Reflections on the World of Investments, Finance, and Wealth Management.

Henry Fund Economic Outlook – February 2016

The following release was prepared by Nihar Patel and Josh Vander Plaats on behalf of the 2016 Henry Fund research team. The team updates its economic outlook several times throughout each semester. This analysis forms the basis for class discussions, company selection, and investment research.

Henry Fund Research

With real GDP growth for 3Q2015 at 2% coupled with a 0.7% growth rate in 4Q2015, the Henry Fund research team’s short-term forecast (6 month) for US Real GDP growth is 2.3%. Our long-term forecast (2 year) expects growth to increase to 2.8% by 2018. The current volatility in the market has not dulled consumer confidence, and consumer spending remains strong. An improving labor market and low inflation should also have a positive effect on GDP growth. A risk to the economy is the contraction in the energy market caused by the decline in oil prices. We expect this to dampen growth in the near-term, but our long-term outlook remains strong.

Oil continues to cause ripple effects through the global economy. It recently dipped below $30 per barrel for the first time since 2001, before recovering back above $30/barrel. We feel the weak GDP growth of the final quarter was driven by the dramatic decline in the price of oil. The team’s 6-month price estimate is at $33 as over production continues to keep a cap on prices. The uncertainty in the Middle East and unsustainability of current production levels lead the team to expect the price of oil to increase over the long term to $48 by 2018.

Inflation is expected to stay at current low levels for the near term with the 6-month rate forecasted to be 0.8%. The low price of gasoline, driven by the collapse of oil prices, and cheaper food is responsible for lowering change in CPI. The long-term 2-year outlook has CPI moving up 1.7%. The team expects that the price of oil will stabilize and rise some, because the oversupply will eventually lead to a cut in production. Demand for oil might also pick up, driven by emerging economies. With this weight lifted inflation will begin to rise. Core CPI, which excludes oil and food, has been on an upward trend. The Core CPI change reported in Dec 2015 was 2.1%. The Federal Reserve uses Core CPI as part of its overall outlook when deciding monetary policy including increases in the Fed Funds rate. Core CPI excludes volatile goods, but eventually the low cost of oil will filter down and keep a lid on Core CPI increases, even if CPI starts to rise.

The US unemployment rate has continued to decline with the Dec 2015 rate being reported at 5.0%. However, this must be balanced against the labor participation rate, which measures the part of the labor force that is employed or looking for work. This rate gives more context to the unemployment rate, and a fuller picture of the US labor market and the health of the economy. The labor participation rate is at its lowest level since the late 1970’s, and has been stable between 62% and 63% since 2014. As more working age people leave the workforce the unemployment rate will artificially decline, but a strong labor market might see people enter back into the active labor force. In this case, we should see the labor participation rate start to increase. Many economists also believe that full employment in the US is around the 5% unemployment mark. Considering all this, the team does not expect any significant moves in unemployment, with only a decline to 4.9% expected over the next two years.

The Federal Reserve has a stated inflation target of 2%, and it has a mandate to achieve maximum employment. The current 0.25%-0.5% rate range is the 6-month expectation. The long-term 2-year forecast sees the fed funds rate going to 1.25% once the recent weakness passes and the underlying strength of the economy requires balancing growth against inflation.

With the increase in the fed funds rate, the 1-yr T-Bill and the 10-yr T-Bond yields are expected to increase over the next 2 years. The team has projected the yields to be 0.8% for 1-yr T-Bills and 2.2% for the 10-yr T-Bond by mid-2016, which are modest increases over current levels. The 2-year projection calls for yields to increase to 1.6% for the 1-yr T-Bill and 3.2% for the 10-yr T-Bond.

Pressure on US exporters will continue as the dollar strengthens. There are a few drivers to the dollar. The increased US interest rates make it an attractive currency compared to others whose central banks have kept the interest rates low. There is also the flight to safety of the US dollar as the migrant crisis strains Europe, the slowdown in China, and the collapse of commodity prices. Over the next 6 months the EUR/USD is expected to be $1.08. Our 2-year long-term outlook sees the Euro weakening against the dollar to $1.03.

Market volatility has yet to hurt consumer confidence to this point, but we expect a decrease in consumer confidence in the short-term. The market volatility and international environment will make consumers wary. The collapse of oil prices is straining many states, the flood of migrants is straining the EU, and terrorism is still a big problem. With the effects from the fed funds rate hike uncertain, we expect caution and fear to drive down consumer confidence. These doldrums will pass quickly, and we expect that by 2018 we will see consumer confidence rebound to current levels.

Following the sell-off that started off 2016, the team expects short-term volatility in the markets and the price of the S&P 500 staying close to current levels. In the long-term, we expect equities to experience strong gains and a simple return of 14.69% from the S&P 500 level of 1890 over the next two years to 2168. Once the shock of the first rate increase in almost a decade passes the index should recover.

Death Valley

Todd Houge

Todd Houge is the Curt and Carol Lane Faculty Fellow in the Tippie College of Business. He teaches applied equity valuation, applied portfolio management, and wealth management courses to undergraduate and MBA students. Todd also supervises the department’s award-winning Henry Fund and Krause Fund programs, which provide a real-world, money-management opportunity for UI students.

Todd received a Ph.D. in Finance and an MBA from the University of Iowa. He also earned his Bachelor of Arts degree from Wartburg College and holds the Chartered Financial Analyst (CFA) designation from the CFA Institute.