BOA Merrill Lynch Managing Director Ethan Harris: 2015: Stocks Up Near 10%, September Rate Hike.

Includes: DIA, IWM, QQQ, SPY
by: Harlan Levy

Solid 3% GDP growth in 2015, jobless rate near 5%, first rate hike in September.

Wage growth gets to 3.5% pace in nexxt few years. Stocks up about 10% in 2015.

Strong home price increases end, rising about 5% in each of the next two years.

Economist Ethan Harris is managing director and co-head of global economics at Bank of America Merrill Lynch.

Harlan Levy: What do you think of the fourth-quarter 2.6 percent GDP growth, and does that change your expectations for growth in 2015 and 2016?

Ethan Harris: The fourth-quarter GDP number was disappointing, particularly because of weakness in capital spending.

However, we're still optimistic about solid 3 percent growth in the year ahead. A variety of indicators point to healthy growth, including strong job gains and improving consumer confidence.

In addition, the economy should benefit from lower oil prices and the drop in interest rates, which we believe more than offsets the negative impact of the stronger exchange rate.

So in our view the economic improvement remains on track.

Q: What are the implications for the U.S. economy from the Federal Reserve's statement indicating no rate hike until June at the earliest?

A: The Fed right now is presenting a very positive view of the economy but hasn't really acknowledged how weak inflation is. We believe that the next FOMC meeting in March they will finally acknowledge how weak inflation has become and they'll hint to markets, and that will suggest to markets that the first rate hike could come later in the year.

We think the Fed will face a very tough choice. On the one hand the unemployment rate should be approaching 5 percent by the end of the year.

On the other hand we expect very low inflation, far below the Fed's 3 percent target. So they will be meeting one of their objectives. For that reason we think the first rate hike comes a little later than they're currently suggesting. Our best guess at this point is September.

Because inflation is so low we think the Fed will try to exit as gently and as slowly as possible. They will try to minimize any shock to the market, and, for that reason we think the Fed's policy moves will only have a small restraining impact act on the economy.

It's important to remember that there are two kinds of Fed rate hike cycles. The nasty version is when the Fed sees a serious inflation problem and tries to stop it by hurting growth. The friendlier version is when the Fed is hiking interest rates because it thinks the economy can handle it and is not concerned about high inflation.

We think the current cycle is very much the latter not the former.

Q: How negative is the strong dollar for the U.S. economy?

A: The dollar is up about 10 to 15 percent relative to our major trading partners in the past year. That's a big move by historic standards. We think that this is slicing about 0.4 percentage points off U.S. growth for this year. Fortunately, we think the economy is strong enough to handle the shock, and the recent drop in interest rates almost fully offsets the negative impact of the stronger dollar.

So, while U.S. trade may weaken, interest-sensitive parts of the economy such as housing and business investment should do well.

Q: What do you think of the labor market from the latest reports on jobs and wage growth?

A: The labor market has been in a solid recovery for more than a year now. We are getting much closer to full employment.

However, there's still some work to be done. We think that there will not be any notable wage pressure until the unemployment rate gets close to 5 percent, but over the next several years we do expect wage growth to accelerate from its current anemic 2 percent pace to a more normal 3.5 percent growth rate.

This improvement in wage growth should help reverse some of the recent widening in income distribution, as more of the fruits of economic growth is shared by average workers.

Q: What does the latest housing news tell you?

A: After hesitating a bit in response to higher interest rate a year ago, the housing recovery looks like it's back on track. We're looking for a steady growth in home construction with continued outperformance of multi-family construction versus single-family construction. However, we do think the period of strong price increases is over, and we expect home prices to rise at only about a 5 percent pace in each of the next two years.

Stepping back, we think the housing market is finally putting the 2008-2009 crisis behind it.

Q: What do you think of earnings so far?

A: Corporate earnings have come under pressure from a combination of global factors. The drop in oil prices has hurt the earnings of energy companies, and the strong dollar has hurt earnings for many multinational firms. Offsetting this is the improvement in the U.S. economy, but the net effect is that we expect only slow single-digit earnings growth in the year ahead.

Q: Stocks seem dominated by oil prices, high-speed trading of massive blocks of stock, and lots of volatility. Is that the short term future, and will stocks eventually get over it and start moving higher without all the bumps?

A: This is certainly a bumpy period in the equity market. I think that investors face a lot of uncertainties, including the plunge in oil prices hurting energy stocks, the strength in the dollar hurting global companies, the uncertainty around Europe, with good news from the European Central Bank starting its new buying program but rising concerns about Greece and the conflict between Russia and Ukraine. All of these uncertainties have created a very choppy market.

However, over time we think the equity market will get back on its feet, and our stock market strategists expect a roughly 10 percent gain in the U.S. market this year.

Q: What sectors are healthy and what aren't?

A: From an economics perspective it's clear that we've had a big income transfer in the economy, with oil producers losing profits and consumers gaining spending power due to the drop in oil prices. This suggests that companies that cater to consumers should benefit, and oil and oil-related industries should suffer.

We've also seen very big movements in the dollar exchange rate, which will hurt companies with particularly high exposure to the global economy.

On the other hand, with mortgage rates coming back down, housing-related industries should benefit.

So the big movements we've seen in the markets have clearly created some winners and losers in the economy.

Q: Do you think the European Central Bank's new policy of buying massive amounts of euro bonds will save Europe from falling into a serious recession and deflation?

A: I'm very encouraged by the ECB's recent action. For most of the last six years the ECB has always seemed to be one step behind the curve, only moving when crisis occurred and moving in an indecisive manner.

The recent ECB action was aggressive in terms of both the size of the asset-buying program and in terms of promising to do more if needed.

Clearly, the drop in inflation in Europe has been a wake-up call to the European Central Bank. Unfortunately, ECB action alone can't save Europe. What it does is buy time for banks to heal, for governments to do structural reform, and if there are no new shocks in Europe we could see Europe come out of its crisis at some point in the next several years.

However, it's still a very tough road ahead, and there's a significant risk, not this year but next year, if a renewed debt crisis emerges in Europe.

European governments still have a long way to go to fix their finances.

Q: Will austerity continue?

A: We're expecting no significant new austerity measures in Europe in the next year. We do think that the Europeans have learned from their mistakes, and Germany, in particular, seems willing to tolerate a much slower pace of fiscal adjustment.

However, Greece will remain in the center of attention. The new Greek government wants to reverse the austerity measures it's already taken, and the leaders of Europe want Greece to stick to its current plan. This will create a very messy negotiation in the next several months, but, ultimately, we think they'll reach a compromise where Greece maintains most of the austerity measures they've already implemented.

Outside of Greece, we expect most governments to do modest structural reforms but little new fiscal austerity.

This should give Europe some breathing room to grow.

Q: What's your biggest worry?

A: Europe is still the main concern in the global economy, and we do need to keep a close eye on whether Greece does exit the eurozone, or Europe starts having more severe deflation issues.

So while we believe Europe is OK this year, it's still on the top of my worry list.

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