Market Perspectives - July 2013
2013 midyear outlook: Time to change your focus?
The economyBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
Many market participants seem to be focused on central bank policy. To the extent that the Fed is responsible for moving markets with its asset purchase program, the last half of 2013 could be choppy. In addition, the composition of the Federal Open Market Committee (FOMC) will be changing in 2014. While the seven members of the Federal Reserve Board of Governors and the president of the New York Fed are always voting members, the remaining four FOMC members rotate annually from the other Fed districts. The 2014 FOMC will likely be much less tolerant of asset purchases than the 2013 FOMC. Although the eight core members of the committee may not change their views, noncore members will likely voice more dissents. Without clear databased guidance from the Fed as to how its asset purchase program will be slowed to a stop, the markets may move erratically as investors try to secondguess the Fed.
Some market bulls may argue that if the Fed cuts back its stimulus, the Bank of Japan (BOJ) will fill the gap, but that may be overstating the case. In April 2013, the BOJ announced its qualitative and quantitative asset purchase program. If realized, this aggressive proposal would double the size of the BOJ’s balance sheet in two years. The goal is to hit a 2% inflation target, but that looks to us more like a dream. Doubling the monetary base is not the same as doubling the money supply, nor does it guarantee hitting a 2% inflation target. For the money supply to expand, the monetary base must be transformed into loans and bank deposits. Without significant financial institution reform, it doesn’t look like that transformation process is going to happen.
The European Central Bank (ECB) has been all bluster and no action. That’s the sad record of ECB President Mario Draghi since he announced that the ECB would do whatever it takes to keep the eurozone together and then insisted that it would do whatever it takes for as long as necessary. The drop in embattled eurozone government bond yields and the rise in eurozone stocks suggest that the markets believe him. But that belief could turn to incredulity.
Emerging markets central banks, such as Brazil’s, once complained that the U.S. was engaging in a currency war—that is, it was trying to gain a competitive advantage by depreciating its currency. We think the Fed wasn’t, and isn’t, engaging in a currency war. It only appeared that way because some emerging markets countries were deliberately manipulating their currencies for their own advantage. This practice was becoming increasingly difficult to continue, and emerging markets currencies are coming under pressure.
Now they appear to be reversing course: Instead of rising too quickly, emerging markets currencies are dropping. This trend is due, in part, to anticipation of higher rates in the U.S. and financial-capital fleeing countries that have a history of being hostile to foreign investors. This may be contributing to the emerging markets’ underperformance in the financial markets. Many emerging markets economies either extract substances from the earth and sell them to the developed world or transform substances into products that are then sold to the developed world. Also, many emerging markets companies depend on developed market banks for financing. Slow growth in the developed world and banks that are building up capital instead of expanding their loan books will likely continue to cause emerging markets to underperform developed markets for the remainder of the year.
Global growth challengesBeginning in 2001, countries in the eurozone began to lose their competitive edge relative to the U.S., as measured by unit labor costs. Unit labor costs are one measure of how much it costs to produce goods and can be an important determinant of where jobs and wealth are created. Other costs, such as energy, taxes, and transportation, are important, too. The regulatory environment and access to financial capital also enter into the calculus of where a business should operate. Across all these variables, the U.S. has been a relatively good place to run a business—at least when compared with the eurozone.
Relative to emerging markets, the U.S. hasn’t been as attractive. In the early 2000s, a wave of offshoring took place—though that’s a bit of a misnomer, as a job that goes from the U.S. to Mexico isn’t technically moving offshore, unless you consider the banks of the Rio Grande shoreline. With the prospect of low wage growth in the U.S., rapid wage growth in countries like China, and lower energy costs from natural gas exploitation in the U.S., talk about onshoring is now spreading. This talk is overdone. The jobs that are being created in the U.S. are of a different quality and kind than the jobs that left a decade or more ago. The declining competitiveness of countries like China is also overstated. Yes, China is experiencing more rapid wage growth than the U.S., but productivity is another important consideration. Over the past five years, labor productivity in China has grown about as much as wages, so it experienced no real net effect on competitiveness.
Besides, the type of growth in employment we’d like to see isn’t the result of cannibalizing jobs from another country. The growth we’d prefer would come from new ideas, new techniques, new opportunities, and new wealth. When it comes to newness, the U.S. seems to be in a funk. One way to measure entrepreneurial activity is by looking at the number of firms that exist in any given year that are less than 1 year old. In 1994, there were 550,308. The number of new firms peaked in 2006, with 667,341. In 2010, the last year for which there is data, there were only 505,573 newbie firms. These companies are also creating fewer jobs. While they were responsible for creating 4.1 million new jobs in 1994, they generated only 2.5 million in 2010.
Although they don’t have to be, new businesses tend to be small. Firms with one to 249 employees employed 50.8% of the workforce in 1993 but only 47.6% in 2010, providing another measure of decline in entrepreneurship. To unlock the growth potential of the U.S. labor force and the United States’ resources, it may take some serious work by policymakers. With the mid-term elections in 2014, we might get a preview of what types of policies are coming. The Congressional Budget Office estimates that the federal government will hit the debt ceiling in October or November. The debate over whether to raise that ceiling may capture headlines, but it will likely prove to be a trifle compared with what Congress should be working on, such as tax reform.
Because a natural catalyst to accelerating economic growth isn’t evident, we’ve revised our forecasts since our January outlook for 2013. Instead of accelerating growth going into the end of the year, we expect sputtering growth—not enough to dip into a recession but enough for the first quarter of 2013 to prove to be the high-water mark for growth (see Table 1).
Slow growth, high profitsPerhaps counterintuitively, we are mildly pessimistic about economic growth but optimistic about corporate profit growth. Corporate profits after tax, as a percent of gross domestic product (GDP), have taken a rollercoaster ride since 2000 but they look to be trending upward from 1986, when they bottomed at 3%. In the first quarter of 2013, corporate profits after tax were 10.9% of GDP. With wages growing slower than inflation, corporate profits as a percent of GDP aren’t likely to shrink anytime soon. And, yes, corporate profit margins are high. During the first quarter of 2013, the S&P 500 Index reported 9.52% operating margins. This brings the average margin since the third quarter of 2010 to more than 9%. When comparing margins over time, consideration must be given to changes in the composition of the S&P 500 Index—it is not always made up of the same 500 stocks. We have no reason going forward to believe an irresistible force of nature will push the margins back to their average of 6.5%—the average in the future could change. And when it comes to investing, it’s the future that matters.
With high corporate profits but slow economic growth and low inflation, monetary policy is likely to stay accommodative. The Fed may begin to slow its pace of purchases, but even then, tapering is not tightening. When the Fed cuts back on the pace of its asset purchase program, it will still be infusing more liquidity into the economy. The markets will likely take the pace of the tapering as a signal of when the Fed will shift to tightening. If this shift occurs before the U.S. economy is at full employment and inflation begins to pick up, then the market will likely react badly. If, on the other hand, the pace of tapering, as a prelude to tightening, is consistent with full employment and stable inflation, then the market should take it in stride. The Fed has effectively taken a stance that it will loosen longer rather than tighten sooner than necessary. This is why we think interest rates could stay low for the balance of the year, if not the next couple of years, and equity valuations could continue to rise.