Rare Washington Compromise + Rising Consumer Debt = Modestly Higher 2014 GDP

Includes: DIA, QQQ, SPA
by: Russ Koesterich, CFA

As we look ahead to 2014, the U.S. economic growth picture becomes a little bit rosier. In fact, I expect the U.S. economy to post slightly higher economic growth next year, edging past the post-recession 2% level to around 2.5% to 2.75%. As I write in my new weekly commentary, here are two reasons why:

1. The bipartisan budget deal is a modest economic positive. In a rare act of negotiation and bipartisanship, leaders in the House of Representatives and Senate last week agreed to a bipartisan budget deal that funds government discretionary spending for the next two years. If the rare compromise passes the Senate this week (as I assume it will), initial estimates suggest it will add approximately 0.2% to gross domestic product (GDP) in 2014 through mitigating fiscal drag related to planned "sequester" government spending cuts that were set to take effect.

The deal swaps out those cuts for a series of cuts and fees to be implemented further down the road. In addition, the compromise also removes the risk of an imminent government shutdown, which had the potential to undermine both business and consumer confidence.

2. U.S. households are rediscovering their appetite for debt. U.S. household debt increased at a 3% annualized pace in the third quarter, the largest quarterly increase since the first quarter of 2008. This is the result of several factors: a marginally better jobs market, rising household net worth, and a low-interest-rate environment that makes borrowing more attractive.

Should this trend continue, it could help support economic growth in 2014. Assuming any interest rate rise next year is modest, I would expect borrowing to continue to stabilize into 2014, helping to mitigate the impact of slow income growth and promote some increase in consumer spending, allowing, at least temporarily, for stronger U.S. growth.

To be sure, the Washington deal and rising consumer debt aren't panaceas for the economy. For instance, it's important to emphasize that the very modest budget agreement doesn't address the debt ceiling (likely to be hit sometime in mid-2014), tax reform, long-term entitlement reform or the pending expiration of extended unemployment benefits. As such, I expect that political wrangling over the debt ceiling will continue into 2014 - especially as next year brings with it the backdrop of the midterm elections.

Still, the two factors I cite above are likely to lead to modestly higher economic growth in 2014. This, in turn, has two implications for investors:

1. A combination of better data and less risk from Washington do suggest a greater likelihood of a December taper. That said I still believe an early 2014 taper is the most likely scenario. This view is supported by the fact that inflation continues to break to the low side (more evidence of that last week came from the November Producer Price Index report) giving the Fed more latitude.

2. Stronger U.S. growth is a positive for stocks, but a negative for bonds.

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