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A return to higher growth

weather vane

By Adam Baley

A recovery from a financial crisis can be longer than average and slower than normal.  Indeed, below-average economic growth is what we have experienced since the Great Recession ended more than five years ago.

Investors should expect that to improve.

From 1948 through 2000, we averaged 3.6% annual growth in real gross domestic product (GDP, adjusted for inflation). Since 2000, average growth has been 1.9%. But in the last two quarters, GDP has grown at the fastest pace since the end of 2003.

News of such accelerated growth may come as a surprise, but investors should be aware of improving economic trends and understand how they can impact investment portfolios.

Gross Domestic Product rising

Real GDP is improving and is expected to increase 3%-3.5% in 2015. Last winter’s cold snap put consumer spending on ice, but pent-up demand led to better-than-expected  GDP in the second and third quarters, with results coming in at 4.6% and 5.0%, respectively. Those readings reflected broad gains across key sectors of the economy.

Light vehicle sales, manufacturing, housing starts and capital goods orders are all on the rise. Dealers sold nearly 17 million autos in 2014, a level not seen since before the recession. Manufacturing production rose in December, up three months in a row, with improvement across all sectors, including consumer goods, which in November posted the largest gain in 16 years. New housing starts have risen and are on pace to reach 1 million annually. Although still below the 20-year average of 1.3 million, it is a sign there is still some room to grow.

A healthy consumer

The gains seen across key sectors of the economy coincide with improvements for the consumer. Employment is up, year-to-year wages are improving and consumer balance sheets are in good health.

Rising wages signal that workers are participating in economic gains, but real wages still have a long way to rise before a decade’s worth of income stagnation can be undone. The average hourly wage actually declined in December.

Consumer balance sheets are healthy.  The household debt service ratio has fallen to 9.9% of disposable income – that’s the lowest level since the index began in 1980. With about 70% of our economy powered by consumer spending, it’s good to see the economic engine back up and running.

Growth and consequences

A possible consequence of above-trend growth is that we can run out of capacity. The November capacity utilization report (a gauge of how much production equipment is in use) reached 80%. Economists traditionally point to 80%-82% as the phase where bottlenecks appear in the supply chain and capacity-driven inflation begins to form. We are essentially at that point. However, that does not mean inflation is near.

Businesses still hold trillions of dollars of cash on their balance sheets, which they can deploy to increase capacity if managers see supply constraints limiting profits.  Adding capacity at this point in the business cycle puts downward pressure on inflation, as supply bottlenecks would be less likely to form.

When businesses commit to increasing capacity, like building another assembly plant, it directly impacts employment. Increasing capacity can lead to higher economic output, higher employment and possibly higher wages.

Another side effect of an expanding economy is rising interest rates. Federal Reserve officials have said they will remain patient and are in no hurry to raise rates. The central bankers anticipate initial rate hikes later in 2015.

What investors need to know

Stronger economic growth amid low interest rates and low inflation suggests that corporate profits should remain robust without the threat of aggressive action by the Fed. Normally, that translates into higher stock prices.

The expansion cycle typically lasts about five years. This one is just past five years old. The strong economy and low interest rates indicate we still have room to grow.

There is always a chance for something unexpected to impact the global economy and investment markets. This year, like every year, we likely will experience unforeseen events that could affect portfolios. A balanced and diversified portfolio still remains the best strategy for withstanding such uncertainty.

We may be in the middle innings of the current business cycle, an expansion phase, typically marked by stronger consumer spending, increased business investment and higher economic output. Investors should remain patient and have confidence in the strength of a growing economy.

Adam Baley is a registered representative and investment advisor at Landaas & Company.

(initially posted Jan. 16, 2015)

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