Beware of the 'Accepted' 2015 Outlook

It is now almost universally accepted as a given -- at least as may be gleaned from publicly available communications provided by the largest financial institutions: Accelerating economic activity in the U.S. will drive up the rate of inflation, along with long-end Treasury yields, and require the Federal Reserve to increase the Fed Funds rate sometime in 2015.

Beyond the financial sector narrative and pronouncements by Fed Bank Presidents for rate hike expectations next year, the primary rationale appears to be that economic activity, as measured by GDP, is increasing and warrants the beginning of rate normalization. However, GDP is only one measure of output and must be considered within the context of all other gauges of economic activity.

The primary other aggregate measure of economic activity is income. And measures of income generation over the past few years have been indicating a rapid deceleration in private sector economic activity. I've discussed this issue on a regular basis with respect to the decline in payroll tax receipts received by the Treasury from employers.

In this column, I'll address the issue of income more broadly, defining it as the sum of government tax receipts, minus transfer payments, (social security, Medicare), plus corporate profits after taxes, plus individual income after taxes, and adjusted for inflation. This is a measure of total real income for the federal government, business, and individuals and is implicitly a measure of real final sales minus the federal fiscal deficit.

The reason for doing this is to subtract the impact of government deficit spending and private sector inventory building from economic activity in order to ascertain what real income is and whether or not it is actually increasing. GDP includes both deficit spending and inventory building, and as a result presents a much less accurate picture of real economic activity.

The first chart below shows the average annual rate of growth in real income over the past 50 years on a rolling 10 calendar quarter basis, and compared to real final sales, which is GDP minus inventories. I addressed the reason for removing inventory building from GDP when attempting to ascertain real economic activity in the column, "The GDP Estimate and Economic Activity."

The second chart shows the same over the past seven calendar quarters.

The purpose of using long-term rolling averages is to smooth the immediate issues that may mask the trend. The reason for using two periods of average duration is to determine whether the long-term trend is getting better or worse.

Both charts validate the observations I've offered throughout this year on individual incomes, based on payroll tax receipts, and indicate that the long-term trend of real income generation is negative.

The first thing for investors to consider is why there is no corresponding conversation (at least publicly) by the Fed and financial sector leaders on the dichotomy between output vs. income measures of economic activity and their implications for economic potential.

The most logical reason is that it doesn't fit the desired public narrative -- annoying or troublesome news never does. Since the 1960s, however, even before the end of the Bretton Woods era of monetary policy, the cyclical change rates of the real sum of government tax receipts minus transfer payments, plus after-tax corporate profits and personal incomes have never decelerated to the current rate from a peak above 5% without the U.S. economy being at the onset of, or in, a recession.

This also occurred in the summer of 2001 and spring of 2008 when the consensus did not perceive, or at least publicly acknowledge, that the U.S. economy was already two to three quarters into a recession.

How does this pertain to the immediate prospects for economic activity and monetary policy? The inference is that the Fed will not raise rates next year, the rate of growth in inflation will continue to decelerate, long-end Treasury yields will continue to decline, the U3 unemployment rate will bottom, employment growth rates will soon peak, U.S. fiscal deficit spending will increase, and the Fed will at some point have to further expand its balance sheet to accommodate such.

The bottom line is that this is bullish for stocks, although there will logically be substantial volatility as the markets and Fed become cognizant that the current publicly offered narrative concerning the economic outlook for 2015 is wrong and it must shift back into stimulus mode.