Economy Shows Modest Improvements, but Risks Remain
During the first two quarters of 2013, the U.S. equity market was pleasantly surprising, while foreign equity and fixed income markets languished or fell sharply. More recently, foreign markets are beginning to show some signs of life. And despite a constant barrage of troubling headlines, such as the Syrian conflict and Detroit’s bankruptcy, the economic news continues to modestly improve, as was expected. Here at the start of the fourth quarter, we find ourselves cautiously optimistic overall about the U.S. and global economies and the opportunities in the capital markets.
In a short video, Mark Griffin, CIMA®, principal and chief investment officer with CliftonLarsonAllen Wealth Advisors, LLC, introduces the October issue of the Market and Economic Outlook.
In this edition of the Market and Economic Outlook, we will discuss the marginal but steadily improving fundamentals, as well as the external risks that threaten the U.S. and global economies. We will also address the relative valuations of major asset classes and the resulting opportunities in the capital markets.
Let’s start with a review of the backdrop.
||Rising interest rates and Federal Reserve “tapering”
|Foreign markets improving
||Looming debt ceiling and congressional gridlock
|Healthy corporate balance sheets
||Systemic risks in Europe
|Modest inflation with low interest rates
||High debt-to-GDP ratios in developed markets
|Growing U.S. energy independence
||Gap between output and productive capacity
|Global equity valuations
Employment continues steady rise
According to the Bureau of Labor Statistics (BLS), unemployment levels have been steadily dropping since June 2009 as noted in the following chart. While much better, unemployment is still disappointingly high at 7.3 percent. More telling, however, is the 13.7 percent broader measure of underemployment also tracked by the BLS. This measure captures the actual unemployed, including those no longer eligible for benefits, and those employed part time for economic reasons. Though it’s not widely discussed, this figure is clearly a better indicator of the continued stress felt by workers in the economy.
Source: Bureau of Labor Statistics
Clearly, monetary policy set by the Federal Reserve has been directly targeting employment levels — a distinct change from prior years where policy targeted inflation rates. Chairman Ben Bernanke has suggested that the Fed will begin reducing (tapering) its extraordinary bond purchases when unemployment levels fall to around 7 percent. Accordingly, we thought that the Fed would begin tapering this fall. However, recent data and dialogue from the Fed suggest an unwillingness to cut back on its purchases.
Interest rates rise, but not inflation
So, at this time, the Federal Reserve is continuing its policy of buying bonds at a pace of roughly $85 billion per month. Though we believe it is highly unlikely the central bank will ever sell the bonds it already holds, tapering will eventually be employed via a reduction of future purchases. However, even the suggestion of tapering roiled the bond markets, causing interest rates to spike sharply. It is clear that rates were increasing because the market is beginning to divest itself of the bonds it holds in anticipation of the Fed reducing its purchases in the future. In other words, the market prefers to sell at current prices in anticipation that they may fall further as rates normalize, which is the expected outcome when the world’s largest buyer is no longer actively participating. However, with the Fed now indicating it will continue aggressive purchases, we would expect rates to stabilize around current levels.
The increase in intermediate interest rates (where the Fed has been buying) was swift and severe. It is likely catching many investors off guard because fixed income prices are inversely correlated to interest rates. Conservative investors may see significant losses accumulating across much of their portfolios, even as U.S. stocks have risen.
Source: Ned Davis Research
Even though interest rates have risen sharply, inflation, which is typically correlated to interest rates, has not. While it is true that the Federal Reserve adjusts interest rates to influence inflation, it is also true that rates are set by the market’s appetite for bonds. When demand increases, bond prices rise, and interest rates (and yields) fall. When demand falls — the situation we’re in today — bond prices fall, and rates (and yields) rise.
So, was bank analyst Meredith Whitney right back in December of 2010 when she famously stated that “between 50 and 100 counties, cities, and towns in the United States would have significant municipal bond defaults, totaling hundreds of billions of dollars in losses”? Perhaps, but we doubt it. Detroit is the poster child for fiscal mismanagement, profligate spending, and pandering. You may pity those foolish enough to finance the city, but Detroit’s problems were well known by anyone paying attention. While there are plenty of municipal bonds that should be avoided, the vast majority of municipalities are in better shape today than in the past few years for three reasons: cost cutting measures in response to the Great Recession, recently rising revenues (from an improving housing market), and lower overall financing costs.
Nevertheless, the news of Detroit’s bankruptcy, coupled with rising interest rates, has caused a fall in the price of even very high quality municipal bonds, with many bonds now yielding north of 4 percent. We think there is significant opportunity in this space for investors seeking tax-free income. Prices are particularly attractive relative to Treasury securities.
Excess industrial capacity
Though the economy is generally improving, there are a number of factors at play that limit both inflation and our potential growth rate, including higher-than-desired unemployment, stagnant to falling real wages, a low savings rate, and a sizable gap between aggregate demand and productive capacity.
With such a large gap, demand for labor in the manufacturing sector will remain soft, as will capital expenditures for new equipment. Both limit our potential growth rate. While we see significant improvements in service sector employment, too many of these are lower paying, part-time, and even temporary jobs with limited benefits. Even so, it is an area of notable improvement this year.
Housing — a ray of sunshine
Recovery of the U.S. housing sector continues to be a bright spot in the economic picture. Of course, there are reasons for skepticism, not the least being that some of the recovery is being driven by institutional investors who have moved aggressively to acquire properties in higher profile markets like Phoenix and Las Vegas. Nevertheless, the recovery is broad based and real. Jobs in the sector are coming back, as is lending. Prices across the country have continued to recover, though they are not back to pre-recession levels in most markets. Even so, attractive prices, which are now trending up, coupled with historically low financing rates, will draw more buyers into the market. New home starts, at roughly 900,000 per year, are still well below the 1.5 million average of the previous decade. However, it’s a number that will help sustain the housing recovery and should prevent another boom-bust cycle.
Rising home prices also improve the debt-to-equity ratio of existing homeowners, many who may be emerging from being “underwater” on their mortgages. This positive turn increases individual wealth, liquidity, and mobility. It also improves the credit quality of mortgage pools, which opens up additional capital for financing and leads to improved availability of financing for marginal borrowers.
Positive equity valuations
Stocks in the United States are trading for approximately 15 times expected (forward) earnings. Relative to history, and particularly in light of low interest rates and high fixed income valuations, this is a reasonable multiple that leaves room for further price expansion. We hold this view even if earnings don’t improve.
Indeed, even with a slowly expanding economy, it’s unlikely that earnings will improve much over the course of the next year given already extraordinarily wide corporate profit margins, which are negatively affected by rising interest rates. In addition, top lines are likely to grow only modestly because of a still over-indebted and under-saving consumer who has seen real wages decline over the past five years. Regardless, reasonable valuations mean that stocks can produce decent returns going forward. These valuations also limit downside risks to stocks, particularly in light of healthy balance sheets.
As noted in this table, valuations are even more compelling in foreign markets, which are trading at 10 to 60 percent discounts to the United States based on expected earnings (though we acknowledge there’s good reason to be particularly skeptical of Russia). The discounts dramatically improve opportunities in foreign markets.
Forward Price/Earnings Ratio
(Data as of June 30, 2013)
|EAFE (Europe, Australasia,
Far East) Index
|Emerging Market Index
Source: MSCI, FactSet, J.P. Morgan Asset Management
Improvements in Europe
We’ve shared our negative views on Europe fairly extensively during the past couple of years, but the market is beginning to show some signs of life. Collectively, continental Europe is the largest economy in the world, so it should be no surprise that improvements there are beneficial here.
While we continue to worry about insolvent participants (Greece), high levels of unemployment (Spain), confiscatory tax policy (France), and many impaired and under-capitalized banks, we are beginning to see stabilization and improvements across the region in gross domestic product (GDP) output. According to Markit Economics, the United Kingdom experienced the fastest rate of increase in manufacturing output since 1994 as its purchasing managers index (PMI) rose from 54.8 to 57.2 (a number above 50 indicates expansion; below 50 indicates contraction). Though not as robust, German PMI is up to a remarkable 51.8 from 44.7 a year ago. In the broader eurozone, PMI rose to 51.5 in August, up from 50.5 in July, and a dismal 45.1 a year ago. These are encouraging improvements that mirror the service sector, which experienced growth for the first time in almost two years. While we will be looking for month-to-month consistency, it does suggest that the European economy may be through the worst of its crisis.
If true, then we would also begin to expect an improvement in bank lending, stabilization in employment levels, and a slow return to economic growth and normalcy. More importantly, it signals a reduction in systemic risks for the region, and appealing opportunities in risk assets (stocks).
Still watching Japan
Japan is an enigma to many. The country suffers from challenging demographics as the population is aging rapidly and is well past the peak consumption years. The country has the highest debt-to-GDP ratio in the world, dwarfing even Greece. And yet, far from the expected inflationary cycle (currency devaluation) typical of high debt levels, Japan has experienced on-and-off deflation for nearly 25 years. In addition, the country’s stock market fell more than 75 percent from its peak in 1989 to its trough in 2009. And yet Japan is an export-based economy with world-class companies and advanced manufacturing capabilities. This has created an opportunity.
In the past, government debt has been purchased aggressively by pensions because of the aging demographic. High appetite for government bonds has pushed up prices, exacerbating the deflationary cycle with a corresponding rise in the value of the Japanese currency. A rising currency has made exports more expensive in other markets, causing a fall in tax receipts and greater issuance of government debt, creating a stubborn deflationary cycle.
Current policies promoted by Prime Minister Shinzo Abe are pro-growth and intended to create inflation north of 2 percent to break this deflationary cycle. The Bank of Japan has been active in pushing down the value of the currency in order to make exports more competitive. We’ve already seen a decline in the yen relative to the dollar of roughly 20 percent from peak levels, and we expect the currency to fall another 20 to 40 percent from current levels. If this occurs, we would also expect exports to accelerate, precipitating a dramatic increase in corporate earnings and tax receipts. We think Japanese stocks are not properly priced for this outcome, and we’ll be watching closely.
Opportunities in China
The Chinese government is forecasting a 7.5 percent annualized growth rate for 2013, a far cry from the nearly 10 percent of the recent past. Even if those projections are too optimistic, China will still grow at more than three times the pace of the developed world. Furthermore, according to The Economist, China’s unemployment rate was running at 4.1 percent for the second quarter of 2013, while enjoying a roughly 2 percent current account surplus and a modest 2.1 percent budget deficit. The United States would love to be in a similar fiscal position.
Certainly, all is not well in China. Among other things, the country’s real estate bubble is very real, its shadow banking system needs to be further curtailed, and transparency in many areas of the Chinese economy and capital markets is sorely lacking.
Still, fears over a potential “hard landing,” or that things will get much worse before they get better, have created an environment in which risk assets (stocks) are priced for deep recession. Chinese stocks trade for roughly eight times expected earnings, while in the United States, stocks trade closer to fair value at around 15 times forward earnings.
We think it is unlikely that Chinese companies, which provide goods to the world, will see their earnings fall significantly from here. We also think it is unlikely that Chinese officials, who are intensely focused on economic growth (if for no other reason than to quiet the masses), would tolerate a deep recession without employing policy tools at their disposal. While our outlook can change, the significant valuation discount to the United States and other developed markets greatly improves the risk-adjusted opportunities for the region.
The looming debt ceiling debate
The U.S. Treasury Department announced in August that it expects to exhaust its borrowing authority by mid-October. While there really is no choice but to raise the limit, you should brace yourself for another round of Congressional debates regarding our borrowing level. Expect a rancorous debate, given the dysfunction in both houses of Congress (as underscored by continuing squabbles over health care reform), our inability to determine what to do with the Syrian threat, and a lame duck president.
On a more positive note, the country’s budget deficit has narrowed from 10.1 percent in 2009 to roughly 4 percent for 2013, according to the Congressional Budget Office. This is the result of an improving economy, revenue increases, and a slowdown in the rate of spending increases. Furthermore, data suggest the deficit should continue to narrow over the next couple of years.
Unfortunately, the same data also show the budget deficit expanding again in a few years. To be candid, it is common and not problematic for a healthy economy to have modest, but fairly persistent, budget deficits. However, persistently growing deficits are a problem, particularly in light of the country’s massive debt load. If rates normalize (our long-term view), then financing costs, as a percentage of GDP, will accelerate the budget imbalance. Offsetting this increased expense will require a combination of raising revenue, higher inflation, and cutting expenses. None of these would be welcome outcomes.
Source: Ned Davis Research, Congressional Budget Office
Given the modest improvements in the economic backdrop, we view the debt ceiling debate, and the potential policy changes it implies, as the biggest risk to our economy and capital markets over the near- and mid-term.
Where to look for opportunities
Though U.S. equity markets are up significantly, foreign markets have traded sharply downward or sideways until very recently. However, the U.S. economy has been growing but cannot accelerate that growth in a meaningful way. At the same time, foreign economies appear to be either bottoming or exiting recession. While there are certainly sizable risks, they are mostly attributable to potential policy mistakes as the United States and global economies are clearly on better footing today than over the past few years. Accordingly, we feel equity valuations in the United States are fairly attractive compared to most fixed income markets (though we like municipals at current prices), and that foreign equities, and emerging markets in particular, offer some appealing opportunities.
View as a PDF.
Mark A. Griffin, CIMA®
Principal, Chief Investment Officer
View CliftonLarsonAllen Wealth Advisors, LLC disclaimers.