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The U.S. stock market has surprised investors in 2013, producing returns in the low teens in the first half of the year. The U.S. economy, on the other hand, produced few surprises, continuing to plod along despite headwinds that included higher tax rates, budget cuts from "sequestration," high unemployment, and a sluggish global economy. In the second half of the year, additional headwinds are likely. Interest rates have risen sharply in response to the Federal Reserve's plan to "taper" the quantitative easing program, and are likely to rise further before the end of the year. In addition, while the eurozone remains stuck in recession, China, the world's second-largest economy, has recently taken deliberate steps to slow the pace of its economic growth.
Given these hurdles, how is the U.S. economy likely to fare in the remainder of the year? Will higher interest rates affect one of the economy's few bright spots, the housing market? Could the U.S. economy tip into recession? And what can investors expect from the markets in this challenging environment? In this roundtable, Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; and David Linsen, Director of Domestic Equity Research, tackle these and other questions concerning the second half of 2013.
Q: The rise in interest rates since Federal Reserve chairman Ben Bernanke raised the issue of tapering the quantitative easing [QE] program has been dramatic. Will higher interest rates hurt the economy?
Zane Brown: Prospects for future growth may have changed as a result of higher Treasury yields, which have affected mortgage rates. The positive impact of mortgage refinancings has been eliminated by this rise in interest rates. The yield on the 10-year Treasury has risen by about 80 basis points,1 but according to Freddie Mac [Federal Home Loan Mortgage Corporation] reports, mortgage rates have risen by more than that. So the rate on a 30-year mortgage has gone from around 3.35% to around 4.46%.2
So the boost to consumer spending that was occurring as homeowners refinanced their mortgages, and either took out some cash or reduced their payments—that additional boost to economic growth is now gone.
Higher mortgage rates might also price some prospective homebuyers out of the market. This impact may not be large, but it could have an effect on the margin.
Milton Ezrati: But housing affordability is still very good. And, in fact, I would argue that higher mortgage rates might boost home sales in the short term. With home prices and mortgage rates rising, there may be a "get in while you can" effect. This would steal from future sales, but accelerate sales in the short term.
Refinancing of home mortgages has dropped precipitously, but new mortgages have not. In fact, they're up. That supports the idea that prospective homebuyers might be motivated to buy before rates go higher.
If rates continue to rise, they are likely to have an effect on home buying, but it will probably be slight. Keep in mind that these rates are rising from near record lows. Mortgage rates, after the tax benefit, are still less than 1% over the rate of inflation. So they're still very affordable by historical standards.
If rates continue to rise, a relaxing of lending standards could more than compensate for that. The data on commercial and industrial lending show that small- and medium-sized businesses are at last getting credit.
David Linsen: I think we're seeing a tug of war between a cyclical recovery of the economy and the prospects of the withdrawal of the unconventional monetary easing that has been in place for so long. So one of the questions the market is struggling with is: will the cyclical recovery be enough to sustain the market once the Fed begins to taper the QE policy?
Ezrati: The economic data have been mixed. The May durable goods report was strong, even excluding aircraft orders, which are volatile. And durable goods orders had been falling.3
Personal income growth has been weak, but it's not as weak as the data suggest.4 The data were affected by the huge dividend and bonus payouts that were made late last year to avoid the higher tax rates in 2013. So payments that normally would have been made in February, March, and April of this year were accelerated, and when those payments weren't made this year, income was understated.
By the way, those accelerated bonus and dividend payments have also helped shrink the federal budget deficit. The income taxes on those payments were paid in April of this year, so that's one of the main reasons why the deficit is down so much. It's about $627 billion year to date through May 2013.5
Linsen: The unemployment rate of 7.6%6 suggests there is still slack in the system. Wage growth should be modest until labor supply tightens.
Brown: But if personal income growth is weak, and the run-up in the stock market is slowing, then consumers won't have the confidence to increase their spending. So, unless job growth picks up, we're left with an economy that appears to be stuck at a growth rate of around 2%.
Q: If the economy is relatively weak, why did Bernanke suggest that it's time to begin tapering quantitative easing?
Brown: Bernanke's discussion of tapering was an effort to be transparent as well as an effort to establish a legacy and clear policy path for his successor. He wants to set the policy direction for the QE program before his term is up in January 2014. I don't think he expected the markets to react as they did because he has always said that the Fed's actions would be data-dependent.
But if higher interest rates slow the economy, then the Fed may not be able to pull back on QE this year. And if you consider that personal income is not growing much and that consumers don't have much in savings, I question whether they can continue the current pace of consumption, much less expand it.
So, with manufacturing now slumping, and many of the newly created jobs being part time and low paying, unless we get some boost from lower commodity prices, I question where an improvement in economic growth will come from. So I think it is very likely that the Fed may not be able to pull back on QE in September, as some have suggested.
Q: Does the Fed's plan to make the tapering dependent on the condition of the economy return us to a risk-on/risk-off environment in which markets hang on every pronouncement from the Fed?
Ezrati: Markets don't need to hang on every word from the Fed, because the Fed reassured them last year that they have nothing to fear in the immediate future. The tapering of bond purchases could go from $85 billion per month to $75 billion, and that would not rock the markets. Unfortunately, traders seem to think that tapering is like an on/off switch. But tapering doesn’t mean bond purchases stop; it means they are tapered.
Linsen: I don't think we're back into a risk-on/risk-off environment. Risk-on/risk-off was defined mostly by the crisis in Europe, in my opinion. In 2010 and 2011, markets were reacting to the possibility that the eurozone would collapse. It was a "tail risk" environment.
Brown: I agree the risk-on/risk-off environment was defined by external tail risks. That risk-on/risk-off environment continued in 2012, with Greece threatening to leave the eurozone and with fears of a "hard landing" in the Chinese economy.
Q: First-quarter gross domestic product7 was revised downward from 2.4% to 1.8%, and other economic data have been mixed.8 Is the U.S. economy in danger of slipping into recession?
Ezrati: During the risk-on/risk-off environment, when we were subject to the risks of these external shocks, there was a sense that the economy could lapse into a recession at a moment's notice. And although we've gotten some bad news recently on manufacturing [May 2013's ISM Manufacturing Survey slipped below 50%, indicating contraction9], we’re also getting mixed news that describes an economy that is plodding along.
Three factors point to continued growth. First, housing has turned. Historically, the economy has not slipped into recession when housing is expanding, even if it is expanding slowly. Second, the corporate sector is flush with cash. They're being very cautious, but recessions occur when corporations are squeezed and they have to cut back. But now they're flush with cash, so they're unlikely to do that. They may be very tight when it comes to expanding, but that's different from cutting back. So, although unemployment remains high, mass layoffs continue to trend downward. Third, even though the savings rate is down and income growth is slow, consumers have rectified a lot of the debt overhang on their balance sheet, and as a consequence personal consumption will probably track income growth, instead of lagging behind as it has recently.
Brown: For the most part, the corporate sector is not overextended. Companies don't have too much debt, so they won't have the volatility in their earnings that could lead to recession. The same is true of banks; they also have de-levered.
If they hadn't de-levered, even a slight economic slowdown could be a shock to them. But because corporations and banks are in good financial shape, they should be able to continue to plod along and contribute to economic growth of around 2%.
Ezrati: Data from the Fed show that nonmanufacturing companies have checking account deposits equal to 10% of their liabilities. That's an amazing number. It speaks to how flush they are.
Brown: They've also reduced their liabilities because the cost of financing has come down, and they have had plenty of time to lock in lower-cost debt. But there's no reason for corporations to start spending that cash because economic growth is so slow that there's no need to add capacity.
Ezrati: Earlier, we saw corporations making a lot of labor-substitution investment, and I would place that at the feet of government policy, particularly the Patient Protection and Affordable Care Act, because if a company doesn't know what the cost of health care is going to be, it makes more sense to invest in machinery that replaces labor.
But that trend has probably run its course now. So the capital spending that was driving the economy is probably now going to lag. But that doesn't mean companies will cut back enough to cause a recession.
Linsen: The economy grew by 1.8% in the first quarter despite higher payroll taxes and some cuts to government spending as a result of "sequestration." It was not great but also not that bad. So the U.S. economy has held its own in the face of some strong headwinds.
Now the economy faces the likelihood of higher interest rates, which could hurt consumer spending. We continue to see job gains in the U.S. market; and in Europe, the purchasing managers' indexes [PMIs] are improving, so the European economy could be turning.10 China may slow, but that could have a positive impact if it results in lower commodity prices. So, on balance, though the economy is not great, it's not terrible either.
Brown: That's true, but 1.8% growth is still pitiful, and sequestration doesn't hit government spending very hard until the second half of the year. And on top of that, there could be some impact from rising interest rates, as well as the $109 billion 2014 sequester beginning in October.
Ezrati: I think we're quibbling; we can all agree that the economy is likely to grow, but grow very slowly.
Linsen: I agree. There has been no real trend change. The economy has been growing at the rate of about 1.8–2.4%11 and producing jobs at the rate of 100,000–150,000 a month for most of the last four years.12
Brown: It has been widely expected that economic growth in 2014 would be better than in 2013, but how is that going to happen? The expectation was that the rest of the world would provide a boost to the U.S. economy. But the eurozone remains in recession, and the PMI is only 48.8 [a reading below 50 indicates contraction in the manufacturing sector].13 The rest of the world is also not growing very rapidly. Brazil is not doing that well, and other emerging markets are more dependent on the developed world. Japan is doing well, but its central bank has said that it's done with stimulative policies, and now China is trying to slow down its economy.
The U.S. economy will also have another round of sequestration at the beginning of next year, and that will continue every year through 2021. And the economy is not creating enough jobs to bring down the unemployment rate, and many of the jobs that are being created are part time and low paying. Personal income growth has been flat, and with unemployment so high, that is unlikely to change. I agree that lower commodity prices will help, but where else will the economy get a boost?
Q: What about the revival of U.S. manufacturing? Could that help drive the economy?
Brown: Last year was great for manufacturing, but in the past several months, the manufacturing sector has lost jobs and the sector seems to have lost some of its momentum.
Linsen: The loss of momentum lately is probably more a reflection of the softness in the global economy. With several U.S. export markets in recession, I don't think we can expect any resurgence in the near term. So while the renaissance is still occurring, the cyclical downturn has temporarily overwhelmed it.
Q: So, can we conclude that the U.S. economy is likely to grow by only 2% a year for the foreseeable future?
Ezrati: I would expect 2% growth through at least the end of next year. It may not change after that, but it’s hard to see beyond that point.
Linsen: Improvements in Europe could help. Any cyclical improvement could make a difference.
Brown: I agree with that. I don't think the eurozone economy will get worse. It's still contracting, but it's contracting at a slower rate. It might even be growing in 12 months, but I can't be much more optimistic than that. Greece is still struggling, and unemployment is very high in Spain and Italy.
The U.S. government did a lot to get the economy going again, but in Europe, Germany's insistence on austerity programs makes those kinds of policies difficult to implement in the countries that need it. Long-term unemployment is also a big problem. We have that problem, too, but it's much worse in Europe.
The United Kingdom is showing some improvement and is one bright spot in Europe. In Asia, Japan is growing, but that growth is likely to be short-lived.
Ezrati: [Japanese prime minister Shinzo] Abe's program is to do the same thing that Japan has done since the end of World War II, which is increase public works spending, devalue the yen, and goose the export industry. Abe will get reelected on the basis of this, but then it's over.
This plan has only so much staying power. Japan will likely get a surge of growth, and then it will probably have run its course. For it to continue, Japan would have to take an increasing share of the export market away from the likes of China, Indonesia, and Vietnam. But that would require Japan to devalue the yen to ¥150 to the dollar [from about ¥100].14 They can't do that.
Japan has to make a dramatic shift. There needs to be the same changes made to the Japanese economy that China is now making—that is, reorient the economy toward domestic consumption. But Japan should have done that 20 years ago. There's nothing in Abe's program that addresses this.
Q: Given the likelihood of a tepid economy in the United States, what can we expect from the markets?
Ezrati: Even in a 2% real growth environment, we could see 6% nominal growth in earnings.
Brown: Right. Assume 2% real growth in earnings, paralleling the 2% real growth in the economy, then add another 2% for inflation, and maybe an additional 1%, based on exports—that adds up to nominal growth of 5%. Then if companies buy back shares, that could provide another 1% in earnings, calculated on a per-share basis. And if you add a 2% dividend, that would be an 8% return.
Linsen: It is possible that multiples could expand as well, given the lack of inflation. But for a rise in the market to be sustainable, you would want it to be driven by earnings growth, not just an expansion of multiples.
Brown: Given that returns on Treasury securities could be negative, investors might be willing to pay up for what many expect will be a return of 6–8% on stocks, so that could push up price/earnings [P/E] ratios.15 An increase in the P/E from about 16 currently to about 17 would add another 6–7% to equity returns, so stocks could provide a total return in the mid-teens over the coming year.
In the fixed-income market, the political strife in Brazil, Turkey, and Egypt could lead to a flight to quality. But that's about the only reason that interest rates on high-quality debt would go lower from here.
I think investors now take a qualitatively different view of the fixed-income market. They know QE is going to come to an end, and subsequently that short-term interest rates will be raised, and that then interest rates will normalize. So investors don't want to bid up prices on high-quality fixed-income securities and push yields below 2% again. So although we might see yields get back down to 2% if some kind of world event causes a flight to quality, I think we are unlikely to see a retracing of the rise in yields that we saw in June.
In investment-grade bonds, I think investors would be lucky to get 3%. The yield on the Barclays U.S. Aggregate Bond Index16 is probably just over 2% now (as of July 1). So if that yield went to 3% or 3.5%, that suggests that bond prices are going to fall, so the total return over the next 12 months would be less than 3% and could be negative.
High yield, on the other hand, is likely to compete well with equities if the expected return for equities is 6–8%. High yield currently is paying more than 6.5% (as of July 1),17 so I think high yield could do well over the next six to 12 months given its lack of interest-rate sensitivity and its attractive yield relative to other investment alternatives.
Q: Thank you.
Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Investments in high-yield securities (sometimes called junk bonds) involve higher risks than investment-grade bonds and carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Foreign securities generally pose greater risk than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation, or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. These risks can be greater in the case of emerging country securities. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
The market may not perform in a similar manner under similar conditions in the future.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.