In the following piece, Fifth Third's chief investment strategist Jeff Korzenik outlines Fifth Third's perspective on a few key questions facing investors.

Earlier this year, Fifth Third's investment management group outlined five concepts that Fifth Third believed would be of importance to investors in 2015. Our beliefs were that:

  • the U.S. economy would continue to grow
  • inflationary constraints to growth would become increasingly apparent
  • the price of oil would continue to be an important factor
  • the Fed's path would be more consequential than most believed, and finally, that
  • This added up to an environment with more narrow investment opportunities.

With a full quarter of the year behind us, little has happened to dissuade us from these core beliefs. However, recent market action and economic releases have undermined investor confidence. Our own tactical stance shifted in recent months away from our multiyear preference favoring equities at the expense of bonds. We now prefer to be more aligned with a longer-term strategic allocation during this period of investor uncertainty.

Before we can witness a sustainable move in major markets (in either direction), we believe investors must find conviction in the answers to three critical questions. We consider each of these questions in turn.

Question #1: Why has the U.S. economy slowed?
Investors, policymakers and citizens are well-justified in feeling frustrated by the U.S. economy. Throughout the initial years of the recovery from the 2008-09 recession, the U.S. grew at a historically lackluster pace; in Fifth Third's opinion, this was largely a function of the need to repay the excess indebtedness incurred in the years approaching the downturn. This deleveraging process came at the expense of consumption, the traditional engine of the American economy. However, by 2014, most of those headwinds had been eliminated, both through reduced consumer debt burdens and by lower interest rates alleviating the cost of carrying that which remained.

By the middle of last year the economy appeared to be achieving a long-awaited rapid and accelerating pace of expansion. Annualized GDP growth in the second and third quarter averaged 4.8% and the calendar year was the best for net job creation since 1999. Yet by the fourth quarter, the rapid advance in the dollar and the free fall in oil prices undermined export growth, oilfield employment and the energy sector's capital investment, leading to a quarter in which the U.S. GDP grew by only 2.2%

More troubling, the first quarter of this year may well reflect a yet slower rate of GDP expansion. To be sure, many of the factors commonly blamed for tepid growth are receding. The winter weather disruptions are behind us, West Coast port labor disputes have been settled, and the disruptive speed of the U.S. dollar's advance and oil decline have slowed.

While such headwinds are passing, we worry that the disappointing growth rate implied by these numbers may also reflect an economy effectively "running out of room" to grow. Chief among our worries is the availability of labor that fits the needs of employers. Recent results of a survey conducted by the NFIB (National Federation of Independent Businesses), suggests that the difficulty in filling job openings is comparable to periods that marked the late stages of business expansions.

Question #2: How will the Fed respond?
Shortages of labor immediately act as a brake on economic growth. But continued demand for a limited supply of workers ultimately resolves itself in wage inflation. The discussions of 2015's monthly employment reports have focused on a deceleration in payroll growth from the preceding year. Missing from this conversation is that these releases do contain some limited evidence that wages inflation may be accelerating. While year-over-year numbers still show tepid growth in average hourly earnings, the first quarter data shows a significant pickup. It is simply too early to draw any conclusions from such a limited time frame, but the headline stories of major U.S. corporations voluntarily raising pay (e.g., McDonald's, Home Depot) all support the notion that compensation costs may be rising, which historically correlates closely with rising core inflation.

The Fed has made clear that a limited amount of wage inflation would be acceptable, particularly if it helped raise labor force participation rates. However, a pickup in wage inflation would add urgency to the Fed's stated need to start "normalizing" short term interest rates. Some Fed officials have explicitly noted that the normalization process can start without wage inflation.

Our central bankers see a need at least to start the "lift off" process in order to return rates toward neutral levels so as to have more maneuvering room in the event of an economic slowdown. They also recognize that complacency over unchanging short-term interest rates set at zero can create systemic risks. In the post-WWII history of the Fed, the central bank has never held rates at a single level as long; at 77 months (and counting), the Fed has easily bested its previous record level of stability of 19 months. See chart to the right. Source of data Federal Reserve Bank of New York. Under these conditions, we have been well within the industry consensus in anticipating a Fed liftoff between June and September, given reasonable economic growth, with or without inflation, with the subsequent pace of rate increase would be dependent on data.

What has not been contemplated publicly is the risk that the Fed is faced with both a slowing economy and rising inflationary pressures. While this is not our base case, the March labor report which, combining weak growth and a pickup in hourly earnings, could presage just such an environment. Such a modest "stagflation" environment is our central bankers' more problematic scenario, one in which they are forced to choose between fulfilling only one of the Fed's dual mandates of full employment and price stability.

Question #3: What will happen to the price of oil?
The price of oil is likely to be a critical component in determining both the growth prospects for the economy and the flexibility with which the Fed has to maneuver. We continue to believe that the most likely scenario for the U.S. is a rebound, led by consumers empowered by low energy costs; this would be a historically typical pattern, a delayed response to changed gasoline prices. Moreover, docile energy prices would help keep overall inflation numbers lower, even given potentially rising wages, giving the Fed more latitude to remain accommodative. However, we must consider the case for rising oil prices. It is often said that, "the cure for low commodity prices is low commodity prices." Recent weeks have supported this truism, as domestic oil rig counts have started to decline in response to lower prices, signaling lower supply and higher prices ahead.

Beyond these modest moves, we also must consider the potential for a policy shift by Saudi Arabia. Even in the face of opposition by other OPEC members, the Kingdom's production policies had driven prices lower than justified by the surge of U.S. exploration alone. To the degree that Saudi policy was intended to disrupt U.S. oil production, their officials can claim victory. However, we believe part of the motivation for this policy was to economically cripple Iran. As of this writing, Iran is on the cusp of an agreement with the West that would throw an economic lifeline to that country, rendering the Saudi policy ineffective and obsolete. A reversal of their production excesses could result in meaningfully higher jump in energy prices. While not likely to completely reverse the price decline of the past year, such a move would impede a consumer rebound and increase headline inflation numbers, an unwelcome outcome for the Fed.

The narrow opportunity set
At Fifth Third we continue to see opportunities for investors through 2015, but we must note that even in the friendliest economic case, this year offers challenges not seen in earlier stages of our current expansion. The answers to the questions delineated above can dictate very diverse outcomes, and we would not expect 2015 to be a year which offers robust returns in a vast multitude of markets. As always, diversification, particularly international exposure, can play an important role in mitigating portfolio risk. With U.S. stock market valuations elevated and low bond yields offering limited returns, we believe our most important message to investors this year is to manage expectations, and maintain a long term investment plan.

I hope you find these pieces helpful. Please contact me with any questions; it is a top priority for me to keep you informed on the market in general and about your personal situation.