Is the Risk-Off Environment Flashing Amber for US Economic Growth?

By David Absolon, Investment Director at Heartwood Investment Management

A cursory glance of US economic data releases since the start of this year raise concerns about the strength of the recovery particularly as global deflationary fears intensify. The US ISM manufacturing index fell more than expected with a contraction in new orders, while the ISM non-manufacturing index and factory orders also underwhelmed the market’s expectations. As oil prices plumbed to a new six-year low last week, asset markets have reacted nervously. US equities have stuttered and declines in intermediate and longer-dated US treasury yields highlight ongoing investor uncertainty in the sustainability of the US recovery.

Nonetheless, our conviction remains untainted that the US economy will make incremental improvements in 2015. While many fear the downside risks of falling energy prices, we think this trend will ultimately be a positive force for growth.

The latest minutes of the Federal Open Market Committee (FOMC), the monetary policy setting committee of the Federal Reserve, corroborate this view. There were no major surprises following December’s monetary policy statement, but the FOMC placed particular emphasis on the net effect of recent energy price declines as positive for economic activity. This expectation is important at a time when some economists worry that lower energy prices could derail job growth as companies providing services and supplies to the oil industry cut costs. On current forecasts, the FOMC expects growth in 2015 and 2016 to surpass 2014.

The key to US growth is consumer spending; consumption accounts for two-thirds of the US economy. The US economy is better insulated than many other export-orientated economies from global risks. US job creation has been especially robust, evidenced by the last three months’ payrolls reports. This together with low interest rates and the decline in household debt relative to income are expected to support consumer spending over coming months. While average weekly earnings remain subdued (falling -0.2% m-o-m in December on a seasonally adjusted basis), the low inflationary backdrop should boost real income gains.

All things considered and despite market jitters over the last week, the US economy should proceed at a reasonable pace. We acknowledge there are downside risks to this view, but overall we consider the US remains an attractive investment prospect relative to the rest of the world over the medium term. The US dollar remains supported by the higher interest rate differential versus other developed economies, as well as a strengthening economy. Shorter-dated US treasury yields will continue to be sensitive to the debate around Fed tightening, but intermediate and longer-dated yields should be underpinned by the low inflationary backdrop and a gradual tightening cycle. Indeed, in a low inflationary environment where growth is reasonable but not spectacular, the Fed can afford to be patient.