Market Perspectives - January 2013
2013 outlook: Love risk by managing it
The economyBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
The United StatesAt its December 2012 meeting, the FOMC took another unprecedented step. The expansion of its balance sheet since late 2008 has left many people wondering, “When will this expansion end?” After giving vague guidance about when it might reverse course, the FOMC provided calendar-date projections as to when policy might change. That wasn't enough for investors and the public, so the Fed changed its policy guidance from depending on the date to depending on the data. At its December 2012 meeting, it set data triggers for when it would likely tighten policy. The triggers of 6.5% unemployment and 2.5% forecasted inflation are consistent with the Fed's earlier projections of mid-2015 for when its target for the federal funds rate might increase.
However, Fed forecasts can change abruptly. The Fed began releasing economic projections at its April 27, 2011, press conference. At that meeting, it estimated that real gross domestic product (GDP) would increase between 3.5% and 4.3% in 2013. At its December 12, 2012, press conference, the forecast for 2013 was a bleaker 2.3% to 3.0%. In fairness, at the April 2011 meeting, it's unlikely the FOMC members foresaw the coming debt-ceiling debate in August 2011 and fiscal cliff problems at the end of 2012. Regardless, this shows that those forecasts can, and do, change, sometimes dramatically. We continue to think the Fed will keep its zero-interest-rate policy in place until at least the end of 2013. We also believe it will stop its bond-buying programs before raising rates, which could be as soon as the end of 2013 or early 2014. The Fed is unlikely to stop buying bonds before it accelerates its bond buying, perhaps increasing its purchases of MBS.
Although the Fed cannot take all the credit, its bond-buying program has aided the housing market by keeping mortgage rates low. This is similar to how the Fed's low-interest-rate policy helped revive the automobile industry by indirectly keeping auto financing rates low. The Fed will likely try to continue with that success throughout most of 2013, especially since the housing market began to turn in the middle of 2012. For 2013, housing could make a significant contribution to economic growth. But while it can add to economic growth, it might not add a significant number of jobs. Housing construction payrolls went from over one million in 2006 to just over 550,000 in November 2012. Thus, any growth in payrolls will be from an extremely low base.
State and local governments may also stop detracting from economic growth and job creation in 2013. Tax collections have risen since the first quarter of 2010. State and local payrolls peaked at 19.8 million in August 2008 and bottomed at 19.1 million in June 2012. While the jobs may not come back, at least the shrinkage should stop.
Another area that we believe could provide a lift to the economy is in the area of investment spending by businesses. Much has been made about how nonfarm, nonfinancial corporations have more than $1.7 trillion in liquid assets on their balance sheets. While this is a record in nominal terms, rarely does a year go by when new records aren't set in this category. Relative to other assets and liabilities, the amount of excess liquidity on corporate balance sheets isn't as impressive, but it's still a large quantity. Some of that money should have been spent in the past two years when the federal government was providing incentives to spend by offering full expensing in 2011 and then half-expensing in 2012 of investment expenditures. If the ability to immediately reduce taxable income doesn't entice a financial officer to open up the corporate checkbook, what will? In fact, the problem was more one of prospective growth rather than tax savings. What's the point of investing for growth if you don't think there will be growth? But that perception could turn in 2013. Even if there is only a slightly positive growth rate to the economy, that could be enough for some to start thinking about growing their businesses.
Where those investment expenditures are made will largely depend on where the growth opportunities exist and where the regulatory and tax environment is most favorable. A lot of the supposed cash on balance sheets is actually outside the U.S., and that might be where it remains unless the U.S. enacts comprehensive corporate tax reform. That is a stated aim of the president and many members of Congress, but reform usually takes a long time, so that might be a story for 2014 and not 2013.
Despite wage growth that has barely kept pace with inflation, consumer spending has been growing slowly. This is partially due to a lower savings rate but also because of a higher dependence on government transfer payments. With the new fiscal consciousness in Washington, D.C., those transfer payments may be reduced or their growth rates slowed. If anything, the return of the payroll tax to its pre-2011 level will likely hinder consumer spending. As a result, we are not looking for consumer spending to add as much to growth in 2013 as it has in the recovery thus far.
International economicsDuring the course of 2013, the dollar is likely to strengthen relative to the yen and euro, but depreciate relative to some emerging markets currencies, like the Mexican peso. Japan's newly elected prime minister, Shinzo Abe, leader of the Liberal Democratic Party (LDP), has promised significant reforms to lift Japan's economy out of its going-on-three-decade malaise. Considering the LDP ruled from the end of WWII all the way up to 2009, it is doubtful that significant reforms will actually be in the offing. The threats to the Bank of Japan's (BOJ) independence have been enough to weaken the yen, but the yen could fall further if there is any follow-through on the threats to get the BOJ to print money to stoke inflation. Since Japan has a debt-to-GDP ratio of more than 220%—any increase in inflation expectations would likely result in higher interest rates, which could destroy Japanese government finances without significant tax increases. While a weak yen would benefit exporters in Japan, the government might need to lean on the banks to help finance the government debt, which would be detrimental to the banking sector, smaller businesses, and households in Japan. The higher taxes also would likely slow growth. If they think a little inflation will fix their problems, then the picture is not pretty.
In Europe, as we predicted at the beginning of 2012, nobody was expelled from the eurozone. As we wrote in our 2012 outlook, we were—and still are—of the opinion that it would be more likely for the U.K. to leave the European Union (E.U.) than to have a country like Greece or Italy kicked out of the eurozone. We think the eurozone and the E.U. need significant reforms, and they are slower than a sloth in pursuing those reforms. At least they are becoming less austere in their austerity, which can help growth. There are two big wildcards in 2013 for the eurozone: the February elections in Italy and the September/October elections in Germany. Mario Monti, the Italian prime minister who took over in the crisis, will likely wield considerable influence in Italian politics even if he doesn't run for prime minister in the February election (he could become president or—at worst—he is a member for life of the Italian parliament). His reforms were important in restoring investor confidence in Italian government debt. Even the prospect of backtracking on those reforms could be devastating for the eurozone project.
German Chancellor Angela Merkel has been a key player in the eurozone crisis. After all, her government is the one with the most money to help prop up the other governments. She has been a steady advocate of further integration of the eurozone economies. Her re-election would be a significant positive for the eurozone as a whole.
Then, there is the Middle East. In June 2012, Mohamed Morsi was elected president of Egypt. Since then, the world community has been trying to determine if he is committed to liberalizing reforms or if he will attempt to build his own autocratic government in the image of that of the deposed Hosni Mubarak. Egypt has had a tenuous peace with Israel, and the status and future of that relationship remain unclear. Iran also has been stubborn, defying international organizations with its atomic missile/energy program. In June 2013, Iranian President Ahmadinejad will be up for re-election. The sanctions imposed on Iran by the U.S. and its allies have been starving the Iranian government of oil revenues. This could lead to Ahmadinejad losing favor with his people, or it could galvanize them in their opposition to the U.S. and its allies. Either way, the uncertainty over the outcome could keep the price of oil elevated.
Emerging markets, in general, were dragged down with the slowing growth and outright recessions in the developed world. While we believe emerging markets are likely to experience accelerated growth through 2013, the growth will not be uniform across the emerging markets. There are country-specific factors that could favor areas like China, emerging Asia, and Central to South America. China's new leadership team will take the reins in March 2013 and may roll out targeted fiscal stimulus programs to lift living standards in rural areas. Although countries like Venezuela, Bolivia, Argentina, and Brazil (only the last of which is technically an emerging market) seem to have dysfunctional or inconsistent policies, others—like Chile, Mexico, and Colombia—appear to be liberalizing their markets with progrowth policies.