ECONOMIC OUTLOOK FORUM Time To Take Off The Training Wheels?
Fermanian Business & Economic Institute at PLNU
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Copyright © 2013 by the Fermanian Business & Economic Institute. All rights reserved. The material in this report includes forecasts and projections and may, in some instances, be judgmental in nature. The Fermanian Business & Economic Institute, Point Loma Nazarene University, and their affiliates all disclaim any and all liability from the use of this material other than the executive summary, publication or distribution of any portion of this document is prohibited without the express approval of the Fermanian Business & Economic Institute. Copies of the publication may be obtained by contacting the Fermanian Business & Economic Institute at
[email protected].
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Fermanian Business & Economic Institute Economic Outlook December 2013 Time to Take Off the Training Wheels? 2014 will be a year in which… >
Global growth and trade strengthen with improvement in both advanced and developing countries.
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The U.S. economy finally shakes off enough of the remnants of the 2008 financial crisis to push growth moderately ahead of the sluggish pace of the past three years.
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More jobs are created, unemployment falls further, but income disparities are wide.
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The Federal Reserve takes its first step to exit from five years of highly expansionary monetary policy.
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Investors face a landscape with lower potential gains unless coupled with much higher risks.
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California continues to recover with job gains and an improving fiscal position.
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San Diego copes with a shrinking defense budget but grows with gains in real estate, technology, tourism, and health care.
But 2014 will also demand that policy leaders solve critical issues… >
Many advanced and developing countries need to reform their economies, removing barriers to efficiency and competition.
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The Federal Reserve will need to map out its future strategy for winding down its program of massive ease.
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The President and Congress need to address entitlement programs that are likely to soar future years and a tax system badly needing reform.
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The Affordable Care Act’s first year of operation must be managed, while immigration and education policies demand attention.
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LETTER TO THE READER As 2013 draws to a close, it is our pleasure and honor to present our economic forecast, an effort by the entire Institute team to present practical analysis and economic and investment commentary. We pose the question that billions of people across the globe are asking—Is it finally time to take off the “training wheels” of massive monetary and fiscal stimulus? The theme, topics, writing, charts, conclusions and format in our forecast is designed to answer this question and to present the technical and complex information needed to do so in a highly readable and usable format. At the Fermanian Business and Economic Institute we call this “actionable economics” but perhaps it is even better understood with our mantra “Business and Economics-in Action.” Attendees to our annual breakfast event and presentation each receive an individual copy of our annual publication that contains an easy to duplicate two page Executive Summary. While the entire document is copyright protected, we do encourage you to use and distribute this brief snapshot to colleagues and associates. Our “Special Report” sections are always of great interest to us. While we are doing research in the months ahead of forecast publication, we seek to find critical topics of interest that we believe our stakeholders and community need to have brought to their attention. This year we focus upon the North American Free Trade Act (“NAFTA”), our growing concern over the stagnation in personal income in the U.S., and finally the interesting and burgeoning field of Additive Manufacturing and 3D Printing. On a personal note, this is the final publication where I will serve as Executive Editor. On January 1, 2014, I will step down from my full-time position at the Institute and PLNU, but remain engaged, albeit on a part-time basis, as Senior Counsel to the Fermanian School of Business and the Business & Economic Institute. I am grateful to have had the opportunity to lead the Institute for the past eight years, and to watch its remarkable transformation into a prominent business and economic voice. With full confidence in the experienced and capable hands of Cathy Gallagher, assuming the role of Executive Director, and the wonderful faculty, staff, and students, the best days of the Institute lie ahead. On behalf of the remarkable institution that is Point Loma Nazarene University, we are pleased to present our 2014 Economic Outlook and publication.
Randy M. Ataide, M.A., J.D. Associate Dean of Business and Economics Fermanian Business & Economic Institute
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About the Fermanian Business & Economic Institute The Fermanian Business & Economic Institute (FBEI) is a strategic unit of Point Loma Nazarene University. The FBEI provides the following services:
> > > > > > >
Economic forecasting and events Business and economic roundtables Expert business and economic commentary and speeches Economic consulting and related services Economic studies and research Professional and executive development events Special projects
The Institute Staff Randy M. Ataide, J.D. Associate Dean for Business & Economic Development
Lynn Reaser, Ph.D. Chief Economist
Cathy L. Gallagher Director
Laura Yoccabel - Dibble Assistant Director
Dieter Mauerman, MBA Business & Economic Research Associate
Cameron A. Foltz Assistant
Peggy Crane, M.S. Economist
Mark Undesser, MBA Economic Analyst
Special thanks to the entire FBEI student staff for their assistance. > Brett Baughman > Kristin Beeman
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> Leah Crane > Luke Hoover
> Josh Meersman > Kristen Raney
> Jacy Romero > Ali Turnquist
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The Fermanian Business & Economic Institute would like to thank our sponsors for the event.
MEDIA SPONSOR
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TABLE SPONSORS > > > > > >
Institute of Real Estate Management Northwestern Mutual Financial Network The Office of University Advancement at PLNU San Diego Military Advisory Council Paulson | Raintree Point Loma Credit Union
> > > > >
Jon Engle Pacific Sotheby’s Intl. Realty Eva Parsons Executive Development LeSar Development/St. Vincent de Paul San Diego Military Advisory Council MBA at PLNU
In addition to our sponsors, the FBEI would also like to acknowledge the following: PLNU Marketing and Creative Services, Nate Spees, and Neyenesch Printing.
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EXECUTIVE SUMMARY >> Around the world in 2014, various nations will need to pull back from the enormous amounts of monetary and fiscal stimulus applied after the financial crisis of 2008. Although these adjustments will not be easy, 2014 should be a better year for both advanced and developing countries. >> After five years of healing from the financial crisis, consumer spending and business investment should be strong enough to push real gross domestic product (GDP) up about 2.8% over the four quarters of 2014. This will follow three consecutive years of more sluggish growth of around 2.0%. >> Nonfarm employers can be expected to add 2.4 million workers to their payrolls in 2014, with job openings developing across a wide range of industries. Look for the unemployment to continue to grind lower with a drop to around 6.8% by the end of 2014 versus the 7.3% seen at the end of 2013. >> Despite the Federal Reserve’s expansionary monetary policy, inflation remained subdued during 2013 and is likely to remain tame in 2014. Look for wage and salary increases to continue to be restrained in the coming year, but pay raises should stay at least slightly ahead of the 1.7% projected rise in consumer prices. >> Expect the Federal Reserve to take the first steps in removing the “training wheels” it has provided the U.S. economy since 2008. Early in 2013, monetary policy officials are likely to begin to reduce their monthly purchases of Treasury and mortgage-backed securities. The federal funds target is likely to hold at zero throughout the year. >> Look for the yield on 10-year Treasury notes to rise to around 3.5% by year-end 2014 as growth firms and the Federal Reserve gradually tightens. Despite higher interest rates, credit availability should improve as banks’ appetite for new loans rises.
U.S. Real GDP Shows More Life
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San Diego Home Prices Bounce Back
California Hiring Steps Up December change over prior year, thousands
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>> Stocks, after the sharp run-up in 2013, are likely to post only a modest rise in 2014. Bonds will fall further as interest rates rise. Residential and commercial real estate may again offer some of the best opportunities for appreciation in 2014. >> Anticipate further growth in California’s economy, with the state adding about 265,000 jobs over the year and the jobless rate receding to around 7.5% by the end of 2014. The state’s fiscal health should improve further, with California ending the year with a positive balance. >> Although defense cuts will impact San Diego, the region’s alignment with key elements of the military’s new strategy will combine with strengths in technology, tourism, housing, and health care to push the economy ahead. Look for about 28,000 jobs to be added as the jobless rate falls to 6.5% by the end of 2014. On balance, it is time to take the training wheels off. However, there are many obstacles in the road ahead.
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TABLE OF CONTENTS I. SCORECARD 10
Taking Stock 10 Where We Called It Right 10 Mixed Results 11 The Misses 11
II. TIME TO TAKE OFF THE TRAINING WHEELS? 13 III. GLOBAL ECONOMY - GETTING IN GEAR 14
A Brighter Vision 14 Advanced Countries Firm 14 Developing Countries Pedal Faster 17 The U.S. Dollar - Leading the Pack 19 Special Report: NAFTA at 20 Years 20
IV. US. ECONOMY - WEARING THE YELLOW JERSEY
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Will Resilience Return? 22 Less Red Ink, but Still Hazardous 24 The Job Search Continues 25 Inflation - Barely a Bump 26 Special Report: Incomes in America - Leaders & Laggards 27
V. MONETARY POLICY, INTEREST RATES, AND CREDIT MARKETS 30
The Federal Reserve - A Difficult Exit 30 Interest Rates and Credit Markets - Struggling for Balance 31
VI. INVESTMENT OUTLOOK - A DIFFICULT TRANSITION
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VII. CALIFORNIA - BUILDING MOMENTUM
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Stocks 33 Bonds 34 Real Estate 35 Other Investment Classes 35 Special Report: 3D Printing - Racing Ahead of the Pack 36
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Upswing Defies Doubters California’s Budget Steadies
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VIII. SAN DIEGO - STAYING UPRIGHT 41
Overcoming Obstacles 41 San Diego’s Military Cluster - Downshifting 43 Technology - Extending Its Lead 44 Tourists Cruising In 45 Real Estate - Riding Faster 46
IX. RISKS TO THE FORECAST 49 X. ACTION STEPS FOR 2014 52
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For Students 52 For Households 52 For Investors 52 For Businesses 53
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INDEX OF CHARTS Chart 1 Chart 2 Chart 3 Chart 4 Chart 5 Chart 6 Chart 7 Chart 8 Chart 9 Chart 10 Chart 11 Chart 12 Chart 13 Chart 14 Chart 15 Chart 16 Chart 17 Chart 18 Chart 19 Chart 20 Chart 21 Chart 22 Chart 23 Chart 24 Chart 25 Chart 27 Chart 28 Chart 29 Chart 30 Chart 31
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Advanced and Developing Nations Firm 14 Global Trade Revives 14 Eurozone Sees Glimmers of Growth 15 China Finds Steady Growth 17 Mexico Regains Momentum 18 Greenback Strengthens 19 U.S. Real GDP Shows More Life 22 Households Save Less 23 Home Builders See More Work 24 Federal Budget Deficit Narrows from Highs 24 More Hiring, but Selective 25 Jobless Lines Gradually Shorten 26 Consumer Prices Remain Tame 26 Fed’s Balance Sheet Expansion to Ebb 30 Fed Delays Interest Rate Hikes 31 Interest Rates Diverge 32 Stocks Soar 33 Commodity Prices Stabilize 35 California’s Job Upturn Tracks the Nation’s 38 California’s Jobless rate Remains Above U.S. 38 California Hiring Steps Up 40 California’s Fiscal Picture Brightens 40 San Diego Home Prices Bounce Back 41 San Diego Creates More Jobs 42 Defense Spending’s Share of U.S. GDP Shrinks 43 Tech Creates Valuable San Diego Jobs 44 Venture Capital Still Struggling 45 More New Homes in San Diego 47 San Diego Office Vacancies Decline 47 Risks to the Global and U.S. Forecasts 49
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I. SCORECARD Taking Stock
To reinforce our credibility with clients and the public, we present in each year’s forecast a review of the year’s projections with the actual outcomes. We believe this is a part of our responsibility to be accountable. The tracking of our hits and misses also helps us understand our biases and the shortcoming of our forecasting models so that we can make necessary corrections going forward. The past year has avoided some of the political, military, financial, and environmental shocks of the past but has faced its share of turmoil and hardship. The devastation and loss of life caused by the typhoon in the Philippines are reminders of the power and unpredictability of nature. Political uncertainty reigned in the United States as the debt ceiling approached and the federal government was shut down for more than two weeks. Military threats nearly came to a head involving the U.S. and Syria. Cyprus rattled credit markets early in 2013 before a bailout was arranged. In the fall, the Federal Reserve surprised markets when it opted to delay dialing back or “tapering” its purchases of long-term treasuries and mortgage-backed securities. Global growth slowed for the third consecutive year following the initial rebound from the recession in 2010. Continued weakness in Europe and sluggishness in the U.S. offset brighter news in Japan. Emerging markets slowed in response to the weakness in advanced countries and efforts by the Chinese to steer their economy to a more moderate growth track. Against this backdrop, how did our forecast fare?
Where We Called It Right
Our general view was that the economic expansion would continue during 2013 in the nation, California, and San Diego with the job market displaying gradual improvement. >> Although we warned that Cyprus would probably need a bailout, we believed that the Eurozone would remain intact and that investors should not bet against the euro. The currency rallied substantially during the year. >> We expected that China would succeed in transitioning to a trend of more moderate growth following three decades of double-digit gains in real gross domestic product (GDP). >> We looked for the U.S. economy to show enough growth to create over 1.9 million jobs during the year and for the jobless rate to decline to around 7.5%. The job market was even slightly better than those figures. >> Our forecast called for the Federal Reserve to hold its short-term interest rate target close to zero and maintain its policy of Quantitative Easing through 2013.
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>> Despite the Fed’s expansionary policies, we expected long-term interest rates, including the yield on 10-year Treasury notes, to move higher during the year as growth expectations firmed, stabilization in the Eurozone reduced the safe haven demand for U.S. Treasuries, and beliefs in future Fed tightening grew. >> Our investment recommendations were generally on target. We favored stocks and real estate while advising against bond purchases. >> San Diego’s economy added jobs for the fourth consecutive year, and the 26,000 job gain was close to the 29,000 forecast. Growth was enough to drive the unemployment rate down even more than the percentage point we had projected.
Mixed Results
Some of our projections made the right call in terms of direction or tone but missed the magnitude of changes. >> We believed that California’s economy would strengthen further with a broad based job gain. Although job growth of an estimated 220,000 will fall short of the 275,000 we had projected, the jobless rate is likely to fall below our expected 9.0% at year-end to around 8.5%. >> We expected housing to be a major positive driver of San Diego’s economy in 2013. Prices soared an estimated 20% versus our projection of around 6%. In contrast, although our projection for multi-family building was on target, lower-than-expected numbers on the single-family side caused our projection of 8,500 units of housing permits to exceed the estimated figure of around 6,500 units.
The Misses
Some of the numbers and calls clearly missed the mark. >> Over the four quarters of 2013, U.S. real GDP increased an estimated 2.0%, failing to pick up speed to the 2.7% we had predicted. >> One of the reasons that growth may have underperformed our projection was our assumption that Congress would not allow the automatic spending cuts or sequestration mandated under the Budget Control Act of 2011 to proceed. Congress also permitted payroll tax rates to rise. >> Inflation did not bump modestly higher to 2.5% in 2013 from around 2.0% in the prior year but rather eased to an estimated 1.4%. While oil prices generally stayed in the $90 to $100 range we had projected, the drought of 2012 failed to push food prices higher.
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2013 Forecast Report Card Eurozone China U.S. Real GDP U.S. Job Market Inflation Fiscal Policy Monetary Policy Interest Rates Investments California Job Market San Diego Housing San Diego Job Market
A AC+ A C+ C A A A B B A
Overall Grade: B
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II. TIME TO TAKE OFF THE TRAINING WHEELS? The theme for this year’s Economic Outlook, “Time to Take Off the Training Wheels?” focuses on the challenges countries, regions, and cities will face in 2014. Around the world, various nations will need to pull back from the enormous amounts of monetary and fiscal stimulus applied after the financial crisis of 2008. We choose to call this global stimulus “Training Wheels.” In Europe, countries need to be able to tap outside sources for capital rather than rely on more rounds of “bailouts” from their brethren. Structural reform, making labor markets more flexible and competitive, needs to be achieved throughout Europe. China will need to adjust to a more moderate pace of growth, while it scales back state lending for many of its state sponsored enterprises and reduces its dependence on heavy infrastructure spending. India and Brazil must deregulate their economies and also temper inflation. Mexico, which has already opened up its economy significantly, still faces the challenge of deregulating its important energy sector. Although Japan will likely continue with its highly expansive monetary policy, it will be trying to rein in its budget deficit while making its private sector more competitive. Russia, the Middle East, and other oil producing regions may have to cope with somewhat more moderate oil prices. The United States will need to adjust to less support from the Federal Reserve, as monetary policy makers finally begin to reduce their purchases of Treasury and mortgage-backed securities. Another round of sequestration or an alternative plan will mean a slower rise in government spending. California will need to adapt to efforts to slow the pace of state spending to shore up its finances. San Diego will face the prospects of competing for its share of a shrinking defense budget. On balance, government support in the form of monetary ease, deficit spending, and protective regulations is likely to be scaled back around the globe in 2014. The private sector will need to prove its independence and its resilience.
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III. GLOBAL ECONOMY - GETTING IN GEAR A Brighter Vision
After faltering in 2013 under the legacy of financial stress in Europe, a slowdown in China and other developing nations, and a tepid U.S. economy, 2014 should be a better year for both advanced and developing countries. Prospects cannot be described as strong or robust and unemployment will remain high in many regions. Yet, most countries should be on the growth side of the ledger and global trade should pick up.
Look for world output, in terms of real GDP, to expand by 3.5% in 2014 versus the 2.8% experienced in 2013. Both advanced and developing nations should contribute to the step-up in growth. (See Chart 1.) Global trade, a key outcome and driver of economic activity, should strengthen. Look for the total volume of world exports and imports, including both goods and services, to expand by 5.0% in 2014 compared with the 3.0% gain of 2013. (See Chart 2.)
Free trade agreements remain under discussion. Some of the most important include the proposed Transatlantic Trade and Investment Partnership, involving the U.S. and the European Union, and the Trans-Pacific Partnership, a 12-nation bloc including the U.S. and key countries in the Western Hemisphere and Asia. These new trade alliances continue to face political and economic hurdles, but if approved, they could boost trade further.
Chart 2
Chart 1
Advanced and Developing Nations Firm Real GDP, percent change over prior year 6
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Advanced Countries Firm
The Eurozone finally is emerging from bouts of financial crisis and months of economic decline. The recovery is still modest and fragile, but real GDP is likely to rise nearly 1.0% in 2014 following two years of contraction. (See Chart 3.)
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Almost all of the current 17 nations in the Chart 3 economic bloc should eke out at least a modest gain, even including the weaker Eurozone Sees Glimmers of Growth nations on the periphery, such as Greece, Real GDP, percent change over prior year 2.5 Portugal, and Spain. Only Cyprus and 2.0 Slovenia may see further reductions in real GDP. Latvia is scheduled to become the 18th 1.5 member of the Eurozone on January 1, 2014 1 and will bring a strong expected real GDP 0.5 performance of about 4.0%. 0
The value of the euro has mirrored the -1.0 2010 2011 2012 2013e 2014f improvement in the Eurozone’s outlook. As recently as the middle of 2012, the currency was worth just $1.23, but by the latter part e=estimate; f=forecast Source: International Monetary Fund; FBEI of 2013, it had rallied to $1.35. Markets now believe that the European Central Bank will honor the pledge it made in 2012 to “do whatever it takes to keep the Eurozone intact.” It has not yet been forced to take such action as traces of economic growth have started to appear and confidence has improved. Unemployment remains distressingly high in a number of countries and citizens have grown weary of the prolonged period of austerity forced by government cutbacks. In response, policy leaders have eased up slightly on their timetables for deficit targets, although programs to scale back government benefits and make wages more competitive remain in place.
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To extend and expand the early signs of economic improvement, the Eurozone needs to take some important steps: >> Banks need to lend more to companies rather than continue their focus of investing in the sovereign debt of European countries. The current rules of Basel III, which require much higher capital for investing in companies than in national bonds, need to be modified to uncouple the risk of banks and governments. >> The Eurozone needs to move towards a centralized banking system, with a common regulatory, enforcement, and insurance program for deposits. Such unification may be necessary to safeguard against another financial crisis. >> To sustain the benefits of monetary union, the members of the Eurozone ultimately will need to move towards more standardization on the fiscal side. History and cultural differences rule out any form of true political union, but rules and enforcement mechanisms in terms of deficits and other metrics of fiscal soundness could be developed. >> Structural reforms, including making work rules and labor compensation more competitive, will be necessary to restore stronger growth in many of the bloc’s members, especially in a period of a stronger currency.
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A year ago, many still questioned whether the Eurozone could survive. Those uncertainties, while not totally quashed, are much diminished. The Eurozone’s next goal should be to insure that the region can achieve a strong and broad enough growth trend to include all of its members. Japan appears to be finally shaking free of two “lost decades,” which followed the bursting of bubbles in the stock and property markets in the early 1990s. Prime Minister Shinzo Abe launched a major wave of stimulus upon his taking office in 2013. Termed “Abenomics,” it included a massive dose of quantitative easing or monetary expansion by Japan’s central bank intended to end deflation in the country and drive down the value of the yen in order to boost exports. Government spending on various infrastructure projects was also ramped up. Success has been palpable, with economic activity picking up and consumer prices starting to rise. Japan’s winning of its bid to host the 2020 Olympic Games in Tokyo has further boosted business and consumer confidence. Economic improvement has been sufficiently convincing that the government plans to boost the sales tax rate from 5% to 8% in April 2014 in order to begin to scale back the country’s large budget deficit. In order to sustain these early encouraging signs for Japan, further actions will be necessary: >> In addition to fiscal and monetary stimulus, Prime Minister Abe needs to pursue the third leg of his economic strategy — deregulation. Although easing Japan’s practice of assuring life-long job security for full-time workers may be politically impossible, opening up agriculture, electricity, retailing, and other industries to greater competition needs to be pursued. >> Japan needs to determine its energy strategy following the closing of nearly all of the country’s 50 surviving nuclear reactors following the Fukushima disaster of March 2011. Decisions need to be made as to the role of various fuel sources, ranging from renewables to U.S. shale gas. >> Japan needs to address the continued decline in its workforce, as its population continues to age. Immigration policies will need to be revisited if productivity gains cannot offset the shrinkage in the number of employees. Japan’s early signs of emergence from a long period of stagnation are encouraging. The challenge will now be to solidify these fragments of improvement. Other advanced countries should see healthier prospects in 2014 compared with 2013. For example, the United Kingdom should see some strengthening in growth as a result of its own path of monetary support, while Canada benefits from an expected improvement in the U.S. economy.
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Developing Countries Pedal Faster
Anticipate the performance of most developing economies to strengthen in 2014, with real GDP rising by 5.0%. This will be up from the 4.5% gain estimated for 2013 and will also be about three percentage points higher than the growth rate estimated for the coming year in advanced countries. The largest common threat to developing countries will come from any sign of a shift in U.S. monetary policy away from aggressive ease. This could cause a reversal in capital that has freely flowed into many of these nations in search of higher returns.
Chart 4
China Finds Steady Growth Real GDP, percent change over prior year 12 10 8 6 4 2 0 2010
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China will continue to drive the performance of many developing and also advanced countries dependent on their exports of raw materials to China for its industrial machine and rising consumer base. China has struggled to define and then achieve a sustainable growth track. That path appears to be a real GDP growth rate of around 7.5%, which should be reached in 2014. (See Chart 4.) Over the past year, China’s policy leaders have attempted to curb lending by the “shadow banking sector,” which includes wealth management firms and other financial entities outside of the formal regulatory net. These efforts briefly risked cutting off credit to broader areas of the economy but were swiftly adjusted to avoid a widespread “credit crunch.” China’s efforts to temper growth from the double-digit rates of the recent past also reflect attempts to cool various pockets of speculation and overheating in the housing or commercial property markets. While China appears to have steered its economy towards a relatively smooth glide path, a number of economic tasks remain for President Xi Jinping and the rest of the nation’s leadership: >> Efforts at rebalancing the economy towards a greater role for consumer spending, as opposed to exports and government investment, need to continue. >> The rural population needs to be supported by granting them the right to own their own land and to receive various social services when they migrate to the cities. >> The role of state owned enterprises needs to be sharply scaled back to give room for the private sector. >> More openness to foreign investment, including the protection of intellectual property rights, needs to be encouraged and enforced.
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>> The banking system needs to be strengthened, with write-offs of non-performing loans allowed and required where necessary. >> Interest rates on consumer bank deposits need to be deregulated to discourage households from investing their savings in speculative ventures, which has further risked inflating asset bubbles. >> China’s currency needs to be managed less closely and eventually allowed to be traded in global markets. >> Because China is such a critical lynchpin for the entire global market, its ability to further the liberalization of its economy and achieve steady growth will be vital.
Mexico can be expected to return to its trend of solid growth in 2014 after briefly slowing in 2013. Look for real GDP in the coming year to expand by about 3.0% after faltering to a rise of less than half that pace in the prior year. (See Chart 5.) The nation should benefit from some of the economic reforms President Peña Nieto has implemented together with stronger gains in the United States.
Chart 5
Mexico Regains Momentum Real GDP, percent change over prior year
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The Mexican economy continues to realize a renaissance in manufacturing as rising labor costs in China drive companies to production sites closer to the U.S. Mexico has also benefited from sound monetary and fiscal policies as well as its openness to foreign trade and competition.
Mexico’s president is committed to further deregulating the nation’s economy. He has taken significant steps to reform the education and tax systems. The next major hurdle will be to open up the energy sector, which has long been controlled by state-owned Pemex, to foreign investment. Halting the decline in the nation’s oil output will be important to further boost the country’s growth prospects, which remain bright.
Brazil has disappointed many by failing to carry out its strong growth potential. In 2013, political unrest has been sweeping throughout the country. Real GDP growth should equal about 2.5% in 2014, matching the performance of 2013. However, this will be only about half the growth prospects that seemed possible just a few years ago. A dampening in commodity prices, brought on by China’s slowing, has been a negative for Brazil. More fundamentally, Brazil needs to substantially cut back high import tariffs that have prevented domestic producers from boosting their competitiveness.
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It also needs to reduce price pressures that have robbed consumers of some of their purchasing power. The drop that has occurred in Brazil’s currency will help the country’s export potential, but the economic boost will only be temporary and needs to be backed up by monetary, fiscal, and regulatory reforms.
The U.S. Dollar — Leading The Pack Although the U.S. continues to show imbalances in terms of its “twin deficits” in the federal budget and foreign trade account, the dollar has remained strong. Other countries, ranging from Japan to Brazil, have sought weaker currencies to boost their exports. Meanwhile, in times of financial crises, such as enveloped the Eurozone, investors have scurried to the “safe haven” of the greenback. In 2014, the major appeal of the dollar is likely to come from a shift in U.S. monetary policy towards a modest firming. The United States, in contrast to many nations, does not manage its currency and does not target any particular dollar level. Although the U.S. desires to keep its currency strong, policy leaders believe sound monetary and fiscal policies will achieve that objective over time. Doubts regarding those issues could erode the greenback’s value, but for now, international investors believe that the dollar will retain its integrity and its position as the world’s primary reserve currency.
Although the Federal Reserve is unlikely to boost short-term interest rates in 2014, a scaling back of asset purchases could signal an eventual end to the era of extraordinarily low interest rates that has persisted since the end of 2008. As the first major country to tilt towards tighter money, investment flows can be expected to come to the United States, pushing up the value of the currency by about 2.0% over the Chart 6 course of the year. (See Chart 6.)
Greenback Strengthens Broad Trade-Weighted Index, Jan. 1997=100, Dec. average 120
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The dollar’s expected rise by the end of the coming year will still leave it down about 20% from the high reached in early 2002. Companies realize, however, that they cannot depend on dollar declines to make their products competitive. Ongoing innovation and productivity gains remain necessary to penetrate international markets and stave off foreign competition at home.
Source: Haver Analytics; FBEI
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SPECIAL REPORT: NAFTA at 20 Years
The end of 2013 marks the twentieth anniversary of the North American Free Trade Agreement (NAFTA) signed in 1993. This agreement extended the earlier liberalization of trade between the U.S. and Canada to include Mexico. At the time, opponents feared that there would be an enormous “sucking sound” as jobs were pulled from America to our neighbor to the south. The actual outcome has turned out to be quite different as sizable benefits have accrued to all three countries.
Over the past 20 years, the total value of trade in terms of both goods and services has more than tripled to over $1.2 trillion between the three countries in the partnership. NAFTA now serves a market of about 470 million people. U.S. exports of goods to Canada and Mexico currently exceed $500 billion per year. Service exports to both countries combined have climbed to around $100 billion annually. Mexico and Canada represent the two leading export markets for American small and medium-sized businesses.
When NAFTA was signed, many of its provisions had already been implemented through prior agreements between the U.S. and Canada. NAFTA cleared the entire three-nation bloc from almost all trade restrictions. In particular, it broke down barriers to the flow of goods, services, and capital between the U.S. and Mexico, while also protecting intellectual property rights. It thus created the largest free-trade area in the world.
While some industries have been disrupted, such as cut flowers, the treaty has been a positive economic game changer, giving a particular boost to border cities, such as San Diego and Tijuana. NAFTA has been a key factor reinforcing actions by Mexico to reform its economy and become globally competitive. Mexico today exports more manufactured goods than the rest of Latin America combined. Many Mexican firms are increasingly opening up their supply chains to U.S. bidders.
Employment has expanded in manufacturing, transportation, health care, retailing, and various business services as a result of NAFTA’s effects in the three-country zone. Enhanced competition has raised productivity and incomes. Investment funds are flowing in both directions across the border. Consumers have more choice and more lower priced goods.
NAFTA has set the standard for other free trade agreements. The next most promising step could involve the signing of the Trans-Pacific Partnership (TPP), which would bring Canada, Mexico, and the U.S. into a free trade area including nine other nations: Australia, Brunei, Chile, Japan, Malaysia, New Zealand, Peru, Singapore, and Vietnam. Despite its enormous accomplishments, NAFTA’s work is not done in its own three-country territory. Several steps need to be taken: >> Border procedures need to be streamlined. Border crossing times between the U.S. and Mexico vastly exceed those between the U.S. and Canada.
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>> Investment in roads, rail lines, airports, and seaport facilities needs to be boosted. >> Immigration reform is sorely needed to facilitate the flow of workers between countries. >> Mexico’s drug violence problems demand ongoing attention to realize the potential of tourism, travel, and business investment.
In sum, NAFTA’s impressive successes over the past twenty years have dispelled many of the early fears about economic losses. While substantial momentum remains, the next two decades will require significant policy actions to extend those gains even further.
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IV. US. ECONOMY - WEARING THE YELLOW JERSEY Will Resilience Return?
The U.S. economy has time after time displayed its resilience, which makes the past three years of relatively sluggish growth so disheartening. Real GDP has expanded at an average annual rate of just 2.0% since 2010. In 2014, American consumers and businesses will likely see less support from the Federal Reserve, while government outlays will not be providing a prop for economic activity. The American economy should not need a steady diet of stimulus to move ahead. After five years of healing from the financial crisis, consumer spending and business investment should be able to expand on their own. Confidence will be key. Look for real GDP (gross domestic product) to grow at an annual rate averaging 2.8% over the four quarters of 2014. (See Chart 7.) This will match the performance of 2010 and reflect the swing of economic drivers to the positive Chart 7 side. A number of forces should help propel the economy forward: >> Innovation is the watchword of the 21st century and will be a positive economic driver in 2014. New inventions and digital applications continue to flow from Silicon Valley and other technology clusters around the country. 3D printing or additive manufacturing could transform large slices of the economy. (See Special Report in the investment outlook.)
U.S. Real GDP Shows More Life 4th quarter, percent change over prior year 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2010
e=estimate; f=forecast
2011
2012
2013e
2104f
Source: Haver Analytics; FBEI
>> Housing is staging an impressive comeback, particularly in terms of home prices. Prices started to recover in 2012 and by the third quarter of 2013 were up nearly 13% from the prior year. Some of the areas hardest hit by the earlier plunge in prices, such as Florida, Nevada, Arizona, and California, are experiencing large rebounds. While price appreciation nationally is likely to moderate in 2014 to a pace of around 8%, home sales and homebuilding should rise further. >> Credit is flowing again to households and businesses. Banks have seen their nonperforming loans drop and deposits expand as a result of the Federal Reserve’s expansive policies. As a result, many financial institutions have eased credit conditions and are anxious to make new loans.
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>> State finances have strengthened as better employment, rising stock prices, and higher home values have boosted income, sales, property, and other tax revenues sources. >> Natural gas and oil have drastically changed the U.S. landscape. While just a few years ago, fears raged that we were running out of oil, hydraulic fracturing (“fracking”) and horizontal drilling are now putting us within reach of becoming the world’s largest energy producer. Some negatives will tarnish the upside potential: >> Federal government cutbacks can be expected to adversely affect certain segments of the economy heavily depending on defense spending, research grants, and other “discretionary” outlays (spending requiring appropriations by Congress). >> Health care costs could rise substantially for business as insurance companies may see a shift in their subscription base to a more expensive mix of health care consumers. Concerns about cost increases, reimbursement rates, and profitability could adversely affect hiring both by the health care industry and business in general. >> Monetary tightening, even in the form of a modest and gradual scaling back of bond purchases, could drive long-term interest rates higher and stock prices lower.
Households and businesses should post stronger gains in spending than in 2013. Look for government outlays to contribute a small amount to real GDP growth as modest increases at the state and local levels offset another decline in federal expenditures. Job gains, a modest rise in earnings after inflation, and wealth gains due both to higher stock and home prices have boosted the overall financial position of U.S. households.
Chart 8
Households Save Less Percent of disposable income, annual average 10 9 8 7 6 5 4 3 2 1 0 1986
f=forecast
1990
1994
1998
2002
2006
2010
2014f
Source: Haver Analytics; FBEI
This overall rise somewhat masks the growing inequality in wealth and incomes that has taken place and the fact that many Americans are still struggling to make ends meet. (See Special Report in this section.) The household saving rate is likely to fall back to an average of about 4% in 2014 after reaching 6% in 2009 following the financial crisis of 2008. (See Chart 8.) Pent-up demand for cars, digital devices, appliances, apparel, travel, and other goods and services will continue to be released.
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Business investment in equipment, software, and new facilities will be essential to sustain productivity growth and maintain competitiveness. Solid balance sheets, strong cash positions, and credit availability will make such investments possible. Homebuilders will respond further to the sharp rise in home prices, drop in inventories of distressed properties, and rise in sales. Look for housing starts to reach about 1.1 million units in 2014, compared with about 900,000 units in 2013. (See Chart 9.)
Less Red Ink, but Still Hazardous
The U.S. federal budget deficit has dropped sharply as economic recovery and an ending of earlier tax cuts have boosted revenues. In fiscal year 2013 (ending September 30), the deficit shrank to $680 billion following four consecutive years of deficits exceeding $1.0 trillion. (See Chart 10.) Relative to the size of the overall economy, the deficit equaled about 4.1% of GDP in fiscal 2013 versus the nearly 10.0% peak reached in 2009. The deficit is likely to ease slightly further in fiscal 2014 as economic growth boosts revenue. Look for a deficit of approximately $635 billion, equal to an estimated 3.7% of GDP. Congress can be expected to continue with some spending constraint due primarily to limits on discretionary outlays mandated as part of the Budget Control Act of 2011. More flexibility is likely to be granted to various agencies versus the across-the-board cuts set as part of the 2013 sequestration process. Little action is expected to curb the growth of entitlement spending in fiscal 2014. As baby boomers continue to retire over the next two decades, an ongoing stream of deficits will further raise the amount of outstanding debt. Rising costs of health care and social security will be the primary culprits. Interest costs will rise as share of total spending. If foreign investors grow weary of financing our debt or find better opportunities elsewhere, interest rates will rise, weighing on spending and investment. The dollar also might fall.
Chart 9
Chart 10
Home Builders See More Work Thousands of units
Federal Budget Deficit Narrows from Highs Trillions of dollars, fiscal years
1,200
0.0
1,000
-0.2 -0.4
800
-0.6
600
-0.8 400 -1.0 200
-1.2
0 2010
e=estimate f=forecast
2011
2012
2013
2014f
Source: Haver Analytics; FBEI
-1.4 2010
e=estimate f=forecast
2011
2012
2013
2014f
Source: Haver Analytics; FBEI
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Higher interest rates and a weaker dollar represent the market’s solution to a debt level that is no longer viewed as sustainable. Such an outcome will mean slower economic growth and a slower rise or even decline in living standards. Surely a political solution to curb the escalation of the national debt through a necessary slowing in entitlement spending would be much better.
The Job Search Continues
Jobs remain as the primary concern for both households and policymakers. The U.S. economy is creating new jobs and the private sector is generating most of them. Employment gains have not yet become consistently vigorous to quickly drive us to full employment. Look for 2014 to allow us to continue towards that goal but at a moderate pace. Nonfarm employers can be expected to add 2.4 million workers to their payrolls in 2014. (See Chart 11.) More job opportunities should span a wide array of sectors and industries, encompassing energy, construction, manufacturing, trade, health care, education, tourism, and professional services. The federal government is likely to be the only primary segment reducing payroll counts. The job gains expected for 2014 should allow us to finally recover all of the jobs lost during the “Great Recession” by the middle of the year and reach a new all-time high by year-end. These will not be the same jobs that were lost. Some will be in entirely new industries, such as 3D printing or additive manufacturing. Many of the new jobs will be high paying, such as in technology, but others will be part-time or lower paying. Income inequality is likely to continue to be wide.
Look for the unemployment rate to continue to grind lower with a drop to around 6.8% by the end of 2014 versus the 7.3% seen at the end of 2013. (See Chart 12.) A key factor behind the reduction of the unemployment rate thus far has been a sluggish growth in the labor force. Part of this traces to demographic factors, such as aging Chart 11 baby boomers retiring. More Hiring, but Selective
Other individuals have grown weary in their search for positions and have stopped looking for work. Ironically, an improvement in the job outlook could slow progress in the unemployment rate’s decline by encouraging some of these people to restart their job search.
December, change over prior year, millions 3.0 2.5 2.0 0.5 0.0 0.5 0.0 2010
e=estimate f=forecast
2011
2012
2013e
2014f
Source: Haver Analytics; FBEI
Some pickup in the pace of economic growth will certainly help the job outlook, but structural problems will also weigh on the picture. Geographic mobility should improve as individuals are able to again more easily sell their homes and move to regions with job openings.
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Chart 12
Jobless Lines Gradually Shorten Unemployment rate, quarterly average 12
Actual
Forecast
10 8 6 4 2
At the same time, many positions, ranging from welders to software engineers, will remain unfilled because of a scarcity of individuals with the required education or skills. The dynamics of the labor market are changing. Turnover rates in companies have slowed as employees place a great value on job security and have become reluctant to seek out new opportunities. College graduates are also in many cases being forced to accept part-time jobs or positions not requiring a four-year degree.
0
Despite the general improvement in the job market forecast for 2014, long-term unemployment will remain a source of concern. Around three e=estimate f=forecast Source: Haver Analytics; FBEI million people will have been out of work for six months or longer at the end of the coming year, comprising about one-third of the total unemployed. While down from the approximate four million individuals in this status at the end of 2013, that number is still far too high. 2009
2010
2011
2012
2013e
2014f
Inflation — Barely a Bump
Despite the Federal Reserve’s expansionary monetary policy, inflation remained subdued during 2013 and is likely to remain tame in 2014. Look for wage and salary increases to continue to be restrained in the coming year, but pay raises should stay at least slightly ahead of prices.
On a year-end to year-end basis, consumer Chart 13 prices rose only about 1.4% in the U.S. during 2013. This was well below the Federal Reserve’s inflation target of close Consumer Prices Remain Tame to 2.0%. In 2014, U.S. consumer prices are 4th quarter, percent change over prior year likely to rise about 1.7%. (See Chart 13.) 4
Excess capacity and comparatively sluggish growth have been the major factors keeping a lid on prices. Technological advances and productivity gains have also helped. Competition in the job market for a limited pool of jobs has kept wage increases down, while few companies have found significant pricing power to even pass on any cost increases that they might have incurred.
3
2
1
0 2010
e=estimate f=forecast
2011
2012
2013e
2014f
Source: Haver Analytics; FBEI
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Most factors will work to push up inflation slightly in 2014. Total employee compensation, including the cost of various benefits, is expected to rise about 3.0% in 2014. Productivity gains could offset about half of this advance, holding the rise in unit labor costs to around 1.5%. Although quite modest, it will be above the virtually flat performance in unit labor costs registered in 2013. Education and health costs can be expected to rise substantially and housing costs (either explicit rents or the rental equivalents assigned to homeowner units) will rise further.
A generally downward slope in energy prices will help limit the overall rise in consumer prices, while food prices should post only moderate increases barring major adverse weather effects. Advances in technology will continue to push down the cost of various electronics products. Inflation is ultimately a monetary phenomenon. The Federal Reserve has continued to add to the volume of bank reserves through its programs of low interest rates and asset purchases.
Inflation has remained quiescent even as the Fed’s balance sheet has ballooned. The tinder is clearly in place for a potential flare-up in inflation should bank lending accelerate with a stronger economy and a surge in business borrowing. That time seems to be in the distant future and monetary policymakers believe they can act in time to prevent any inflation outburst. That remains to be seen.
Special Report: Incomes in America — Leaders & Laggards
Incomes adjusted for inflation continue to stagnate for most U.S. households. Although edging only a tad below the year earlier number, real median household income in 2012 totaled about $51,000, a sharp 9% drop from the peak of approximately $56,000 reached thirteen years earlier. The percentage of U.S. households earning less than poverty wages remained at an all-time high as did measures of income inequality.
What are the causes of these dismal trends? What are the implications for the nation? What are the solutions?
The Causal Factors
The drop in median family earnings has both short-term and long-term causes. Much of the short-term impact traces to employment. The U.S. has suffered two recessions in the past thirteen years, including the deepest one since the 1930s Depression in 2007-2009. Unemployment, although down from its peak, is still relatively high. For example, at the peak of real median household income in 1999, the jobless rate was only about 4%. In contrast, last year the unemployment rate was nearly double that figure.
The role of education and its connection to the job market and earnings are clear. Comparing 2012 with 1999, individuals with a bachelor’s or higher degree have experienced an increase in unemployment and a loss in real earnings, but the slippage has been much milder than suffered by individuals without college degrees.
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For college grads, median real earnings dropped a sizable 10%, but they plunged by about 20% for those with only a high school education or less.
Median inflation–adjusted household earnings have increased at an annual rate of less than one-half of a percentage point over the past forty-five years. Meanwhile, income inequality has widened, with the top fifth of income earners gaining an eight-percentage point gain in their income share, while other groups have seen their shares erode. These, of course, are not all the same people, with many able to migrate up from low salaries to higher incomes as their careers progress. But, for many, especially in the last several years, it seems to have been a “lost decade.” The root causes of these longer term trends relate to education, the rise in the services sector with more part-time jobs, the demand for highly skilled workers, global competition, and innovation.
Implications for the Nation
The recent data has two distinct aspects: the level of income and its distribution.
The large and extended weakness in household earnings represents the greatest issue for concern. Until the economy grows at a faster pace and we restore full employment (with the unemployment rate down to around 5.5%), employees may see minimal wage gains and only modest gains in total incomes.
Total income equality should not be a goal since it would dissuade individuals from acquiring more education and skills, working harder, or taking greater risks. America is a country founded on the principle of “equality of opportunity,” not “equality of outcomes.”
Yet, a large disparity in incomes, with most of the gains concentrated at the top, can lead to political instability, particularly when other groups are realizing losses in their absolute as well as their relative income levels. There is also a serious problem if income inequality leads to an erosion of the equality of opportunity.
This risk can take place in education. Wealthier families may insure that their children are enrolled in the best schools and receive extra training, a gap exacerbated by escalating costs. Higher income families may also help their children access better job opportunities.
Recommendations
Reversing some of the negative trends related to incomes suggests the following steps for policy, business, and community leaders: >> Set a path for fiscal stability and growth that scales back entitlement programs to provide room for public and private investment in infrastructure and education.
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>> Reform taxes to eliminate incentives for various activities with low economic returns and which raise income inequality (such as the large mortgage deduction for high income households). >> Achieve true financial reform to prevent risk takers, such as hedge funds and investment bankers, from reaping gains while receiving public support when large losses occur. >> Normalize monetary policy that benefits risk-taking investors, harms small savers, and risks future inflation. >> Reform public education with the adoption of best practices, a stronger collaboration with industry to identify needed skills, and monitoring to insure that young people complete their degrees. >> Expand the school opportunities for doctors, veterinarians, engineers, accountants, and other professions. Similarly, vocational opportunities should be developed and promoted to allow individuals to learn various technical skills, ranging from welding to culinary arts. >> Encourage entrepreneurship and innovation through collaboration and mentoring.
The United States is not destined for another lost decade if we can achieve faster growth, lower unemployment, and more opportunities to excel.
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V. MONETARY POLICY, INTEREST RATES, AND CREDIT MARKETS The Federal Reserve — A Difficult Exit
The Reserve will bear the primary responsibility for removing the training wheels from the U.S. economy in 2014. Fiscal policy, in terms of lower taxes and increased spending, has already been pulled away. Now it is the Fed’s turn to test the U.S. economy’s ability to go forward on its own. It could be a wobbly start. Three principal goals guide the Federal Reserve. Congress has mandated the first two: maximum employment and stable prices. Quantifying the first remains in debate, but most economists would identify full employment as a condition where the jobless rate has moved to a range of 5.5% to 6.0%. Monetary policy officials are beginning to stress that the “quality” of the job market is important. A jobless rate driven lower by the departure of discouraged workers from the labor force or the creation of large numbers of part-time positions would not represent full employment. Price stability has now been defined in more concrete times. Early in 2012, the Federal Reserve set an explicit inflation target equal to about 2%. The third policy objective is financial stability, an underlying reason behind the Fed’s creation in 1913 and a goal highlighted by the financial crisis of 2008.
Possible conflicts between these objectives can sometimes pose difficult choices for policymakers. For example, aggressive steps to lower unemployment could trigger credit bubbles and future financial instability while also raising future inflation. Actions to strengthen the financial system through higher capital standards and increased regulation could stifle lending and economic growth. Monetary policymakers continue to weigh the benefits versus the risks of each step they take.
This past year, the Federal Reserve has focused on spurring faster economic growth and lower unemployment. It has deployed three primary tools: near zero short-term interest rates, “Quantitative Easing,” and “forward guidance.” The overnight interest rate, the federal funds rate, has been held close to zero for a fifth consecutive year. The Fed has purchased Chart 14 $85 billion of Treasury and mortgagebacked securities each month in the third Fed’s Balance Sheet Expansion to Ebb Billions of dollars, month-end wave of its Quantitative Easing (QE) 6000 policy. (See Chart 14.) Finally, through 5000 published expectations of the members of its policymaking body, the Federal 4000 Open Market Committee (FOMC), has 3000 suggested that an explicit move to boost 2000 interest rates is unlikely to take place 1000 before 2015. (See Chart 15.) 0 2009
2010
e=estimate f=forecast
2011
2012
2013e
2014f
Source: Haver Analytics; FBEI
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Chart 15
Fed Delays Interest Rate Hikes Number of members expecting increase 14 12 10 8 6 4 2 0 2014
2015
The timing of the first step towards exiting these policies of extreme monetary ease will depend on the strength of the economy. Consistent monthly job gains of at least 200,000 would suggest that business activity is on a strong path and can proceed with less stimulus. March would appear to be a realistic time for monetary policymakers to begin to gradually reduce their monthly purchases of financial assets. Asset purchases might be totally ended by the early part of 2015. The first increases in the overnight federal funds rate could then be expected to be delayed until the latter part of 2015.
2016
Monetary policymakers hope that reactions to a scaling back of asset purchases will be gradual. Source: Federal Reserve; FBEI As demonstrated in the summer when investors thought the Fed would start “tapering” its purchases in September, “gradual” is not a word in the market’s vocabulary. Any hint of a tightening in monetary policy is likely to drive long-term interest rates higher, push down stock prices at least initially, trigger an exit from high-risk funds or financial instruments, cause fund outflows from emerging markets, and put upward pressure on the dollar.
No manual exists for how to remove the extraordinary training wheels provided by the Federal Reserve. Implementing a smooth removal or exit strategy may be impossible. To continue to delay it could pose even greater risks in terms of asset price bubbles and a future upswing in inflation.
Interest Rates and Credit Markets — Struggling for Balance
Interest rates are poised to rise after being suppressed by the Federal Reserve since 2008. Sparks of stronger economic activity and signs that the Fed is finally starting its exit plan will begin pushing them higher. Increases could be abrupt. Despite higher interest rates, credit availability should improve as banks’ appetite for new loans rises.
Look for the yield on 10-year Treasury notes to increase to around 3.5% by the end of 2014, a gain of about three-quarters of a percentage point from year-end 2013. (See Chart 16.) Other longterm interest rates will rise along with this pivotal benchmark. For example, 30-year fixed rate mortgages are likely to break 5.0% and approach around 5.25%.
The Federal Reserve’s commitment to delay the hike in the overnight federal funds rate will tether other short-term interest rates. This will hold down yields on money market mutual funds, bank deposits, certificates of deposits (CDs), and other short-term instruments.
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To place the expected interest rate outcomes in perspective, what yields might be expected to be “normal” or to exist in an era of full employment and 2% inflation? The federal funds rate would probably be around 4%, based on history and Federal Reserve analysis, instead of the near-zero rate expected for the coming year. The comparable yield on 10-year Treasury yields would likely be approximately 5% versus the 3.5% predicted for the end of 2014. Interest rates are still in the early stage of their cycle.
Chart 16
Interest Rates Diverge Quarter-end, percent 4.5
Actual
4.0 3.5
Forecast
10-year Treasury Note
3.0 2.5 2.0 1.5 1.0
Fed Funds Target
0.5 0.0 2009
2010
e=estimate f=forecast
2011
2012
2013e
2014f
Source: Haver Analytics; FBEI
Bank lending should expand further in 2014 as lending standards gradually ease from the stringent levels demanded after the 2008 financial crisis. The Federal Reserve and other regulators are demanding high capital ratios and monitoring bank balance sheets and lending procedures more closely. The largest banks are stress tested to determine if they can survive severe economic downturns. These banks have also been required to craft “living wills,” to show how they could be dissolved if necessary. Wall Street has pushed back against some of the stricter regulations, such as requiring a sharp separation between investment and banking activities.
In general, banks’ financial health has improved significantly. As the economy has gradually recovered, nonperforming loans and delinquencies have dropped. Many small and medium sized banks never entered into the housing or investment frenzy of 2006 and 2007. The rise of long-term interest rates relative to short-term rates (a steepening of the yield curve) will make lending more profitable. Banks will increasingly want to put excess reserves to work and will be competing aggressively for creditworthy customers.
On balance, while mortgage refinancing activity can be expected to decline, other types of borrowing should expand. These include loans to consumers and loans to small, medium, and large businesses.
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VI. INVESTMENT OUTLOOK — A DIFFICULT TRANSITION As the U.S. economy exits from the props of fiscal and monetary policies, investors will face a new and potentially volatile environment. Excessive risk taking may be less amply rewarded and investors could be whipsawed by possible wide swings in asset prices. For most investors, diversification and a long-term investment horizon will be critical. The investment backdrop for 2014 should include improving prospects for growth in both the U.S. and world economies together with the beginning of a rise in the interest rate cycle. Legislators are unlikely to tackle tax reform in an election year, but higher income individuals will likely see some scaling back of the advantage of their deductions at some point in the future. They will face the higher federal tax rates in the coming year implemented in 2013, which will also be true of some states. The Federal Reserve, through its expansive monetary policy, had hoped to encourage greater risk taking. It probably intended that risk assumption to involve investments in plant and equipment together with increases in hiring. Instead, most of the increased risk taking has been in the form of investments in various financial assets. Some of that incentive will now be withdrawn. Following are comments about the 2014 prospects for several key investment classes, including an expected performance rating or grade.
Chart 17
Stocks Soar S&P 500, month-end 2000 1800 1600 1400 1200 1000 800 600 2007
2008
2009
2010
2011
2012
2013
Source: Haver Analytics; FBEI
Stocks >> U.S. Equities. Investment Rating: B The sharp rise in stock prices has raised price-earnings (PE) ratios to high, but not exorbitant, levels. Look for the S&P 500 Composite Stock Average to reach about 1850 by year-end 2014. Equity gains will generally be in the range of 5.5% to 6.0%. This will compare with the 23% climb estimated for 2013. (See Chart 17.) Profit and sales can be expected to grow moderately in 2014, paralleling the performance of the overall economy. Pricing power will be limited, which will continue to put a premium on cost control. Merger and acquisition activity will be active as a central element of this ongoing focus on costs. Look for small and mid-cap companies to outperform large cap firms, which have been favored in a slower growth environment.
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>> Non-U.S. Advanced Country Equities. Investment Rating: B Look for further gains in the Japanese and European stock markets in 2014, following a return of investors to those markets in 2013. Although structural reforms will be necessary, a continued firming in underlying economic trends should take place. Meanwhile, monetary support is unlikely to be pulled back. >> Non-U.S. Developing Country Equities. Investment Rating: B Evidence indicating China’s successful transition to single-digit, as opposed to doubledigit real economic growth, has encouraged investors to again be more optimistic about the emerging market economies. Investors will need to be more selective, paying more attention to the economic policies followed by individual countries. For example, prospects in Mexico now appear more compelling than those in Brazil. Customization might be an investment theme that individuals consider pursuing in 2014. Ranging from personalized medicine to 3D printing to tailoring digital coupons to different households, the 21st century looks to be an era dominated by the individual as opposed to the mass market. (See Special Report on 3D Printing in this section.)
Bonds >> Investment-Grade Bonds. Investment Rating: D+ The expected scaling back of the Fed’s asset purchase program will drive yields up and prices down on most bonds, including those bearing the lowest risk. Bonds with the longest maturities or durations will be hit the hardest. High quality corporate bonds could regain favor with investors, although this effect may only offset part of the general fall in bond prices. >> High-Yield Bonds. Investment Rating: D Bonds of higher risk firms could see especially large losses, particularly where companies have assumed large amounts of debt. Probabilities of default could rise in an economy still not strong enough to support large financing costs. >> Municipal Bonds. Investment Rating: C- The improvement in the finances of most state and local governments due to the pickup in various revenue sources will cushion the impact of the overall drop in bond prices. Their tax preferred status by many high income investors will also help. Performance will not be uniform as many regions continue to suffer from depressed economic conditions and high unemployment. Puerto Rico’s precarious financial situation, with $70 billion of debt, and possible bankruptcy could jolt the municipal market at least briefly.
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Real Estate >> Residential. Investment Rating: A- The expected scaling back of the Fed’s asset purchase program will drive yields up and prices down on most bonds, including those bearing the lowest risk. Bonds with the longest maturities or durations will be hit the hardest. High quality corporate bonds could regain favor with investors, although this effect may only offset part of the general fall in bond prices. >> Commercial. Investment Rating: A Office, industrial, and retail markets continue to strengthen. The paucity of new construction and gradual rise in economic activity and jobs have caused a firming in rents and property prices. While location has returned as a key factor affecting returns, the commercial segment appears to have passed its low point. >> Land. Investment Rating: C The abundance of both domestic and foreign capital has pressed on the shortage of developable land to drive prices sharply higher. Restrictive land use policies have further exacerbated this trend in many Chart 18 regions. Residential and commercial developers will still be looking for open space. However, various bubbles Commodity Prices Stabilize CRB Commodity Price Index, 1967=100, month-end appear to now exist, especially 700 in agricultural areas, warranting 600 caution on the part of investors. 500
Other Investment Classes
400 300
200 >> Commodities. Investment Rating: B 100 Commodity prices remained 0 2007 2008 2009 2010 2011 2012 2013 generally soft in 2013 as economic growth in many emerging markets Source: Haver Analytics; FBEI slowed significantly. (See Chart 18.) This curbed industrial demand for many raw materials, while many investors saw little appeal as an inflation hedge in an environment of low inflation. Some cutbacks in excess capacity during 2013 should combine with a pickup in economic activity in 2014 to cause some firming in many commodity prices. Low inflation will still limit investment demand in the coming year, but overall returns should improve at least moderately.
>> Art, Jewelry, Antiques, and Collectibles. Investment Rating: A Investors, particularly high net-worth individuals, are likely to continue to be attracted to many tangible assets that are not easily replicable.
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These include both classical and modern works of arts, expensive jewelry, antique furniture and cars, and other collectibles, including musical instruments. Wealth increases rising from the development of new technologies and the rapid emergence of various developing economies are helping support this investment class.
Special Report: 3D Printing — Racing Ahead of the Pack
Additive manufacturing (AM), commonly referred to as 3D printing, is a system of creating three-dimensional solid objects of virtually any shape from a digital model. This process is referred to as additive because it is achieved by joining layer upon layer of thin horizontal cross-sections of materials to create the object. In traditional machining methods, items are created through the removal of materials through methods such as drilling, cutting, and grinding (subtractive processes). AM was once primarily associated with the creation of prototypes and models, but in recent years it has been increasingly used to produce finished goods and to produce manufacturing and assembly tools. Companies across the globe are discovering the advantages of AM processes, and finding new ways to use it to reduce costs and better customize products. Among the advantages of AM compared to traditional manufacturing processes are the following: >> Manufacturing complexity and variety add no additional expense. Unlike traditional manufacturing, in AM complexity costs the same as simplicity. Different shapes can be fabricated each time, removing overhead costs of retraining labor or retooling machinery. >> Zero lead time. Print on demand when an object is needed is possible with AM, reducing the need for large physical inventories. >> Unlimited design space. Capacity is currently limited by tools available for use; AM removes such barriers and enables the fabrications of shapes much more complicated than basic geometric ones. >> Reduction in skills needed to operate manufacturing machinery. Significantly less operator skill is needed in AM which could open up production opportunities for people in remote environments, including less-developed countries. >> Compact, portable manufacturing. AM systems can fabricate objects as large as its print bed or larger if its printing apparatus can move freely, taking up less physical space than in traditional machining.
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>> Less waste by-product than with subtractive processes. Grinding, drilling, and cutting materials create significant waste compared with AM. For example, machining metal processes waste an estimated 90% of the original metal which is ground off and ends up on the factory floor.
A wide variety of industries are benefitting from AM technology in both military and civilian markets. Products currently being produced using AM processes are many and varied, including: medical and dental devices, automobile interior parts, jet engines, eyewear, aircraft parts, and mobile phones.
In the medical and dental fields, AM technology is particularly useful as it allows practitioners to fit appliances and devices that are custom-made for each individual patient’s unique anatomy. As of 2012, 10% of dentists had systems in their offices that they use to create custom-fitted crowns for patients, eliminating the need for temporary crowns and allowing crowns to be placed in one office visit.
Nearly 10,000,000 hearing aids in circulation worldwide as of 2013 have been created using 3D printing technology. Traditional hearing aid manufacturing required nine steps, while AM has reduced the number of steps needed to manufacture a hearing aid to three: scanning, modeling, and printing. The result is a more cost-effective and better-fitting product. All of the large orthopedic implant manufacturers are using AM to create appliances that fit better and are more comfortable for users. More than 50,000 patients per year are being treated with guided surgery using AM-fabricated instruments. Scientists are currently working on developing 3D printed human tissue, which may someday be used as replacement organs and in pharmaceutical trials.
The United States is currently the leader in terms of production and sales of professional-grade, industrial AM systems, while Europe is the second largest producer of such systems. Some analysts contend that AM technologies may be the solution that will allow U.S. and European companies to compete with China’s stronghold in mass-produced goods.
AM is not without its challenges. Materials used in AM processes can be relatively expensive, build rates are sometimes very slow, AM systems are still relatively expensive, and labor retraining costs can be high. Most of these issues should be resolved over time as processes are refined, patents expire, and research leads to improvements in AM technology.
In 2012, worldwide revenue from all AM products and services was estimated at $2.2 billion. With universities, private companies, and consortia around the globe investing millions of dollars in research and development on AM-related products, materials, and systems, growth in this field is expected to continue at a rapid pace over the next ten years.
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VII. CALIFORNIA — BUILDING MOMENTUM Upswing Defies Doubters
California’s economy has continued to show more favorable signs, refuting claims that the state has lost its ability to grow. Although the path has not been straight upward, jobs, incomes, and retail sales are again expanding, while home prices climb. The state’s fiscal picture has also brightened significantly. Although not without hurdles and risks, look for California to show more of its resilience in 2014. Job growth in California is now tracking the nation’s relatively closely on a year-over-year basis. (See Chart 19.) While the state’s unemployment rate remains well above the U.S. average, it has dropped more rapidly than in the rest of the country over the past year. (See Chart 20.) Job gains have been widespread and especially pronounced in construction, real estate, professional and business services, transportation, trade, health care, and leisure and hospitality.
Chart 19
Chart 20
California’s Job Upturn Tracks the Nation’s
California’s Jobless Rate Remains Above U.S.
Nonfarm employment, percent change over prior year 4
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2003 2004 2005 2006 2007 2008 2009 2010
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Source: CA Employment Development Dept.; FBEI
Looking ahead to 2014, California will benefit from a number of positive elements: >> Technology continues to lead. California remains a global leader in innovation with a full array of new products and applications for both business firms and households. Ranging from social media to biotechnology to the emerging field of 3D printing or additive manufacturing, the state is the hub of creative destruction and game changers of the 21st Century. >> Housing is on the rebound. Soaring home prices have shored up home equity values and transformed housing from a buyer’s market into a seller’s one. Delinquency rates and foreclosures have dropped sharply. Although higher mortgage rates along with rising prices will dampen affordability to some degree in 2014, look for further sizable gains in home sales, prices, and new building.
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>> Travel and tourism is on the rise. The coming year should see further gains in both business and leisure travel. Businesses are beginning to slowly ramp up their budgets for sales and business development. Convention and trade shows should increase further. Consumers, who slashed spending for vacations during the recession, are taking more holidays away from home. Foreign travel should pick up in 2014 and California will be a favored destination. >> Exports will advance. Demand for the state’s technology and agricultural products will be particularly strong. On the services side, in addition to tourism, California’s higher education system will continue to attract foreign students, while its entertainment sector has deep appeal abroad. >> Lower gasoline prices will be a plus. In light of California’s car culture and its reliance on the automobile, lower gasoline prices will boost household buying power and also be a positive for transportation firms. Because gasoline prices are also a major factor affecting consumer confidence, their decline will be particularly constructive.
Some major barriers will limit the state’s ability to grow in the coming year: >> Federal budget cuts will hurt. Cutbacks in funding for defense, research and development, education, social services, and other programs will negatively impact California. >> Electricity prices remain high. While Californians have embraced the principle of a cleaner environment, consumers and businesses will bear the cost of that decision. The requirement that utilities generate one-third of their electricity from renewable sources (wind, solar, and geothermal) will continue to make electricity prices here significantly higher than in the rest of the nation. The state will also not be able to benefit as greatly as the rest of the country from the boom in natural gas development and production, which have sharply reduced prices. >> California’s regulatory climate remains oppressive. California companies continue to deride the state for its costly, time-consuming, and often contradictory regulations. The largest impact is less from the exit of firms from the state than from the negative effects on new business formation and expansion in California.
The positives will outweigh the negatives in 2014 to allow California to continue to advance. Look for the state to add about 265,000 jobs, following the estimated 220,000 new positions created in 2013. (See Chart 21.) Job growth should be enough to drive the unemployment rate down more than a full percentage point towards about 7.5% by year-end 2014. It should be emphasized that California suffers from wide gaps in incomes, such as between the coastal and inland areas, including much of the mostly rural Central Valley. Disparities in incomes trace largely to differences in skills and education levels. Times of economic improvement should be used to address some of these inequities.
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Chart 21
Chart 22
California Hiring Steps Up
California’s Fiscal Picture Brightens
December change over prior year, thousands
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Source: California State Controller; FBEI
California’s Budget Steadies
Increases in jobs, incomes, home prices, and capital gains from the stock market’s surge have refilled the state’s coffers. The turnaround in California’s economy has particularly boosted personal income tax receipts, which comprise about 70% of the state’s total revenues. As consumers release pent-up demand, auto sales and other retail spending are also generating higher tax receipts. Tax increases approved by voters in November 2012 have further boosted the revenue numbers. Spending restraint has been seen, especially in terms of the cost of state operations.
The state is legally required to have a balanced budget each year, which formally occurs on paper. Yet, operating cash shortfalls have continued to occur in recent years. That situation should change in fiscal 2013-14. The state began the current fiscal year on July 1, 2013 with a negative balance of $2.4 billion. With revenues projected to exceed disbursements by about $6.4 billion over the coming year, California stands to end the year with a surplus of approximately $4.0 billion. (See Chart 22.)
Such a surplus will give the state the ability to start to pay down its outstanding debt and build its reserves. State revenues remain subject to the economic swings and developments affecting the rest of the nation. To continue to follow a trail of financial improvement, continued fiscal discipline will be required. While much needs to still be done to achieve full financial health, including addressing the state’s pension fund, the coming year’s expected outcome represents a promising start.
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VIII. SAN DIEGO—STAYING UPRIGHT Overcoming Obstacles
San Diego survived sequestration, government furloughs, and heightened uncertainty during the past year, but it was not easy. Job growth began the year robustly and then lost momentum as the year progressed. Hiring was generally widespread and was enough to drive the unemployment rate lower.
Important positives will help drive the region’s economy forward in 2014: >> Housing’s recovery will continue. The precipitous plunge in home prices pummeled San Diego’s economy during the recession. The rebound has been the region’s most important catalyst. In 2013, home prices in San Diego soared 20% and another 9% rise can be expected in 2014. (See Chart 23 and following section.)
Chart 23
San Diego Home Prices Bounce Back Zillow/Case-Shiller Index, Jan 2000=100, seasonally adjusted 300 250 200 150 100 50 0
>> Biotechnology will be a growth leader. Capital is returning to e=estimate f=forecast the sector as stock prices of many biotech firms have surged. Initial Public Offerings (IPO) have soared, while merger and acquisition activity is active. Biotech is rapidly expanding its reaches into various sectors of the economy beyond pharmaceuticals, such as food manufacturing and energy. 2004 2005 2006 2007 2008 2009 2010
2011
2012 2013e 2014f
>> Wireless technology and software will advance further. The applications of wireless communications will continue to spread throughout the economy and transform much of it. As one example, restaurant ordering and operations are likely to change radically. San Diego firms will be part of this ongoing communications revolution. >> Leisure and hospitality will be strong. Supported both by residents and outside visitors, the region’s hotels, restaurants, sports facilities, and entertainment venues will be important generators of economic activity in 2014. >> The health care industry will expand. Although successful implementation of the Affordable Care Act remains in question, the medical care sector will expand to cover increased numbers of Californians who will have insurance. The sector will change, with a much great focus on out-patient facilities.
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>> Mexico represents an important opportunity. A return of Mexico to its stronger growth trend should help San Diego firms. The opening up of supply channels in sectors such as medical equipment and aerospace manufacturing promises good opportunities for many of San Diego’s firms. >> Shipbuilding is seeing strong orders. Private sector demand is now joining substantial business from the U.S. Navy in shipbuilding and repair. Private U.S. carriers are beginning to add capacity, such as in tankers, and modernize their fleets to attain efficiency and environmental objectives.
Three primary elements will put a brake on potential growth in 2014: >> Federal budget cuts, including some form of sequestration, will stifle growth. Defense spending is likely to bear the brunt of deficit reduction measures contained in the Budget Control Act of 2011. San Diego’s important military cluster, although significantly insulated, will not escape the effects. (See following section.) Research funds vital to the region’s Universities and nonprofit centers are also vulnerable.
Chart 24
San Diego Creates More Jobs December, change from prior year, thousands 35 30 25 20 15 10 5 0 2010
2011
2012
2013e
2014f
e=estimate f=forecast Source: Haver Analytics; FBEI >> Skill shortages will limit the expansion of some firms or sectors. Companies are still desperate to fill software engineering jobs and various other positions requiring math, engineering, or programming skills with qualified applications. Outside of business and professional services, jobs requiring such skills as welding remain unfilled. (FBEI recently completed a major study on this topic which underscores the risk to San Diego. To view full report visit www.workforce.org)
>> Uncertainty may keep many on the sidelines. Uncertainty about federal spending and interest rates will add to the ongoing volatility in sales to cause many businesses to refrain from assuming greater risk. This will dampen both investment and hiring.
On balance, the positive forces should outweigh the negatives to enable San Diego to add about 28,000 jobs during 2014, adding to the estimated 26,000 positions created in 2012. (See Chart 24.) This should be sufficient to push the jobless rate down close to 6.5% by the end of 2014 from an estimated 7.0% at the end of 2013.
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San Diego’s Military Cluster — Downshifting
The ending of the primary U.S. military commitments in Iraq and Afghanistan will combine with pressures on the federal budget to challenge the amount of support provided by defense spending for San Diego. The military continues to be the most important economic driver in San Diego’s economy. Although the region possesses comparative advantages that align well with the military’s new strategy, it will not escape some impact of a smaller defense budget.
Chart 25
Defense Spending’s Share of U.S. GDP Shrinks Percent, fiscal years 9 8 7 6 5 4 3 2 1 0 70
f=forecast
U.S. spending for national security has probably peaked at least for the near-term. As a percentage of gross domestic product, total national defense spending (including that funded out of agencies other than the DoD, such as the Department of Energy) is likely to fall to 3.7% in fiscal 2014, the lowest level since 2003 and down more than a percentage point from its recent peak of 4.8% in fiscal 2010. In contrast, during the first half of the 1970s, national defense spending ranged from about 5% to 8% of U.S. GDP. (See Chart 25.)
Although Congress is likely to give the Pentagon more flexibility in cutting spending than the Source: DoD; FBEI across-the-board reductions mandated under sequestration during 2013, overall national expenditures for defense could drop by as much as $20 billion during the coming year.
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Dollars linked to national security enter San Diego through three primary channels: wages and benefits for active duty and civilian workers; spending on contracts, grants, small purchases, and tourism from family members and friends visiting the military; and benefits for retirees and veterans. Retirement and veterans’ benefits can be expected to be exempt from budget cuts, but other areas will be vulnerable. Defense-related spending is responsible either directly or indirectly for approximately 22% of all jobs in San Diego County. (See Chart 26.)
Chart 26
Military Responsible for 22% of All San Diego Jobs Share of total, FY 2013 estimate Jobs Supported by Defense Spending, 22%
Other, 78%
Source: FBEI
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These span a wide range, including engineering, food services, construction, shipbuilding, health care, real estate, research, and tourism.
The number of San Diego individuals directly employed by the DoD is likely to ease to around 136,000 from 139,000 between fiscal years 2013 and 2014. Most of the reductions can be expected in the Marines and among civilian employees. Active Duty members of the Navy and members of the Reserves are likely to hold relatively steady.
San Diego stands to hold an edge in competing for a share of a shrinking defense budget over the next several years. A new national defense strategy calling for a pivot to the Pacific Ocean, greater reliance on rapid-response forces, emphasis on unmanned vehicles and weapons, a focus on cyber-security, and need for vital air-training space will all favor the region. However, the inflection point has clearly been reached.
Technology – Extending Its Lead
San Diego has a wide variety of industries that operate in the tech space. Some of these include: Chart 27
>> Aerospace and security technologies >> Clean technology and energy generation >> Communications and Information technology >> Life science diagnostic and research tools >> Clean technology and energy generation >> Software >> Sports technology
Tech Creates Valuable San Diego Jobs Thousands, December 2013e 60 50 40 30 20 10 0 Prof, sci, and tech srvc
Sci research
Comp and elec mfg
Telecomm
e=estimate Source: California Employment Development Department; FBEI There are nearly 120,000 tech-related jobs in San Diego County. (See Chart 27.) San Diego possesses the diverse set of ingredients needed to cultivate innovation and growth. Each of these sectors has its own levels of potential, but there are several developing capabilities that can contribute to growth in all of them.
Big data, along with cloud computing and mobile technology, are currently the largest growth opportunities in the technology industry. Big data represents a huge opportunity for businesses around the globe. Companies of all sizes, across all industries, are producing huge volumes of data that need to be processed. This need could represent a significant growth driver for the region. San Diego’s healthcare sector is being transformed with the implementation of the Affordable Care Act.
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Companies will need to reduce costs while accommodating larger volumes of patients. San Diego’s defense contractors are also facing tighter federal budget constraints. Both of these industries, along with most others, could see large cost savings by implementing efficiencies derived from big data analysis.
Chart 28
Venture Capital Still Struggling Millions of Dollars 1500
1000
On the other hand, Venture capital 500 spending in San Diego has slowed since 2012. With a projected total of only 0 $838 million dollars for all of 2013, this 2012 2013 2014f 2009 2010 2011 represents a decline of nearly 30% from Source: Pricewaterhousecoopers/ the 2012 amount. This can be explained by e=estimate f=forecast National Venture Capital Association; FBEI the large decline in Biotechnology funding of nearly 40% for this year. Stronger economic activity should push venture capital up by 15% to 20% in the San Diego region during 2014. (See Chart 28.)
With the continued possibility of significant federal budget cuts, the large research presence in San Diego could see declines in available grant funding. The National Institutes of Health, National Science Foundation, and National Oceanic and Atmospheric Administration could all see reduced funding, hurting innovation and research efforts across various companies and institutions in the San Diego region.
Despite the immediate challenges, San Diego’s large tech sector already has much of the infrastructure and talent in place to foster further tech-based innovation and growth.
Tourists - Cruising In
The San Diego Tourism industry is expected to see steady growth after the recession of 2008 and 2009. Returning cruise lines to the region and a growing Mexican economy will help drive the tourism economy in San Diego.
The military has a significant impact on tourism in San Diego. Family members and friends come to the region to visit members of the military and civilian DoD employees who are currently based here. The military presence in San Diego will have a tourist impact of about $114 million in 2014, off slightly from the estimated 2013 amount. This decline will largely be due to the projected decrease in active duty forces from the wind down of the U.S. involvement in Afghanistan. The strategic shift of naval forces from the Atlantic to the Pacific will help buffer these decreases for San Diego.
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In the past few years, San Diego has seen a decrease in cruise ship tourism due to the ongoing violence in Mexico. The Mexican government has made an assertive effort to improve the safety of its ports and improve its reputation as a tourist destination. At least one cruise line, Holland America, will be returning to San Diego in the coming months for cruises down the Mexican coast with the possibility of other cruise lines to follow. This will translate into positive tourism growth in San Diego for 2014.
Mexican tourists visiting San Diego contribute significantly to the local economy, especially in the shopping and retail space. About half of all northbound visitors into California come to shop. In 2010, there were 61 million northbound crossings into California. With the San Diego border crossing one of the busiest in the world, this represents a very significant economic contribution to the local area. An expected pickup in Mexican real GDP growth to approximately 3% in 2014 should combine with Baja’s recently enacted sales tax increase to further boost cross-border buying during the coming year.
The hospitality industry saw an average daily room rate (ADR) for the region of just over $130 in 2012, but room rates rose in 2013 and further advances are projected for 2014. Increased tourist traffic from visitors embarking on the returning cruise lines and other activities are expected to drive up room demand. Five properties, representing 870 rooms, are currently in the construction phase of expansion throughout the County. This would represent a 1.5% increase in market supply (PKF Hospitality Research). FBEI projects total San Diego County room demand to increase by 2.5% in 2014.
Real Estate — Riding Faster
San Diego’s real estate and construction sector has shaken off the ravages of the Great Recession and will be a driver of the region’s economy instead of a drag during the coming year. Home sales, prices, and building will post further gains. The nonresidential sector will join housing as a positive economic force as vacancy rates have dropped low enough to begin to justify new construction.
San Diego’s housing market boomed in 2013 as first-time buyers, move-up purchasers, and investors all bid for a limited supply. The pendulum rapidly swung from a buyer’s to a seller’s market, with multiple offers on various properties appearing in different markets. Foreclosure and delinquency rates fell sharply and the much feared “shadow inventory” that might exist and be released by banks did not appear.
Housing prices jumped 20% in 2013 in the region and are projected to advance another 9% in 2014. This will put them approximately 50% above the low point reached in May 2009 but still leave them about 14% off their March 2006 peak. The rise in prices will combine with some increase in mortgage rates to put the affordability index (measuring the percent of households who can afford to purchase the median priced home) at an average of about 25% in San Diego during 2014.
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This will be less than an expected statewide average of 30% and a national average of approximately 55%. In contrast, it will rank substantially higher than the 15% projected for the San Francisco area.
Chart 29
More New Homes in San Diego Housing permits, number of units, thousands 8 7 6
MultiFamily
5 Responding to the revival in housing 4 demand and the collapse of new supply 3 following the implosion of the 20062 2007 real estate bubble, new residential 1 construction should climb further in SingleFamily 0 2014. (See Chart 29.) Land availability, 2010 2011 2012 2009 2013e 2014f permit costs and delays, and remaining caution on the part of banks lending to Source: Haver Analytics; FBEI e=estimate f=forecast developers will temper the amount of new supply. Look for about 7,000 units to be constructed in 2014, up from an estimated 6,400 units in 2013. This will mark the highest pace of new building since 2007 but equal only one-half the average annual number of units built over the ten years through 2006.
Look for single-family units to account for about two-fifths of the total number of housing units built in 2014, which will mark the fourth consecutive year in which multi-family units (apartments, townhouses, and condos) will represent more than half of new construction. Rising rents and pinched incomes have made the apartment market particularly attractive to builders and investors. That dynamic may start to change in the coming year as the rental market could begin to face a situation of oversupply.
Chart 30
San Diego Office Vacancies Decline Percent, annual average 24 20 16 Total 12 Class A
8
Commercial office markets have continued to heal in San Diego as new supply has dwindled and demand has firmed. The drop in vacancy rates has been especially pronounced in upscale or Class A buildings. (See Chart 30.) As lease rates have encouraged tenants to upgrade their facilities, Class A vacancy rates have declined and converged to the average for all property types. Look for both Class A and the total office vacancy rate to equal about 10.5% in 2014. Rental rates are likely to firm and most concessions, which typically end when vacancies drop below 10%, will be much more limited.
4 0 2004 2005 2006 2007 2008 2009 2010
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Conditions should be strong enough to justify more building in the office market in 2014. New construction will focus on higher end space and target technology, research, and engineering firms. A major growth area will involve outpatient medical facilities as the Affordable Care Act increases the number of households with health insurance but also puts a premium on efficiency and cost control. The industrial property market has continued on the mend with virtually no significant increase in new space added in the past four years. The vacancy rate by the end of 2014 is projected to approach 8% in contrast to the nearly 12% reached at the peak of the property slump.
Flex space (affording tenants the capability to combine office or showroom space with manufacturing, laboratory, warehouse, or other uses) saw its average vacancy rate soar to around 17% at the peak. That rate should recede to around 11% by the end of the coming year. Warehouse vacancy rates, which hit a high averaging about 10%, should drop to around 7% by the end of 2014.
New industrial construction should start to revive in 2014, particularly in providing new warehouse and distribution space. The explosion of e-commerce is now being accompanied by the demand for same-day delivery. This will increase the need for major distribution centers near population centers.
San Diego’s retail market has strengthened substantially over the past year as consumer spending has recovered. The overall vacancy rate has ended 2013 at around 4.6% and can be expected to move to about 4.2% by the end of 2014. Vacancy rates will be the highest in shopping centers (neighborhood store clusters) at around 7.0% and lowest in malls at less than 1.5%.
Average leasing rates are likely to advance about 4.0% in 2014, following a 3.5% gain in 2013. Considerable churn among various retailers can be expected to continue, reflecting in part the varying abilities of enterprises to adapt to the rapid uptake of e-commerce. Malls and other shopping venues will be seeking ways to attract households attracted by the “shopping experience” as opposed to the mere purchase of specific merchandise.
Although its downturn has been harsh, commercial real estate avoided the severe pummeling experienced by housing. The sector’s recovery typically lags that in housing and the current cycle is following that pattern. Look for 2014 to see more commercial building and further firming in lease rates and property prices.
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IX. RISKS TO THE FORECAST
A number of factors could derail the overall economic forecast. Following are several that lead the list (See Chart 31).
Chart 31
Risks to the Global and U.S. Forecasts Probability, percent
Fiscal & Political Gridlock >> Fiscal and Political Gridlock. Monetary Backlash The inability of Congress to reach Middle East a compromise on the budget Terrorist Attack could lead to an extension of the European Turbulence Continuing Resolution (holding Chinese Hard Landing spending at 2013 levels, another Natural Disaster round of sequestration (including 0 25 50 75 across-the-board spending cuts), or another government shutdown. The impact of the ripple effects Source: FBEI of spending reductions and uncertainty could more seriously affect the economy than last October’s government shutdown. Failure to raise the debt ceiling in a timely fashion could lead to another credit downgrade of the United States and pummel stock prices. (Probability: 60 percent)
>> Monetary Backlash. Financial markets could react violently to one or more steps of the U.S. Federal Reserve to curb its aggressive policy of monetary expansion. Longterm interest rates could jump sharply while stock prices could plummet. A large rise in interest rates could put pressure on highly leveraged firms or financial products and also jeopardize the housing recovery. (Probability: 20 percent) >> The Middle East. Tensions in the Middle East could flare up, involving Egypt or Syria, for example. Worries about Iran could provoke hostile actions by Israel and encourage Saudi Arabia to acquire nuclear weapons from Pakistan. Oil prices could soar, leading to a pullback in household spending. (Probability: 20 percent) >> Terrorist Attack. Terrorist cells remain active in various countries around the world. While stepped-up security and intelligence have thwarted many potential attacks, other efforts have succeeded in various locations around the world. Another attack in the United States cannot be ruled out. Cyber attacks occur frequently on a limited basis and could take place on a scale that could cause massive harm to transportation, telecommunications, industrial, and financial systems. (Probability: 15 percent) >> European Turbulence. Although financial and economic conditions have recently stabilized in the Eurozone, gaps persist between northern and southern nations. Countries such as Germany, Austria, and the Netherlands oppose further bailouts, while many of the southern countries, such as Greece, Portugal, and Spain, may need further assistance in the face of austerity programs and high unemployment. In Eastern Europe, Ukraine’s precarious financial condition could force a default if Russia or the International Monetary Fund does not provide funding. (Probability: 15 percent)
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>> Chinese Hard Landing. China’s reluctance to curb bank lending and state investment could further inflate property markets to a point where prices finally collapse. Subsequent wealth losses and plummeting confidence could thwart the country’s efforts to boost consumer spending and cause a major economic slowdown, with spillover effects throughout the global economy. (Probability: 15 percent) >> Natural Disaster. Extreme weather events, ranging from severe drought to flooding, continue to be unpredictable both with respect to location and duration. Shocks, including hurricanes, typhoons, earthquakes, and tsunamis, can devastate economic activity for extended periods of time. (Probability: 15 percent)
Each of these risks carries a significant probability of occurring and could have severe economic repercussions. While none of them is incorporated in the forecast we believe is most likely, businesses should at least consider strategies to deal with each.
California faces additional risks that could significantly impact its economic performance in 2014: >> Real Estate Bubble. Home prices could continue to escalate in various parts of the state, which could further erode affordability, adversely affect the state’s competitive position, and lead to another sharp downward cycle. Agricultural land values could be leading part of a general property bubble and subsequent collapse. (Probability: 25 percent) >> Municipal Bankruptcy. Despite the general economic upswing in California’s economy, sizable pockets of high unemployment and poverty persist in both rural and urban areas. These localities could see further strains on their financial positions, compounded by pension obligations and instances of mismanagement or fraud. (Probability: 25 percent) >> Health Care Costs. The roll-out of the Affordable Care Act in California could see far fewer than expected young and healthy individuals signing up for coverage. This could keep the demands on the emergency care systems high while raising costs for private health care providers. Individuals and companies could see large increases in premiums, while smaller businesses avoid expansion in order to avert the requirement to provide coverage for employees starting in 2015. (Probability: 35 percent) >> Immigration Reform Delays. Congressional delays in implementing immigration reform could aggravate worker shortages in industries ranging from technology to agriculture. This could crimp growth in some sectors or encourage industries or firms that are more mobile to expand out of state. (Probability: 55 percent)
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San Diego also confronts particular risks that could jeopardize its economic future: >> Sequestration. Steep budget cuts could bear harshly on San Diego, adversely affecting defense contractors and various businesses dependent on the presence of military support. Severe reductions in grants funded by the National Institutes for Health, the National Science Foundation, and other federal agencies could halt research conducted at universities and other entities. Such declines could not only directly impact employment and incomes in these research organizations but also stunt the emergence of spin-off businesses. (Probability: 25%) >> College Costs and Loan Obligations. The continuing rise in higher education costs could adversely affect enrollment and exacerbate the debt loads carried by many students. The failure of large numbers of students to earn a degree in four or even six years could aggravate this problem. Meanwhile, many students may earn degrees that are given little value in the marketplace. (Probability: 55 percent) >> Regulatory Burdens. Frustration over the cost of complying with various regulations in terms of fees, time delays, or administrative burdens could cause more firms to leave the region despite its various advantages. Marketing by competing states or localities could intensify and accelerate any outflow. (Probability: 45 percent)
In contrast to these various downside risks, the economies at the global, national, state, and regional levels could turn out to be stronger than assumed in our baseline forecast. Five years after the ending of the recession in mid 2009 could see more positive impacts of the improvement in many household, corporate, and bank balance sheets. New developments in technology could unleash many new firms and jobs. The President and Congress might even begin to deal with the long-term problems surrounding the nation’s debt in a rational manner.
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X. ACTION STEPS FOR 2014 The year ahead will be a major transition period for the global economy as the training wheels begin to come off. Each of us will face both hurdles and opportunities. Economic conditions should improve, but the results will be uneven. The following recommendations are offered to help plan and prepare for 2014.
For Students >> Strive to complete your college degree in four years. In California, only about one-third of students graduate from public institutions in that time frame and less than two-thirds earn a degree in four years from private schools. Changing majors or lagging behind can be costly. >> Consider community colleges or trade schools. Learning specific skills, ranging from welding to cooking, can enable many individuals not attracted to a liberal arts college degree to find rewarding opportunities in the marketplace. >> Be cautious in assuming debt. Student loans now rank as the largest source of debt, exceeding credit cards. Individuals may be burdened for many years by paying down the cost of large debts assumed during college years.
For Households >> Increase savings. Put additional amounts of income into savings and insure that you are at least contributing to 401(k) plans the amount that your employer will match. Even high-net worth individuals admit they underestimated their spending requirements after retirement and wished they had saved earlier and more in their younger years. >> Encourage STEM (science, technology, engineering, and mathematics) education. Promote STEM learning for our children, overcoming the stigma and social rejection often plaguing young people pursuing those subjects. >> Purchase your own home. Although we have probably passed the low points for both interest rates and home prices, if you plan on living somewhere for several years, 2014 could still be a good time to buy either your first home or upgrade to a different one.
For Investors >> Exercise caution. Stock prices, after their meteoric rise in 2013, have become relatively expensive and will likely offer much more moderate returns in the coming year. Avoid the temptation to be swept up in buying frenzies that take prices well above levels based on company fundamentals or reasonable expectations.
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>> Remain diversified. Although one lesson of the last recession and credit crisis was that few investments can totally escape global trends, investors still need to have a mix of equities, fixed-income products of different maturities, and hard assets to modulate the effect of swings in asset preferences and fund flows. >> Maintain a long-term investment horizon. Do not be unduly influenced by swings in asset prices since markets can be expected to remain volatile. Investing in stocks of solid companies or properties in good locations should yield good returns over time.
For Businesses >> Invest in technology. Although payback periods will be short as the pace of innovation escalates, investing in new equipment and software will be vital to maintaining and growing your customer base while remaining competitive on the cost side. >> “Stress test” your enterprise. Just as banks are undergoing stress tests gauging their ability to withstand financial or economic shocks, it will be important to determine your organization’s ability to withstand, for example, a sizable increase in interest rates from their current exceptionally low levels. >> Watch for game changers. Monitor new innovations that could impact either in a positive or negative way your basic business model and be prepared to make potentially large changes. >> Listen. Pay close attention to the comments and inputs from your customers, your employees, and your associates. Social media has now made communications much easier and more widespread. Information, suggestions, and feedback are invaluable assets. Even as the economy and markets show signs of improvement, many Americans remain anxious over their current and future condition. Carl Cannon, author of The Pursuit of Happiness, which chronicles the perceptions of U.S. presidents over time, recently described his view of what brings satisfaction to many individuals. Most people need to work for an enterprise that is highly respected, whether on a global, national, regional, or local scale. They also need to have pride in the work they are doing, whether an idealistic mission or a particular, even if modest, product or service they are creating. Organizations that can create value, gain respect, and instill pride in their employees for their role in the enterprise will do much to foster that happiness in 2014. This in turn can become a primary driver of economic growth and prosperity for all of us.
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Fermanian Business & Economic Institute at PLNU
Does your organization need actionable business and economic solutions? The FBEI is here to partner with you. For information on business and economic consulting, research, and commentary, visit www.pointloma.edu/FBEI or call (619) 849-2692.
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