- The roots of the US and world economic recoveries go well beyond a loose Federal Reserve.
- Oil, housing, advanced manufacturing, improved balance sheets and laboUr flexibility will drive the US economy.
- A weaker China, a tougher Fed and a tightening US federal fiscal policy will keep a lid on short-term economic activity, but don't be fooled: The long-term fundamentals are strong.
The famous book and movie The Wizard of Oz bears a lot of similarity to the relationship between the US economy and the US Federal Reserve. In the story, the Wizard hides behind a curtain and manipulates a bunch of levers to produce a lot of scary images and sounds that thoroughly frighten the citizens of Oz. The people are convinced of the Wizard's powers, both good and bad, to change their world.
Although the Fed has certainly tried to be transparent about its manoeuvres, it indeed still hides behind a curtain and is still thought to be all-powerful. The Fed's behind-the-scenes manoeuvres remain less than well understood by the people, who still shake in fear every time the Federal Reserve chairman pulls a lever.
But most interesting to me is the very end of the story, when the great Wizard is discovered to be a mere mortal. When Dorothy and her crew of travellers further press that their wishes be granted, the Wizard makes a critical and stunning revelation. The Cowardly Lion had already developed the courage that he sought during their long journey to Oz. The Tinman had developed a true heart and no longer needed to be granted a heart by an outsider. Finally, the Scarecrow showed guile and wits during their adventure, proving he really didn't need a new brain; he had already developed one on his own without intervention from a scary, unpredictable outsider.
Similarly, the US economy has improved and strengthened during the current recovery. It doesn't need the continued intervention of an outside, modern-day wizard named Ben Bernanke to save the day. The strength and fundamentals were there all along and just needed a nudge.
US Economic Strengths Are Right in Front of Our Faces
Morningstar's quarter-end sector outlooks paint a picture of some real economic and structural gains. The energy sector outlook is subtitled: "The remarkable surge in US crude oil production is a sight to behold." The 30-year decline in oil production ended five year ago, and progress is still continuing, according to our energy team.
Not to spoil the surprise, but oil production has already moved from 6.2 million barrels per day for all of 2012 to a rate of 7.3 million barrels per day halfway through 2013. By 2016, production could hit as much as 8.9 million barrels per day. Oil imports are dropping through the floor. US production now exceeds imports for the first time in decades. And that's just the oil situation; it doesn't include the even better news from the natural gas sector, where production has spiked sharply over the last five years, although that sector could be plateauing.
Our industrials outlook is chock full of good news, too. Auto sales are back over 15 million units per year, up from a meagre 9 million sold (and far fewer built) in the dark days of 2009. In fact, the US is now exporting automobiles to some markets that were considered untouchable just a few years ago. And the short-term auto news appears to be getting better, too, with auto sales on target to make a new recovery high of 15.7 million units in June, according to market forecaster LMC.
Despite Some Real Underlying Strengths, There Are Short-Term Hurdles
This is not to say everything is perfect in the short run. The growth rates of the economy, consumption and employment remain solid, but slow at around 2%, which will still leave employment below peak levels for at least another year. Additionally, the Congressional Budget Office notes the overall economy is still operating more than 5% below its potential, remaining near record-high underutilisation.
Furthermore, some of the engines of the economy are taking a pause, and although new sectors are slowly beginning to make up the difference, the offset may not be fast enough. One such slowing sector is exports, which are now being hit hard by a slowing world economy. Many of the quarterly outlooks speak to real weaknesses in both Europe and China (paper and chemicals are two groups singled out for particular weakness). While slowing exports won't kill the recovery, it will slow the rate of growth.
I never thought I would say the words, but overly tight government fiscal policy is also slowing economic growth. Hopefully, some of those pressures will ebb by year-end as the worst of federal tightening passes and state and local governments take up some of the slack.
The Big Bad Fed Is Not the Only Game in Town
The Fed putting the world on notice that free money won't last forever certainly isn't helping matters, and its timing clearly wasn't wonderful. Rates will likely continue to move higher, hurting potential borrowers, helping savers and moving others off the fence in order to make home and business purchases and investments before it's too late. So the longer-term impact of higher rates isn't as clear as many naysayers believe.
Although one never wants to underestimate the Fed, it's important to note that the size of the Federal Reserve balance sheet relative to the worldwide bond market isn't as large as many would have you believe. While the Fed is a large and influential player, its total balance sheet is just around $3.4 trillion out of a worldwide $80 trillion bond market. Even in the mortgage market, where it is most influential, it accounts for approximately $2 trillion of about $10 trillion of residential mortgages outstanding in the US. That's big, but not at the levels of a company town with just one bank. And compared with consumers' net worth of $70 trillion, the Fed looks positively tiny.
The Road Ahead Is Rocky, But Moving in the Right Direction
All things considered, the markets could be rocky over the next few months, as the world adapts to the new Fed regime and slower growth in China. However, this is not 2008 all over again. Fundamentals are far stronger than they were five years ago, and there are far fewer apparent bubbles. I expect the underlying economic strengths to shine through the fog, perhaps as early as this autumn.
