posted on 18 December 2015
by Gene D. Balas
The Fed's announcement this week to institute a quarter point hike in the Fed funds rate has arguably been one of the most widely anticipated decisions in the past year. While the strong jobs reports of late and ample Fed communications on the subject left only a few people with doubts of the Fed's move going into the meeting, Fed Chair Janet Yellen has taken care to emphasize the pace of rate increases will be slow and gradual.
To many observers, a slow pace of rate normalization simply represents a need by the central bank for caution amidst a sluggish economy and inflation that remains persistently below the Fed's 2% target. But there is a more fundamental and longer-term reason why the economy needs lower rates than it did in the past: The economy's potential growth rate is also lower. That means investors might not expect U.S. GDP growth rates to exceed 3% for any sustained period of time, and that is far lower growth than what we have enjoyed in the six decades since the end of World War II up to the Great Recession. Consider the nearby graph which represents potential economic growth.
An economy's potential rate of growth is determined by two basic things: growth rate of the labor force (or perhaps a bit more specifically, growth in hours worked) and productivity (how much workers produce during each of those hours worked). It's hardly any secret the population is aging, and Baby Boomers have started retiring. As a result, the Bureau of Labor Statistics anticipates that the labor force will grow by just 0.5% per year over the next ten years. In addition, fewer of those of prime working years are expected to participate in the labor force, for a variety of reasons.
Meanwhile, the Congressional Budget Office (CBO) projects productivity will grow an annualized 1.6% per year from now until 2025. Summing productivity gains with the 0.5% growth of the labor force, yields (with slight rounding) the Bureau of Labor Statistics' 2.2% projected GDP growth rate over the next ten years, which is roughly identical to the CBO's 2.1% forecast for GDP growth during that period. By comparison, the CBO noted in its report that productivity gains from 1991 to 2001 were 1.9%, plus the labor force growth during that period of 1.3%. This yielded a potential economic growth of 3.2% for the 1991 to 2001 period. (Potential GDP growth is not the same as actual, realized economic growth.)
While all of this may seem a bit arcane, the main point of this isn't so much that the Fed plans to go slow with rate hikes and will reach a lower plateau, it is why it is doing so - and what this might mean for your investment returns. First, though, just by means of an explanation, the rates set by the Fed are correlated to GDP growth. The faster the economy grows, the higher rates usually are, as a faster growing economy can be more likely to generate unwanted inflation.
However, a slower growing economy can also be less likely to enable companies to generate profit growth to the same extent they might be able to during periods of robust economic growth. While cost-cutting moves might be possible, the unemployment rate is close to levels indicating "full" employment, below which companies may need to begin offering larger pay raises to their employees in order to attract and retain talent. So, companies may need to start doling out more pay to their employees - and that can spark the inflation that the Fed seeks. Hence, the timing is right for a rate hike. But that means that one key driver - profits - of stock returns may come under pressure, at least in the U.S.
For investors, that may mean considering international exposure, including beyond the developed world (where most countries have similar problems of low rates of labor force growth and thus, economic momentum). With this in mind, a diversified international exposure might possibly include emerging markets, which, over the long term, may experience faster rates of growth, albeit with more potential risks. International investing might not be right for everyone, but your United Capital financial adviser is ready to answer any questions you may have about ways such as this to diversify your portfolio.
By Gene Balas, CFA
Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.
The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.
International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies. Equity investing involves market risk, including possible loss of principal.
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