% for the year to $53 per barrel.  And who expected this?  Well- no one.  Now we all have to adjust to this new reality.  What are the implications of the crash in oil prices?  And why did they plunge?

We all have been reading for years how the United States was dramatically increasing energy production, especially from a method of extracting oil and natural gas in shale regions of the country known as hydraulic fracturing or “fracking.”  Suddenly the US was the world leader in oil production.  Suddenly the world realized that there was a supply glut.  OPEC members and Russia stand to suffer the most from lower oil prices, but have continually sworn to keep production at current levels, perhaps using low prices to stall US investment and production.  While the US economy is growing slowly and steadily, this is not the case in China, Europe, and Japan, who are experiencing low growth, no growth, and outright recession, respectively.  This is a recipe for weak demand which, when combined with a supply glut, means lower prices.  Also, the US dollar has been strengthening, with a 12% increase in 2014, further pushing oil prices lower as oil is typically traded as a dollar denominated commodity.

Think back, too, as to when oil prices were close to $100 per barrel earlier in 2014.  Geopolitical tensions were running rampant as fighting was ongoing in Israel-Gaza, Russia-Ukraine-Crimea, and Syria with ISIS stepping up as a huge threat.  Supply disruptions were the typical fear but the tensions have since subsided.  These tensions could reappear if unrest rises in Russia, Iran, Saudi Arabia, Venezuela, and other countries that are highly dependent on oil for revenues.  Now US consumers can be the biggest beneficiary of falling gasoline prices, which recently peaked at $3.69 per gallon in April, 2014 and ended the year at $2.23.  Consumers rejoice!  And don’t forget that heating oil prices have plunged, too, just in time for another polar vortex.  I have always believed that cheaper oil and gas prices are like a tax cut that helps consumers save money on their “taxes” and spend it on other discretionary goods and services.  I was gratified to hear Janet Yellen reiterate this same point.  Consumer can and will rejoice and spend.  Economists revised their projections to include new assumptions that consumers will save between $70 billion and $100 billion annually on gas and will spend most of the savings, perhaps increasing real GDP by at least a net +.5%.  Yeah, finally!  A 3% GDP number! Happy 2015!

The Economy in 2015
Most economists were projecting +2.5% in real GDP growth in 2015, prior to the windfall from plunging oil prices.  As mentioned, they have increased projections to +3.0%.  Over the past five years, GDP has averaged +2.2%, which is quite disappointing compared to the average growth of +4.6% for the past ten recoveries.  If we make it to +3.0% in 2015, it will be the first time in six years of recovery that we have touched +3.0%.  Perhaps that is why former Federal Reserve Chairman Alan Greenspan just proclaimed that “we still have a sluggish economy,” which will not fully recover until there is more investment in long lived, productive assets and the housing market recovers.  Despite all the euphoria over a lower unemployment rate of 5.8% (down in 2014 from 7.0%), the fact that many of the jobs created have been part-time, lower wage ones and many experienced workers are dropping out of the labor force.  I do see millions of jobs being created in 2015, but still many are part-time, thanks mainly to Obamacare and other regulations.

Who projected that interest rates would fall in 2014?  Well- no one- except maybe Dr. Lacy Hunt of Hoisington Management, who has been on top of trends most of us do not see.  I read his quarterly newsletters with great interest and you should, too.  The ten year Treasury yield topped 3% at the end of 2013 and fell to 2.20% by the end of 2014.  Why?  Falling inflation and falling inflationary expectations will do the trick.  Falling inflation confounds the Philips Curvers, who read their textbooks and expected higher inflation from the falling unemployment rate.  I’ll bet John Taylor is a little upset, too, with trying to use inflation in his Taylor Rule formula.  Weakness in most world economies other than the US is keeping inflation under control with weak demand- especially as seen with commodity prices.  US rates continue to be substantially higher than rates in Europe and Japan with less risk.  That upsets me, because it is not normal.  Yet, the Federal Reserve stubbornly continues to proclaim that they will raise interest rates by mid-2015.  I say, go ahead.  The Fed will just end up lowering them shortly thereafter when they realize they have tightened prematurely.  New York Fed President William Dudley recently warned of just this risk, when he spoke of the historical classic case of premature tightening in 1937 by the Fed, when recession and deflation followed.   

Risks to Growth
I’m an optimist at heart, but I feel obligated to point out the risks to economic growth.  Measuring and managing risk has been my specialty in a banking career that is now 40 years old, of which 29 years have been spent dealing with risk.  The aforementioned risk of a Fed policy error of premature tightening tops the list.  Economies around the world are struggling and their policy makers are still easing monetary policy, making the spread between US rates and those economies’ rates unnaturally wide.  The ever rising US dollar could contribute to weaker and weaker currencies around the world, leaving countries to struggle and have to raise rates.  We have geopolitical (the word made famous by Greenspan in the early 2000s) risks of war, terrorism, epidemics such as ebola and influenza, and cyber attacks.

And there are two more risks that are not getting a lot of press- deflation- which can lead to deferred demand, declining wages, and slowing GDP- and liquidity risk- where restrictions and regulations have nearly strangled the life out of financial institution market makers, who seem increasingly unwilling or unable to take bonds into inventory and hedge them, instead opting to act like brokers, taking too much time to execute trades and too wide a bid-ask spread.  Market makers are not alone in this regulatory nightmare; 79,000 proposal and final rule pages were published in the Federal Register in 2014 affecting all industries, with a cumulative total of 468,500 since the recovery began in 2009.  Once again, I digress.  But, that’s what I am here for.  Stay tuned!  

Thanks for reading!  01/05/15

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004. She is the author of Just Another Good Soldier, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure.

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