Consumer debt is typically broken down into three major categories: real estate (mortgages and home equity), non-revolving (mostly autos and education), and revolving (typically credit cards). In 2014, the share of young people who own homes continued to decline to a multi-decade low. But this trend may turn around in 2015 as the labor market improves, banks ease lending standards, and interest rates start to drift up from their very low levels, thus drawing some homebuyers from the rental market. In fact, real estate brokers are already seeing more traffic, and banks are experiencing stronger mortgage demand. In general, banks appear more willing to meet demand, and are approving more people with a down payment of less than 20 percent.
Home owners’ equity has recovered about 80 percent of its pre-recession high. However, demand for home equity loans has been flat even though lending standards have eased. With home prices gradually appreciating in many markets and the labor market improving, more people may take on home equity loans in 2015, possibly leading to a pick-up in home improvement projects.
Auto sales have been one of the bright spots in the current business cycle including a 17.2 million unit annual rate in November, the second strongest pace since 2006. Consequently, auto loans have been one of the few areas where consumers have been taking on new debt.
Banks have eased auto loan approval standards, but interest rates on auto loans have crept higher. The lower standards may have contributed to a rise in 30-day delinquencies. On the other hand, aggressive collection by lenders has likely limited 90-day delinquencies and repossessions. While more people are getting auto loans, recent warnings of a sub-prime auto loan bubble seem overblown.
In the revolving credit world, more Americans are opening new credit cards but don’t appear to be living off them. Credit cards lines are far from being maxed out. About 25 percent of outstanding balances are paid each month and people are well below their credit limit.
FIXED INCOME INVESTING
The yield on 10-year U.S. Treasury notes has been in a decades-long downward trend since peaking in 1981. Yields touched a low of 1.43 percent in 2012 before rebounding to 3.04 percent at the end of last year. This year, notes averaged 2.6 percent through November 24, making it the first year since 2010 that the yield did not dip below 2 percent (Chart 3).
As the current economic expansion gains momentum, yields across the maturity and quality spectrum – from the safest treasury security to the riskiest high-yield corporate bond – are likely to move higher, driven by expectations for a fed funds rate increase, slightly higher inflation and a somewhat greater willingness by some investors to move away from ultra-safe Treasuries and into slightly more risky investments.
The outlook for fixed income markets in 2015 is not as much about whether rates will rise but when and by how much. The key things to watch will be the timing and pacing of Fed moves (see monetary policy), as well as economic growth and inflation rates. These three factors are important because they could alter the path of monetary policy. The net effect of all these elements is likely to be somewhat higher market rates next year. There are potential wildcards that could alter this outlook, however, such as further weakening in the global economy or the emergence of significant new threats to political stability. Either development could cause a rush to the safety of Treasuries and the dollar.
Most commodity futures experienced a major run-up in prices between 2001 and 2011 (Chart 4). Since then, prices for many raw materials have been roughly flat or have fallen. While every type of commodity, whether energy, agriculture, industrial or precious metals, has its own unique fundamentals, each is influenced to some degree by global economic conditions. The key theme for raw materials next year will be the extent to which global economic growth recovers, particularly in China, thereby pushing up demand.
Despite ongoing weakness in some parts of the world, in aggregate, overall global growth is expected to accelerate slightly in 2015. Broadly, marginal improvements in global GDP are expected to come from the U.S., Europe (though growth there is still expected to be quite slow) and several key emerging economies, such as India, Brazil and Mexico. China and the United Kingdom are the notable exceptions: real GDP is expected to slow in both countries next year compared with 2014.
AIER researchers will be paying particular attention to global energy markets in 2015. Among the many forces that shape these markets is the feedback loop between world economic growth and energy prices and the resulting impact on individual countries. Stronger growth boosts demand, exerting upward pressure on prices. Weaker growth crimps the need for more energy, and that, coupled with rising production, puts negative pressure prices. Crude oil displayed the effects of those influences this year, dropping about 40 percent in U.S. markets as Japan, an energy importer, fell into recession and growth cooled in China while global production continued to rise.
Developments such as horizontal drilling and hydraulic fracturing techniques have been a critical element in energy exploration and extraction. New technologies to produce oil and gas from shale rock or tar sands have led to some major shifts in global output. However, these new techniques and devices tend to be expensive, and may quickly shift from being economically feasible to unprofitable should prices continue to fall.
Politics plays an important role in energy markets, from the internal dynamics of OPEC to the approval of the Keystone XL pipeline in the U.S.; from uncertainties in Russia and Ukraine to shifting Middle Eastern alliances. The recent decision by OPEC, led by Saudi Arabia, to accept lower prices to protect market share is likely a direct result of the ability of nations such as the U.S. to extract crude using new technologies. For example, if oil prices were stable at $100 per barrel, U.S. dependence on foreign supplies is lower as domestic suppliers can profitably produce substantial quantities. Should prices fall to $60 a barrel, the U.S. may become more reliant on foreign sources as economics lead producers to shutdown some domestic wells.
The extraordinary rise in equity prices since 2009 has been well supported by improvements in fundamentals, primarily sales, earnings, and valuations. The Great Recession saw the Standard & Poor’s 500 Index fall 57 percent from the peak in October 2007 to the financial crisis low in March 2009. Since then, the benchmark index has tripled to 2,072.83 at the end of November (Chart 5). That’s 32 percent higher than the pre-crisis peak of 1,565.15. Over the same period, sales per share have risen 33 percent, and earnings per share are up 167 percent. As a result, valuations on a price-to-earnings (P/E) basis are still roughly equal to the long-run average of about 17.
For 2015, we continue to focus on the fundaments of the U.S. stock market and expect continued improvement in the nation’s economy to support sales and earnings growth, as well as valuations and equity prices. However, there are other factors that may influence prices and bear watching. Corporate balance sheets are in generally good health, with strong cash positions and a moderate level of low-cost debt. Strong balance sheets can help reduce the risk associated with investing in shares and provide support for valuations. Furthermore, cash flows remain strong, allowing for substantial stock buybacks by some companies and stable dividend payouts by others.
In addition, while the U.S. expansion is still weaker than previous recoveries, it’s growth is strong compared with other developed markets. That makes U.S. assets more attractive to foreign investors, suggesting further support for share prices.
The main risks that we see on the horizon for U.S. equity markets come from the likely upward move in interest rates noted previously, the potential for extended global economic weakness hurting international sales for some U.S. companies, and a flare-up in geopolitical tensions in places like the Middle East or Ukraine.
An interesting debate among economists and investors in recent years has focused on coupling or de-coupling, or the extent to which global economies are synchronized or their financial markets are correlated. In our view, the prospects for growth among the world’s economies are about as varied today as they have been in many years. Those widely divergent growth prospects are apparent in the widely divergent performance of developed equity markets (Chart 6).
Developed economies are mixed. The U.S. has posted relatively steady growth and appears to be gaining momentum. Canada’s expansion is expected to be modest but stable next year, and Eurozone growth is forecast to accelerate a bit but remain very weak. Conversely, Japan contracted for two straight quarters as of September 30 while growth in the U.K. is expected to cool.
Among emerging markets, the outlook is also quite mixed. In China, the world’s second-largest economy, growth has been decelerating for years and next year is expected to slide to the lowest rate since the early 1990s. Russia looks to be another weak spot with real GDP growth of just 0.5 percent and a rising risk of recession. However, prospects outside of those two look generally favorable among larger emerging economies.
Aside from the growth prospects of each individual equity market, we will mainly be watching two things next year: currency values and commodity prices. The performance of a nation’s currency can have a major impact on the total return of an investment in that country. For example, if an investor buys shares on the local market in a foreign country and the stock rises 10 percent while the currency drops 15 percent, the investor will have a net loss.
The performance of a country’s currency can also have a big impact on economic growth prospects. A weakening currency makes exports cheaper but imports become more expensive. If a country depends on exports for growth or imports of commodities for manufacturing, currency moves become critical to the economic outlook.
Finally, commodity prices may play an important role in global equity markets, especially in emerging economies, as many of these rely on commodity exports. As a result, they are heavily dependent on the prices raw materials command. If weak commodity values persist, many emerging economies may have a tough time meeting growth expectations, while producers such as mining firms may struggle to meet earnings forecasts.