and the month that will be. quick hits · the beneficial effect of lower gas prices will wane as...

… AND THE MONTH THAT WILL BE.

As our current year ends and we near the start of a fresh one in a handful of days, it has become

customary around this time of year to consider what the months ahead might have in store for us. Hear

more about the Raymond James outlook for the New Year and what we, as investors, might be looking

forward to in 2015.

Quick Hits

In looking to the year ahead, Raymond James analysts predict that low oil prices and continuing

improvement in economic fundamentals (particularly the labor market) will lead the US Federal

Reserve to begin raising short‐term interest rates in the 2nd or 3rd quarter of 2015.

However, a number of potential stumbling blocks could alter our experience, including

unanticipated weakness in our domestic economy, a continued slowdown in global growth

(particularly in Europe), a flare‐up of geopolitical tensions and crises in hot spots around the

world, and an overly reactive investment community that leads to increased financial market

choppiness.

Given the recent history of investors and their reactions to monetary policy decisions here (e.g.,

our 2013 experiences with tapering) and abroad (e.g., the on‐again/off‐again suggestion of

quantitative easing by the European Central Bank), we should expect greater volatility in 2015,

particularly as we approach the anticipated date of the first Federal Reserve interest rate hike.

Looking ahead to 2015 – What Raymond James analysts expect for the economy and the markets.

Raymond James, like many large financial firms, has a cadre of in‐house analysts and

forecasters who are skilled at parsing all sorts of economic data and market indicators to give advisors

and clients their best ideas and opinions when it comes to the direction of the investment markets.

Whenever there’s a substantial swing in the stock and bond markets or some significant happening in

the financial news, I’m often asked what the analysts at Raymond James think.

Predictions are very apropos for this time of year – during the changeover to a new year many

market observers have made a tradition out of firing up their crystal balls (written tongue‐in‐cheek of

course) and offering their opinion as to what the year ahead will hold. From my personal standpoint,

I’ve generally found the opinions of the Raymond James analysts to be “fair” in the sense that they

provide their view with a balanced perspective (in that they admit to and allow for uncertainty in their

forecasts). Of course, they’re not the only credible source out there, nor do they own any exclusive

rights to the idea of being even‐handed and reasonable in their predictions.

While I think it’s faulty to try and adjust long‐term investment strategies on the basis of what

could happen in a single year ahead, I do think it’s helpful to consider the possibilities and use them to

adjust our expectations. Managing our expectations is critical to helping us stick with our plans through

high highs and low lows (as opposed to making the mistake of junking a carefully‐reasoned financial plan

to chase after the high‐flier or “hot” asset). Therefore, I thought it might be helpful to share the

highlights of Raymond James analysts’ 2015 outlook here. I’ve also included a handful of market

commentary pieces written by Mr. Jeffrey Saut (Raymond James’ Chief Investment Strategist) and Dr.

Scott Brown (Raymond James’ Chief Economist) so that you may read their thoughts directly, rather

than relying solely on my own interpretation here.

From a domestic perspective, analysts believe the key issues going forward will center on oil

prices, continued improvement in the job market, and impact that overseas developments could have

on the picture here in the US. Their major themes include:

A sustained decline in oil prices will have a negative impact on the energy sector (particularly on

oil exploration and production), but will translate into higher consumer spending in the first half

of the year (as consumers benefit from lower gasoline prices).

The beneficial effect of lower gas prices will wane as oil prices and spending habits adjust over

time; however, improving economic fundamentals, particularly in the labor market (e.g., strong

job growth and increases in average wages) will help make up for this reduced impact in the

second half of the year.

Ultimately, the Federal Reserve will increase interest rates in 2015 as improving economic

conditions warrant (i.e., an increase would “be a natural consequence of an improving economic

outlook”) – likely in June, July, or September.

All in all, the Raymond James analysts expect quarterly real GDP (gross domestic product, or the

total value of goods and services produced during a given time interval) to be in the 2.5% to 3.0% range

and unemployment to decrease into the low 5.0%s as we move forward throughout the year; how these

measures truly progress will depend on our actual experiences as to how the above themes play out.

From a “what could go wrong” perspective, there are a handful of items that might derail these

projections and lead to a significant deviation from our anticipated course for 2015. Among these are:

Unanticipated weakness in our domestic economy (i.e., lower‐than‐expected GDP, weaker labor

metrics including muted wage growth, etc…), which would suggest that any near‐term interest

rate increase would be premature.

Any flare up of existing or appearance of new geopolitical tensions around the world (e.g., the

situation in Ukraine or actions of the Islamic State), which could unsettle the financial markets

(as they did this past summer).

A continued slowdown in global growth and overseas economic weakness, which could have a

substantial impact on many US companies and the US economy as a whole (offsetting any

positive advances in our domestic picture).

Managing the expectations of the investment community may prove to be a significant

challenge for the Federal Reserve, and investment markets may turn choppy in response to any

anticipated change in monetary policy. An overreaction among investors may lead to a delay in

interest rate hikes.

Of the above, the threat of slowing global growth (particularly in Europe) is perceived as the

most immediate – and most impactful – risk. Overall, The Raymond James outlook for 2015 is

optimistic, particularly on the domestic side, but with a number of uncertainties that could significantly

change our experiences as investors (especially as they relate to interest rate decisions by the Federal

Reserve – arguably the most important event in the coming year for the global investment markets).

From an investment standpoint, Raymond James analysts expect the return on US stocks (as

determined by the S&P 500) to be fairly close to its historical average of 10%, give or take. They predict

that the bulk of those returns will be earned in the front half of the year, after which rising interest rates

may hinder additional growth to some extent. They expect it to be somewhat of a “rising tide” type of

market, where many different types of stocks (growth, value, capitalization size etc…) have the potential

to do well. Should the economy continue to improve and the anticipated Federal Reserve rate hike

materialize, bond yields are forecasted to be higher (which translate to lower bond prices, as the yield

on a bond and its price move inversely to one another) by year‐end. The picture internationally is far

murkier, as it depends heavily on what additional policy measures central banks around the world

(particularly in the European Union, Japan, and China) adopt as their respective conditions improve or

deteriorate.

What it means to you as an investor.

I’ve never been a proponent of trying to manage financial plans and investments on the basis of

what “might” or “could” happen in the near future – there are simply too many variables for anyone to

precisely predict what will happen at any point in the future. While any one forecaster might get it right

occasionally, no one individual has ever hit the proverbial nail on the head every single time (which is

why the concept of market timing has generally proven to be a poor approach to managing money over

the long‐term). In my opinion, investors are far better served by 1) funding and maintaining an

adequate cash cushion or “emergency fund” that addresses their immediate liquidity needs (thereby

reducing the panic that comes with short‐term investment losses), and 2) establishing an investment

plan that takes into consideration their individual time horizon(s), tolerance for loss, and rate of return

necessary to achieve their goal(s).

When I try and get a sense of what the year ahead may look like, I’m struck by the similarities of

our current situation with that of 2013, when the investors spent much of the year fretting over when

the US Federal Reserve (the “Fed”) would begin tapering its quantitative easing program (recall that the

Reserve did finally announce the taper in December, though the actually decrease in bond‐buying didn’t

start until the following January 2014). Though the Fed tried to pick and choose its words carefully

when discussing the prospect of tapering, market participants reacted quickly and forcefully (often with

no solid reason) to any possibility of policy change, whether or not that change actually materialized. I

think our experience in the month(s) ahead will be very similar (i.e., we can simply replace the idea of

tapering with the present‐day concern of increasing interest rates, and expect to see very reactive stock

and bond markets as we nervously approach our day of interest rate‐reckoning). Likewise, I believe that

much of our experience with international investments will be dictated by immediate policy decisions

made by various central banks (e.g., if the European Central Bank – the ECB – implements a long‐

anticipated program of quantitative easing). We won’t have to wait long to get our first taste of these

issues – both the Fed and the ECB have policy meetings scheduled for late January.

To me, these will be the biggest stories of the coming year – how the collective investment

community reacts to 1) the suggestion (and eventual implementation) of increasing interest rates, and

2) policy actions (or the lack thereof) by central banks around the world. As far as interest rates are

concerned, if recent past is prelude the answer is not positively (at least initially). From a longer‐term

perspective, an increase in interest rates is a good thing – it means our economy is becoming healthy

enough to stand on its own, without the help of excessive monetary stimulus. However, some investors

have shown a propensity to lose sight of the future and react to the here‐and‐now. As long‐term

investors, I strongly encourage you NOT to do that. Instead, I’d recommend that you ask yourself if your

portfolio remains properly allocated in the context of your plan and your needs and wants. Only after

careful contemplation and examination of your financial plan should you commit to a substantial change

in your approach to investing.

If you do find yourself in that position (perhaps due to a change in your personal outlook, a

significant life event, or a new goal/wish you’d like to fulfill), please give me a call. Everyone wants to

start the New Year off on the right track, and I’d love to help make that happen for you financially.

Investment Strategy Published by Raymond James & Associates

Please read domestic and foreign disclosure/risk information beginning on page 3 and Analyst Certification on page 3.

© 2014 Raymond James & Associates, Inc., member New York Stock Exchange/SIPC. All rights reserved.

International Headquarters: The Raymond James Financial Center | 880 Carillon Parkway | St. Petersburg, Florida 33716 | 800-248-8863

Jeffrey D. Saut, Chief Investment Strategist, (727) 567-2644, [email protected]

December 1, 2014

Investment Strategy __________________________________________________________________________________________

"2015?"

Year-end letters are always difficult to write because there is a tendency to discuss the year gone by, or worse, try and predict what is going to happen in the New Year. I mean really, at this time last year who predicted Russia would invade Crimea, that ISIS would effectively take over a significant portion of Iraq, or the Republicans would sweep Congress. Actually I did get the last one right given my mantra that, “We are going to elect smarter policymakers and therefore get smarter policies.” Coming into 2014, in all of my presentations I noted that despite the “tapering” announcement, the Fed’s balance sheet was likely going to increase by 10% - 12% and the S&P 500’s earnings were going to increase by roughly the same amount. I further opined there has been a fairly tight correlation between those data points and how much the S&P 500 (SPX/2067.56) gains during the year. Accordingly, my guess was that the SPX would gain somewhere between 10% and 12%. As of this writing that looks close enough for government work.

In retrospect one of my worse calls was to avoid Utilities because I thought interest rates were going to rise. With a nearly 20% gain YTD the Utility sector has been one of the best performing macro sectors, while obviously my interest rate call was equally as poor. However, I did get most of the other sectors generally correct. Also coming into 2014 I wrote:

The S&P 500 was better by 32.4% last year (2013), and up over 45% from the June 2012 low without any meaningful correction. The median historical drawdown following such a rally called for between a 5% and 7% decline in the first three months of this year and between a 10% and 12% pullback sometime during the year. But, such a drawdown/pullback should be viewed within the context of a secular bull market.

Well, we got the 5% - 7% pullback in the first three months of the year (6%), and I thought the 10% - 12% had commenced in July when we started experiencing various divergences. Recall the small/mid-capitalization stocks were declining while the large caps were hovering near their highs. Additionally, my Advance/Decline Line Indicator was not confirming the SPX’s upside move and the U.S. Dollar Index was screaming higher. Subsequently I said that if you have stocks in your portfolio that have not performed over the past two years there is likely something wrong and you should sell them to raise some cash. Plainly that “call” proved premature, but came home in spades from mid-September into mid-October where the SPX lost 9.84% from intraday highs to intraday lows. On October 15, 2014 my colleague Andrew Adams and I did a special conference call on behalf of the Raymond James Investment Strategy Committee. Their concern was, “Should we sell stocks?” Our advice was a resounding NO! We stated the time to sell stocks, and raise some cash, was back in July and August, not after a nearly 10% decline that had left the equity markets as oversold as they have been since October 2011. In fact, we espoused that this is how bottoms are made; and while the bottoming process was not textbook, hereto it was close enough for government work.

So, here we are entering the month of December, which historically is a pretty strong month for the equity markets. According to “Moneychimp,” since 1950 the SPX has been “up” during December 49 years and “down” 15 years with an average monthly gain of 1.62%. I would note that if there is going to be some pre-Santa rally weakness, it historically comes in the first two weeks of December. If those historical odds hold this year, it is going to put tremendous pressure on the 90% of money managers that are underperforming their respective benchmarks. Indeed, even from most financial advisors I get the question, “Would you please explain in one of your letters why our portfolios are underperforming the S&P 500.” The answer to said question is pretty easy. You probably have too much cash and have too big a position in international investments. I would suggest advisors tell their clients just what their benchmark is. Additionally, if you are underperforming, but doing so with half of the S&P 500’s “risk” (beta), then you are a “risk-adjusted” financial advisor and have nothing to apologize for to your clients.

Going into the new year presents some headwinds. My biggest concern lies with Washington, D.C. If our president continues to “dig in his heels,” it could damage the economy. Exing that, earnings should continue to grow at a high single-digit pace and revenue growth should accelerate. While the impact of a stronger U.S. dollar, a gradual increase in wages, and higher interest rates will also represent headwinds, these should be more than offset by stronger GDP growth, better productivity, and continued elevated profit margins. Moreover, due to strong earnings growth valuations still look reasonable. Finally, in

Raymond James Investment Strategy


International Headquarters: The Raymond James Financial Center | 880 Carillon Parkway | St. Petersburg, Florida 33716 | 800-248-8863 2

the U.S. investors are sitting on $11 trillion dollars in cash earning a zero return. As fears of the 2008 financial fiasco dissipate, this cash is likely going to find its way into stocks. Given these thoughts, I believe it is reasonable for the S&P 500 to achieve a total return in 2015 close to its historical (since 1921) 10.4% per annum return. The bulk of this return should come in the first half of 2015 and then grind higher in the second half as interest rates rise, causing P/E ratios to marginally contract. I think 2015 will be a year that favors cyclical stocks over the defensive names as the economy continues to strengthen. Large capitalization stocks have clearly outperformed the small/mid-cap complex, but I believe we are at the stage of the secular bull market where everything is going to work. I also think growth stocks look cheaper than value stocks.

As for the here and now, while the SPX grinded its way higher last week, the real show was in the crude oil futures market. By now everybody knows that OPEC did not cut production following Thursday’s meeting and the result was a weekly wilt (-13.72% spot oil) in crude oil prices. In fact, in the last 30 minutes of trading on Friday it was an oil “smack down” that had the feel of capitulation. Rude crude’s slide of some 39% from its June high has had a devastating effect on the energy stocks, leaving the S&P Energy Sector off 9.45% last week. Consequently, it is the ONLY macro sector, at least by my work, that is currently oversold. Accordingly, I think some of the energy stocks are currently very attractive. If you are considering the Master Limited Partnership (MLP) space, the idea of averaging down in Yorkville’s two ETFs makes sense to me. The two ETFs in question are 10.4%-yielding YMLP ($14.84) and 5.7%-yielding YMLI ($21.81). If you own these two in equal dollar amounts you own the entire MLP space. Further, they are structured as C-corps, meaning there is no K-1 to be filed. Moreover, much of the dividend distribution is classified as return-of-capital and are therefore tax deferred (for more tax info please consult your tax attorney). I continue to think crude oil is in a bottoming phase and would advise clients to purchase at least half positions in the energy space with the idea of completing the other half of those purchases during tax loss selling season in the weeks ahead because this is how bottoms are made!

The call for this week: As usual, I will be in NYC this week seeing portfolio managers, doing media, and speaking at a conference. If there is going to be any stock market weakness, at least on a trading basis, it should come this week into next week. From there the seasonality should have an upward bias buoyed by the “Santa Rally.” As for oil, it is now quite apparent that Saudi Arabia is using it as a weapon for whatever reason. Many reasons have been offered in these missives over the past few months, but the Saudis’ action last week, when they knew those actions would accelerate oil’s price decline, makes it clear there are political reasons afoot. This morning Japan’s debt is downgraded, Europe’s factory output weakens, emerging markets get hammered, there is a Russian Rouble rout, October U.S. oil shale permits decline, Hong Kong warns protestors, and all of this has the preopening SPX futures down 9 points at 5:00 a.m. Indeed, if we are going to get weakness it should be in the first two weeks of December.




Important Investor Disclosures Raymond James & Associates (RJA) is a FINRA member firm and is responsible for the preparation and distribution of research created in the United States. Raymond James & Associates is located at The Raymond James Financial Center, 880 Carillon Parkway, St. Petersburg, FL 33716, (727) 567-1000. Non-U.S. affiliates, which are not FINRA member firms, include the following entities which are responsible for the creation and distribution of research in their respective areas; In Canada, Raymond James Ltd. (RJL), Suite 2100, 925 West Georgia Street, Vancouver, BC V6C 3L2, (604) 659-8200; In Latin America, Raymond James Latin America (RJLatAm), Ruta 8, km 17, 500, 91600 Montevideo, Uruguay, 00598 2 518 2033; In Europe, Raymond James Euro Equities, SAS (RJEE), 40, rue La Boetie, 75008, Paris, France, +33 1 45 61 64 90.

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The views expressed in this report accurately reflect the personal views of the analyst(s) covering the subject securities. No part of said person's compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this research report. In addition, said analyst has not received compensation from any subject company in the last 12 months.

Ratings and Definitions

Raymond James & Associates (U.S.) definitions

Strong Buy (SB1) Expected to appreciate, produce a total return of at least 15%, and outperform the S&P 500 over the next six to 12 months. For higher yielding and more conservative equities, such as REITs and certain MLPs, a total return of at least 15% is expected to be realized over the next 12 months. Outperform (MO2) Expected to appreciate and outperform the S&P 500 over the next 12-18 months. For higher yielding and more conservative equities, such as REITs and certain MLPs, an Outperform rating is used for securities where we are comfortable with the relative safety of the dividend and expect a total return modestly exceeding the dividend yield over the next 12-18 months. Market Perform (MP3) Expected to perform generally in line with the S&P 500 over the next 12 months. Underperform (MU4) Expected to underperform the S&P 500 or its sector over the next six to 12 months and should be sold.




Suspended (S) The rating and price target have been suspended temporarily. This action may be due to market events that made coverage impracticable, or to comply with applicable regulations or firm policies in certain circumstances, including when Raymond James may be providing investment banking services to the company. The previous rating and price target are no longer in effect for this security and should not be relied upon. Raymond James Ltd. (Canada) definitions

Strong Buy (SB1) The stock is expected to appreciate and produce a total return of at least 15% and outperform the S&P/TSX Composite Index over the next six months. Outperform (MO2) The stock is expected to appreciate and outperform the S&P/TSX Composite Index over the next twelve months. Market Perform (MP3) The stock is expected to perform generally in line with the S&P/TSX Composite Index over the next twelve months and is potentially a source of funds for more highly rated securities. Underperform (MU4) The stock is expected to underperform the S&P/TSX Composite Index or its sector over the next six to twelve months and should be sold. Raymond James Latin American rating definitions

Strong Buy (SB1) Expected to appreciate and produce a total return of at least 25.0% over the next twelve months. Outperform (MO2) Expected to appreciate and produce a total return of between 15.0% and 25.0% over the next twelve months. Market Perform (MP3) Expected to perform in line with the underlying country index. Underperform (MU4) Expected to underperform the underlying country index. Suspended (S) The rating and price target have been suspended temporarily. This action may be due to market events that made coverage impracticable, or to comply with applicable regulations or firm policies in certain circumstances, including when Raymond James may be providing investment banking services to the company. The previous rating and price target are no longer in effect for this security and should not be relied upon.

Raymond James Euro Equities, SAS rating definitions

Strong Buy (1) Expected to appreciate, produce a total return of at least 15%, and outperform the Stoxx 600 over the next 6 to 12 months. Outperform (2) Expected to appreciate and outperform the Stoxx 600 over the next 12 months. Market Perform (3) Expected to perform generally in line with the Stoxx 600 over the next 12 months. Underperform (4) Expected to underperform the Stoxx 600 or its sector over the next 6 to 12 months. Suspended (S) The rating and target price have been suspended temporarily. This action may be due to market events that made coverage impracticable, or to comply with applicable regulations or firm policies in certain circumstances, including when Raymond James may be providing investment banking services to the company. The previous rating and target price are no longer in effect for this security and should not be relied upon. In transacting in any security, investors should be aware that other securities in the Raymond James research coverage universe might carry a higher or lower rating. Investors should feel free to contact their Financial Advisor to discuss the merits of other available investments.

Rating Distributions

Coverage Universe Rating Distribution Investment Banking Distribution

RJA RJL RJ LatAm RJEE RJA RJL RJ LatAm RJEE

Strong Buy and Outperform (Buy) 55% 64% 50% 45% 24% 34% 0% 0%

Market Perform (Hold) 41% 34% 50% 43% 8% 25% 0% 0%

Underperform (Sell) 4% 2% 0% 13% 0% 0% 0% 0%

Suitability Categories (SR)

Total Return (TR) Lower risk equities possessing dividend yields above that of the S&P 500 and greater stability of principal.

Growth (G) Low to average risk equities with sound financials, more consistent earnings growth, at least a small dividend, and the potential for long-term price appreciation.

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Venture Risk (VR) Companies with a short or unprofitable operating history, limited or less predictable revenues, very high risk associated with success, and a substantial risk of principal.




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Risk Factors

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Scott J. Brown, Ph.D., (727) 567-2603, [email protected] December 18, 2014

Monthly Economic Outlook ____________________________________________________________________________________

The 2015 Outlook – Many Moving Parts What’s going on in the rest of the world will be a key factor

for investors in 2015. Soft global growth is expected to have a mixed impact on the U.S. economy. There is some risk of increased geopolitical tensions and financial disruptions.

A sustained decline in crude oil prices will have a negative impact on the U.S. energy sector, but lower gasoline prices should provide significant positive benefits to consumers and businesses.

The Federal Reserve is expected to begin normalizing monetary policy. Managing financial market expectations is likely to prove one of the biggest challenges in 2015. The recovery has faced strong headwinds in the last few years – a major housing correction, a deleveraging in the financial system, tighter fiscal policy at the federal, state, and local level. With those headwinds largely out of the way, growth was widely expected to pick up in 2014. However, there were new constraints – bad weather in the first quarter, a softer global economy, and lackluster wage growth. By far, the biggest surprise in 2014 was the decline in long-term interest rates. Instead of rising to 3.5% or more, as many had expected, the 10-year Treasury note yield is a lot closer to 2.0%. That’s not what usually happens in a strengthening economy. The drop is interesting if you think of the 10-year Treasury note as a 5-year note plus an implied 5-year note five years into the future. The 5-year Treasury note yield is currently about where it was at the end of last year, trending roughly flat over the course of the year. In contrast, the implied 5-year Treasury note yield five years ahead has declined significantly. Why is that? Investors could be less fearful of higher future inflation, or perhaps they see a lower long-term growth path for the U.S. economy. Inflation compensation measures, calculated from inflation-adjusted Treasuries, have declined over the last several weeks.

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Treasury Yields, %

Source: Federal Reserve, Raymond James

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5 to 10 year horizon

5 year horizon

Source: Federal Reserve, Raymond James

low long-term inflation expectations could be a problem for the Fed

Central bankers know that real (that is, inflation-adjusted) interest rates are what matters for the economy. All else equal, a drop in inflation expectations means higher real interest rates, implying somewhat slower growth. This is a much bigger deal for the euro area. For the U.S., the situation bears watching closely, but “inflation compensation,” the rate implied by comparing inflation-adjusted Treasuries to regular fixed-rate Treasuries, doesn’t actually measure inflation expectations. The drop could reflect distortions from a flight to safety into fixed-rate Treasuries, which are more liquid.

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Annual Job Gains, million

Govt

Private

first 11 months

source: BLS

The drop in bond yields is odd given the relative strength of the U.S. economy. We’ve already added more jobs in the first 11 months of 2014 than in any full year since 1999. Job destruction remains very low by historical standards. New hiring has gradually picked up. Yet, public perceptions of the economy’s strength remain generally poor. That’s not unusual; perceptions of economic strength typically lag in a recovery. Additionally, long-term unemployment and underemployment remain elevated and wage growth has been subpar.

Raymond James Economic Research



Average hourly earnings have been rising at a 2% annual rate over the last few years, barely keeping pace with inflation. Under “normal” labor market conditions, workers would be expected to share in productivity gains and compensation would rise 3.5% to 4.0% per year. In turn, the increase in purchasing power would fuel strong consumer spending growth (and remember, consumer spending accounts for 70% of Gross Domestic Product). Instead, consumer spending has been driven largely by job growth. Weak wage growth has also been a factor in the lackluster recovery in the housing sector, limiting affordability and leading to less improvement in homeowners’ ability to service mortgage debt.

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Average Hourly Earnings, y/y % change, smoothed

nominal

real

Source: BLS

The price of oil is often a wildcard in the economic outlook. The plunge in oil prices caught many investors off guard in late 2014. Some of the decline reflects the increase in U.S. production, but most appears to be a symptom of weaker global demand. Emerging economies were expected to account for much of the global growth over the next few decades, but they’ve been unexpectedly weak.

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2013 2014 2015

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120Crude Oil Prices, $

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WTI

Source: Raymond James

The drop in oil prices should have a substantial negative effect on U.S. exploration and production. Energy extraction has been a rapidly growing area of the economy, with job growth roughly 5.5 times that of overall nonfarm payrolls since 2009. However, oil and gas extraction payrolls were 215,200 in November, just 0.15% of total nonfarm payrolls. Even if you

add twice that in support jobs, you’re still talking about a small fraction of U.S. employment. The bigger impact will be in capital spending. Energy-related structures and equipment accounted for 6.8% of business fixed investment (or 0.9% of GDP) in 3Q14. That will be missed. Low oil prices are expected to have a significant impact on certain regions of the country and we may see some decrease in tax revenues and problems at local banks. However, the negative impact on the overall economy should be relatively limited. The impact of lower gasoline prices on the consumer depends on how low prices go and how long they stay low. The futures market (which doesn’t necessarily provide accurate forecasts) suggests that oil prices will remain low for a few years (WTI below $65 at the end of 2016, but that outlook can change quickly). The impact on spending shows up with a lag (the 13-week average is a good gauge to use). While the decline in gasoline prices is somewhat supportive for spending during the critical holiday shopping period, we should see a more significant impact in the first half of 2015.

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Average Price of Regular Gasoline, $ per gallon

Regular Gasoline

13-week average

Source: Energy Information Administration

A $1 decline in gasoline prices is equivalent to about $100 billion per year in spending (that’s 0.8% of consumer spending or about 0.6% of GDP). Spending less on gasoline, consumers will have more money to spend on other things. For someone who works 25 miles from home and gets 20 miles per gallon, a $1 decline in gasoline prices would free up about $50 per month (twice that for a two-income household). Lower oil prices will help reduce transportation costs for businesses and should benefit energy-intensive manufacturing. However, most large firms, such as airlines, hedge their energy costs out into the future, so it will likely be some months before we see the full effect. Outside the U.S., the impact of a sustained decline in oil prices will be mixed. Energy producers, such as Venezuela, Iran, Nigeria, and Russia, will have a harder time. Energy importers, such as China and Japan, stand to benefit. Ultimately, supply and demand should push oil prices toward equilibrium, but it may take some time for the market to determine where that is. However, in the near term, lower oil prices should be a net benefit to the U.S. economy.




U.S. financial markets were rocked by the increase in geopolitical tensions in the summer of 2014. The situation in Ukraine and the troubles with the Islamic State have not gone away, although the financial markets have paid less attention in recent months. These tensions could intensify and new ones, made worse by the drop in oil prices, could appear, adding to financial market volatility over the course of 2015. The slowdown in global growth has been a more immediate concern. The euro area has been flirting with recession. China and other emerging economies are dependent on exports and have yet to develop sufficient domestic demand. So, sluggishness in the advanced economies hasn’t helped. In early October, the International Monetary Fund downgraded the outlook for global growth. However, the greater worry was the increase in downside risks. Europe’s crisis has entered a new, potentially more dangerous phase. Initially, the crisis was about the survivability of the monetary union. However, European Central Bank President Mario Draghi’s promise to do whatever it takes to keep the currency union intact effectively put that worry to bed. In the meantime, austerity, the result of a misdiagnosis of the problem (it’s a capital crisis, not a sovereign debt crisis), weakened Europe’s recovery from recession. Now the euro area faces the possibility of deflation and an extended period of economic stagnation. The ECB is expected to launch its version of quantitative easing in early 2015, but the fear is that this may be too little, too late, to do much good.

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Trade-Weighted U.S. Dollar

vs. Major Currencies:(Canada, euro area, Japan, U.K., Switzerland, Australia, Sweden)

(Mar-73=100)

str

onger

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r

source: Federal Reserve

Weak global growth will have a significant impact on many U.S. firms (which should be more apparent in 1Q15 earnings). Overseas earnings are likely to slow or decline, while the stronger currency will reduce the dollar value of any given level of foreign earnings. Exports are likely to soften, while imports should increase, subtracting from GDP growth in 2015 (domestic demand should remain relatively strong). Weaker global growth also provides benefits to the U.S. Commodity prices, oil prices in particular, have fallen, boosting consumer spending growth. Capital inflows will pick up as trade outflows increase. Lower long-term interest rates abroad put some downward pressure on U.S. bond yields (lower mortgage rates than would occur otherwise).

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Single-family Permits and New Home Sales, th.

Building Permits

New Home Sales

source: Bureau of Census

The housing market recovery was disappointing in 2014, restrained by a variety of factors. Supply issues (a lack of available lots on which to build, a scarcity of skilled labor, higher costs for materials, and tight bank credit) were a problem for many homebuilders in the first half of the year, but constraints are now less binding. Strong job growth would normally be a significant positive factor for the housing market, but affordability was reduced by 2013’s taper tantrum (higher mortgage rates) and by an increase in home prices into the first half of the year. Affordability has now improved, mortgage credit is getting gradually easier, and job growth is expected to remain strong in 2015. However, weak growth in average wages has been a drawback for the mid-range of the market.

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Motor Vehicles Sales, million, seas.-adj. annual rate

Domestic Autos

Domestic Light Trucks

Imports

12- mo. total source: BEA

Increased autos sales and production have been important to the economic recovery. Improvement has been due to two key factors: cars get old and have to be replaced; and banks are very willing to make auto loans (it’s a lot easier to repossess a car than a home). However, the pace of vehicle sales, now nearing the pre-recession average, may be reaching equilibrium. With sales stabilizing, motor vehicles should provide less support to GDP growth in 2015. Overseas economic weakness and a strong dollar are expected to widen the trade deficit in 2015, which will subtract from overall GDP growth. However, Domestic Final Sales (GDP less net exports and the change in inventories) is likely to be relatively strong over the course of the year.




With short-term interest rates at exceptionally low levels and its balance sheet expanded well beyond normal, the Federal Reserve is expected to begin normalizing monetary policy in 2015. Over the last several months, Fed officials have mapped out a broad strategy for how this will be done. The Federal Open Market Committee is expected to announce a target range for the federal funds rate (rather than a specific level), with the interest rate paid on excess bank reserves held at the Fed (IOER) at the top of that range. Sometime after the first increase in short-term rates, the Fed is expected to end the current program of reinvesting mortgage principal payments and maturing Treasury securities in its portfolio. The size of the Fed’s balance sheet will then decrease naturally, a process that is expected to take several years. The key questions for the financial markets are when the Fed will begin raising short-term rates and how rapidly. In the December 17 monetary policy statement, the FOMC abandoned its conditional commitment to keep rates low for “a considerable time,” instead saying that it could “be patient” in beginning to normalize policy. Yet, the FOMC emphasized that this new language did not represent any change in its policy intentions. Fed officials are unanimous in their view that future policy moves will be data-dependent. However, some are more patient than others. Two hawks (Plosser, Fisher) and one dove (Kocherlakota) will roll off the FOMC in 2015, replaced by one hawk (Lacker) and two doves (Evans, Williams).

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Target Federal Funds Rate at Year-End, %


each point represents a projection by a Fed governor or district

bank president

Dec. 17, 2014 Projections

Fed officials’ projections of the appropriate federal funds rate for the end of 2015 and the end of 2016 are still dispersed, suggesting that officials have different views on the amount of slack in the economy and how rapidly that slack will be taken up in the months ahead. The dots in the dot chart imply that officials may be gravitating toward two camps, one wanting to raise rates sooner, the other later. The impact of monetary policy has a long and variable lag. However, the risks around the timing of the first rate hike are not symmetric. If the Fed hikes too soon, and the economy slows, it will have a limited ability to change course (rates are already low and nobody wants to embark on another round of quantitative easing). In contrast, if the Fed hikes too late, and inflation picks up more than intended, it can easily raise rates to correct course.

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Source: Federal Reserve

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December 17, 2014

central tendency

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PCE Price Index


How do low oil prices factor into the Fed’s decision? Not as much as one might think. The Fed sees the drop in oil prices as transitory. Oil prices are not going to fall forever. Overall inflation will be lower for some time and we could see that feed through to a decrease in core inflation. However, lower oil prices will also stimulate growth and should help reduce the amount of slack in the economy. The Fed keeps a close eye on inflation expectations, but officials don’t seem to be too worried by the market-based decline in long-term inflation compensation (the difference in yields between inflation-adjusted Treasuries and fixed-rate Treasuries), which, according to Fed Chair Yellen, could reflect a decrease in perceived inflation risk or a flight to safety into fixed-rate Treasuries. In her press briefing, Yellen dispelled a couple of popular misconceptions about future Fed decisions. One is that the Fed could raise rates at any policy meeting, not just the ones with a press conference. The other is that, once the Fed begins policy normalization, it may not raise rates at a “measured” pace (25 basis points per FOMC meeting). In a recent speech, NY-Fed President William Dudley noted that the Fed also has to react to a possible overreaction or incorrect reaction to Fed policy. For example, bond yields rose (and credit tightened) in the taper tantrum, but then fell when the Fed actually reduced the monthly pace of asset purchases. However, the decision to begin raising short-term rates should be less confusing for the markets than quantitative easing.




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Federal Reserve Projections of the Unemployment Rate (4Q)December 17, 2014

range of forecasts

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history


The Fed’s views on the labor market will play a central role in monetary policy deliberations in 2015. In their December 17 projections, senior Fed officials expect a further decline in the unemployment rate (5.8% in November) in 2015, likely edging below what the Fed considers to be a long-term sustainable rate in 2016 and 2017. That doesn’t mean that the Fed will be trading off higher inflation for a lower unemployment rate. Rather, the unemployment rate is a distorted measure of labor force utilization. Specifically, there are a lot of people on the sidelines, not officially counted as “unemployed,” but who would take a good job if one were available. These include the long-term jobless who have given up looking for work, as well as recent retirees and stay-at-home spouses.

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Employment / Population, %

Aged 25-54 (left)

Total (right)

source: Bureau of Labor Statistics

The employment/population ratio is the preferred measure of labor utilization. This ratio has improved over the last year, suggesting that labor market slack is being gradually reduced, but a lot of slack remains. Bear in mind that as the baby boomers move into retirement, labor force participation should decline. Participation fell more than three percentage points in the recession. Perhaps a third of that was due to the demographics. Improvement in the employment/population ratio has been more pronounced for the key age cohort, those aged 25-54 (where retirement isn’t much of an issue). At the same time, unemployment rates for teenagers and young adults, while lower, are still relatively high.

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Source: Kansas City Fed

There are many job market indicators. The Kansas City Fed’s Labor Market Conditions Index, which is a composite of 24 of them, provides a convenient summary (according to Fed Chair Yellen). The level suggests that a lot of slack remains, while the momentum gauge has been relatively strong. At this pace, the job market ought to be close to normal in early 2017.

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source: BLS

One clear sign of labor market slack is the lackluster pace of wage growth. Normally, labor compensation costs would increase at an annual rate of about 3.5%, as workers share in productivity gains. The recent pace has been around 2%, barely keeping pace with inflation. For an individual business, this is a zero-sum game. That is, profits decline if workers are paid more. In the aggregate, it’s not a zero-sum game, as wage increases get spent back into the economy. Income inequality has been an important topic this year, but one that failed to gain much traction in the U.S. The bigger concern has been the apparent “whittling away” of the middle class. Many observers fear a decline in mobility. Weak growth in average wages has been a limiting factor for consumer spending and housing. Yet, wage growth should take care of itself as the labor market tightens. There are already reports of better wage growth for many skilled labor positions, but a broader pickup in average wages may not come until the second half of 2015 or later. Uncertainty over wage growth will be another important factor in the Fed’s monetary policy decisions.




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Total Net Borrowing


The recession can be characterized largely as an unwinding of a housing bubble and a massive deleveraging in the financial system (roughly matched by a large, temporary increase in government borrowing). Credit growth now appears to be relatively well-balanced (although the housing sector has remained somewhat soft) and should help to support an expansion in the domestic economy in 2015. There’s no need for the Fed to hit the brakes, but it certainly has to consider taking the foot off the gas pedal at some point. Republicans will control both chambers of Congress in 2015. However, we’re unlikely to see a new era of bipartisanship. Republicans (like Democrats) have their own internal divisions. They do not have a 60-seat super-majority in the Senate, which means that Democrats can still bog things down, and they do not have the two-thirds majority needed in both chambers to override a presidential veto. Next year is likely to be dominated by posturing ahead of the 2016 presidential election. Don’t expect much.

The battle over the FY15 budget has been settled, but the debt ceiling could be a sticking point in 2015. The debt ceiling is currently waived, but will go back into effect on March 18. The debt ceiling will then be whatever the level of the national debt is at that time. Treasury can then use creative accounting to fund the government, and April tax payments will help, but a drop-dead date on the debt ceiling will likely be reached in the late summer or early autumn. There’s some chance of another unnecessary showdown over the debt ceiling next summer, but investors have experienced this nonsense before, and ought to take such disruptions in stride. Corporate cash flows and profits are likely to be mixed in 2015, reflecting weak economic growth in the rest of the world and solid strength at home. In turn, business fixed investment is likely to be uneven across both time and industries. Data on factory orders and shipments through October suggest relatively poor momentum for capital spending in the near term. Small business, which has struggled with tight credit in the recovery, is poised to pick up and should account for much of the job growth over the course of the year.

Forecasting, as everyone should know, is not clairvoyance. We can piece together a coherent story of what to expect in 2015, but that should be viewed as a base-case scenario. Clearly, there are many moving parts and those parts have interactions that may evolve in unpredictable ways in the months ahead. The global economy is expected to remain soft, but there are important downside risks and some possibility of wider-scale financial problems (to which the U.S. would not necessarily be immune). Lower oil prices should be a net positive for the domestic economy. The job market should continue to improve. Fed policymakers are likely to be somewhat cautious as they begin to normalize policy. It’s an optimistic outlook, but one with a number of uncertainties.

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consumer durables 0.2 1.0 0.6 0.2 0.5 0.5 0.4 0.4 0.4 0.5 0.5 0.5 0.4 nondurables & services 0.6 0.8 0.9 1.5 1.6 1.6 1.3 1.4 1.4 1.2 1.1 1.4 1.4 bus. fixed investment -0.1 1.2 0.9 0.4 0.5 0.8 0.7 0.6 0.6 0.3 0.6 0.7 0.7 residential investment -0.2 0.3 0.1 0.4 0.3 0.3 0.2 0.2 0.2 0.3 0.1 0.3 0.2 government -0.2 0.3 0.8 0.0 0.2 0.2 0.2 0.2 0.2 -0.4 0.0 0.2 0.2 Domestic Final Sales 0.7 3.4 3.2 2.5 3.2 3.4 2.9 2.8 2.8 1.9 2.2 3.1 2.8 exports -1.3 1.4 0.7 0.4 0.3 0.3 0.4 0.4 0.4 0.4 0.4 0.5 0.4 imports -0.4 -1.8 0.1 -0.8 -0.7 -0.7 -0.6 -0.6 -0.6 -0.2 -0.6 -0.6 -0.6 Final Sales -1.0 3.2 4.1 2.2 2.9 3.0 2.7 2.6 2.6 1.8 2.1 3.0 2.6 ch. in bus. inventories -1.2 1.4 -0.1 0.0 -0.2 -0.3 0.0 0.0 0.0 0.0 0.1 -0.1 0.0 Unemployment, % 6.7 6.2 6.1 5.8 5.5 5.4 5.3 5.2 5.1 7.4 6.2 5.4 5.3 NF Payrolls, monthly, th. 190 267 224 255 170 230 210 200 190 194 234 203 208 Cons. Price Index (q/q) 1.9 3.0 1.0 -1.2 -0.3 1.7 1.8 1.8 1.9 1.5 1.6 0.7 1.9 excl. food & energy 1.6 2.5 1.3 1.6 1.6 1.7 1.8 1.8 1.9 1.8 1.8 1.7 1.9 PCE Price Index (q/q) 1.4 2.3 1.3 -0.1 0.3 1.5 1.6 1.6 1.7 1.2 1.4 0.9 1.7 excl. food & energy 1.2 2.0 1.4 1.6 1.5 1.6 1.6 1.6 1.7 1.3 1.4 1.6 1.7 Fed Funds Rate, % 0.07 0.09 0.09 0.09 0.17 0.20 0.28 0.74 1.23 0.11 0.09 0.35 1.97 3-month T-Bill, (bond-eq.) 0.1 0.0 0.0 0.0 0.1 0.2 0.4 0.9 1.3 0.1 0.0 0.4 2.1 2-year Treasury Note 0.4 0.4 0.5 0.5 0.8 1.4 1.8 2.2 2.6 0.3 0.5 1.6 2.8 10-year Treasury Note 2.8 2.6 2.5 2.3 2.5 2.8 3.0 3.1 3.4 2.4 2.5 2.9 3.5

and the month that will be. quick hits · the beneficial effect of lower gas prices will wane as...

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