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Few prognosticators expected the S&P 500® Index to produce a total return of more than 30% in 2013,1 and even fewer are predicting such a performance for 2014. In fact, many observers now expect a significant correction. The U.S. economy also surprised some observers in 2013. Many expected that policy uncertainty, higher tax rates, and federal spending cuts due to sequestration would lead to recession. But through three quarters, the economy managed to keep chugging along, edging up by about 2% in inflation-adjusted terms.2
Growth may improve in 2014, despite a likely rise in interest rates and other headwinds. Potential contributors to this performance will be steady personal consumption, lower imports, less fiscal drag from the federal government, and possibly a rise in business investment.
Meanwhile, in the wake of stalled reform efforts, Europe faces the continued likelihood of anemic growth and the possibility of deflation. In Asia, China's transition to a consumption-based economy will proceed slowly, posing little threat to global growth.
Addressing these and other topics are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; Harold Sharon, International Strategist; and David Linsen, Director of Domestic Equity Research.
Q: U.S GROSS DOMESTIC PRODUCT GREW BY 4.1% IN THE THIRD QUARTER OF 2013, UP FROM 2.5% IN THE SECOND QUARTER, AND THE STRONGEST PERFORMANCE SINCE THE FOURTH QUARTER OF 2011.3 WILL THIS RATE OF GROWTH CONTINUE? WHAT'S THE OUTLOOK FOR 2014?
Milton Ezrati: The economy is likely to just continue plodding along. In fact, the third quarter has set us up for a slowdown because of the inventory buildup that has occurred. That buildup will have to be worked off. So from a purely technical standpoint, we will probably have at least one bad quarter, probably in the fourth quarter of 2013 [data to be released January 30, 2014] or the first quarter of 2014, when those inventories are sold off. [A reduction of inventories is subtracted against GDP growth.]
Final sales [GDP minus inventory increase] were a little better than in the earlier estimate for the third quarter, but they're about where they have been for a while. Personal consumption also came in higher, as did exports and business investment, but the surge in exports is not likely to be repeated.
The same thing that has been holding this economy back will remain in place, namely, uncertainty about regulation. There's a lot of uncertainty not only about the Affordable Care Act but also the Dodd-Frank banking reform legislation as well as the huge growth in regulation across the board.
There's also the legacy of the financial crisis. So, even though the banks are flush with cash, they’re not lending very aggressively. They're still not lending much for real estate or to consumers. Lending to consumers has grown some this year, but banks still remain cautious.
Zane Brown: But we are seeing a little more in government spending. In the past couple of years, we haven't seen much spending from state and local governments, but that has started to change. It's likely that there won't be as much fiscal drag from the federal government in 2014. The recent budget deal in Congress modified the sequestration plan passed in 2012. The deal resumes some of the spending over the next two years and then reduces it again over the following eight years. So that new spending by the federal government will help a little over the next year.
But we are still likely to see a continuation of the plodding growth in consumption that we've seen over the past few years, which is around 2%.4 Business investment may pick up, but it seems that businesses are more interested using their cash to pay out dividends, buy back shares, or make acquisitions than they are in expanding via organic growth.
David Linsen: Focusing on consumption, job creation, higher consumer confidence, and low inflation should support a continued recovery in housing and retail sales. Our housing analyst is expecting new starts to be 1.1 million, versus 855,000 in 2013.5 So these developments could provide a good backdrop for overall consumption.
Brown: I'm concerned that housing affordability could be hurt as interest rates rise as a result of the Fed's tapering its bond-buying program. Home prices nationwide are already up 11% or so year over year, according to the S&P/Case-Shiller Index, so affordability has already gone down. Affordability is a matter of home prices and interest rates, and interest rates are probably headed higher.
Linsen: Countering that is the trend in job creation. As more jobs are created, buyers who have been sitting on the sideline may gain more confidence. That confidence should lead to better housing demand, assuming interest rates rise at a more gradual pace from here.
Brown: I think tapering is likely to have a serious impact on housing. It may not be complete even a year from now because the Fed is frightened of a kneejerk reaction like the one that occurred in May, when [then-Federal Reserve chairman Ben] Bernanke just mentioned "tapering." So the Fed will likely proceed slowly. Despite that, I think we'll see the yield on 10-year Treasuries rise to 3.5% by the end of the year, and that could easily push 30-year mortgage rates to 5.25%.
Keep in mind that without quantitative easing, bond yields would be higher. Under normal monetary policy, the yield on the 10-year Treasury ought to be about the same as the nominal growth rate in the economy. So if the economy grows by 2.5% and inflation is running at about 1.5%, then the 10-year Treasury yield ought to be about 4%. So it's likely we're headed in that direction and that we may see the 10-year Treasury reach 3.5–3.75% in 12 months. That could dampen demand for housing and constrain economic growth.
The Fed has reduced its growth forecast for 2014, from 3–3.5% to around 3%.6 I think it's likely that we'll see about the same thing we've seen for the past two years: slow but persistent growth. But we might see a greater contribution from business investing and from government spending. Higher home prices and a strong stock market could also boost consumer confidence.
Ezrati: The wild cards are government spending—although it's not that wild, given that it is constrained—capital spending, and imports and exports. Exports will likely slow because the dollar has gone back up, and imports should continue to improve because we’re not importing that much oil anymore [imports are subtracted in the calculation of GDP].
But even with state and local governments starting to increase spending somewhat, and even with the new budget deal allowing the federal government a little more discretionary spending, that won't be enough to be a game-changer. As for capital spending, I don't see why business would suddenly become excited about increasing it in this kind of an environment. So growth will likely remain slow.
Q: WHAT ABOUT EUROPE? CAN THE EUROZONE FINALLY SHAKE OFF THE SLUGGISHNESS OF THE PAST FEW YEARS?
Brown: The periphery countries of the eurozone, such as Italy, really haven't done much to improve their competitiveness and efficiency. Their inflexible labor markets, for example, are one of a number of hurdles that keep their costs high and make it difficult for them to be competitive internationally. They started to address the problem two years ago, but they really haven't made much progress.
Ezrati: [Italy's then-prime minister] Mario Monti had been leading the effort in Italy and the rest of the periphery, and there was a lot of interest in fundamental change of labor market regulations, product regulations, zoning—a whole mélange of efficiency-destroying regulations. Everybody talked about it, but nobody did much of anything. The influence of the interest groups that oppose reform and benefit from the status quo is tremendous. So the hurdles to competitiveness remain in place.
Brown: There is a small chance that the eurozone could experience an economic contraction in 2014, but the economy's primary driver will be Germany, and it's likely to be strong enough that growth for the eurozone as a whole will be positive. But it won't be that meaningful, and it won't benefit the rest of the world economy much.
Further, I don't think there is much of a risk that Greece or any other country will exit the eurozone in 2014. But it's still a year-to-year situation.
The fact that Europe is trying to unify its banking system helps to reduce that risk. There are huge problems in the banking sector, with many bad loans that haven't been written down. I think the eurozone will make progress toward identifying the bad loans and determining how to deal with them. And if the economy grows at least a little bit, that will provide investors with some reassurance.
Ezrati: Regarding the outlook for the eurozone, I think there are two positives. One is that [former prime minister Silvio] Berlusconi is out of the picture in Italy. He was a major obstacle. The other is, I think, that it's clear that Europe has tagged Germany with the cost of the bailouts, and in return Germany has made certain demands. One is that the bailed-out countries must implement austerity policies. The other is banking reform. So the eurozone is going to implement austerity programs and undergo German-style banking reform because Germany is bankrolling the bailouts. So it's now apparent that the Germans see a benefit to paying to keep the eurozone together because it gives their economy a great advantage.
What's amazing is that that advantage has been enshrined in the euro. The deutschemark converted to the euro at a low price, whereas the currencies of periphery countries, such as the [Italian] lira, the [Spanish] peseta, and the [Greek] drachma, converted at a high price. That means that the euro has enshrined the German advantage in selling to the rest of Europe. And the Germans like that.
Q. THE EUROZONE'S GROWTH RATE AND INFLATION RATE ARE VERY LOW. HOW MUCH OF A THREAT IS DEFLATION?
Ezrati: The ECB [European Central Bank] has said that its push for quantitative easing and for lower interest rates is aimed at raising the inflation rate. So it seems like the ECB has finally realized it is fighting a battle against deflation.
Fortunately, with wages being so high in Europe, it's unlikely that deflation will occur. Because of rigid labor laws, firms are more reluctant to hire in Europe and also slow to lay people off. That rigidity helps keep wages high, which provides some protection against falling prices.
Harold Sharon: The eurozone's low inflation is a reflection of what is happening both in the periphery countries and in the core countries. The periphery is internally devaluing via lower labor costs, etc. (Portugal and Greece, in fact, are experiencing deflation.) And overall, inflation is around 1%, according to the ECB. Will the eurozone actually go into Japan-style deflation? I would say "no," but if it did, there are some tools to help it quickly recover.
The problem continues to be credit shrinkage due to bank deleveraging, but we're getting close to the end of that process. I'd even say that if regulators and courts hadn't been so interventionist over the last 24 months, the banking sector would have been able to lend a bit more to small and medium enterprises [SME] and to consumers. As it stands, it's tough to get an SME loan in some countries, and that's leading to layoffs, bankruptcies, etc.
The fall data showed that price weakness is now evident almost everywhere in Europe—in most countries and in most sectors. Of course, this has spooked the ECB and led [ECB president] Mario Draghi to remind everyone of his July 2012 commitment to "do anything it takes" to save the euro.
We're now in a reverse of the situation that we were in prior to the financial crisis, where monetary policy was basically set for the core countries while the periphery partied. Now monetary policy is set for the periphery's "hangover," and the core, while not partying, is benefiting more than it should. Of course, this excludes France, where the economic data haven't become any better, and politicians desperately cling to their expensive political hobbies.
But the long-term inflationary expectations are still around 2% for Europe on the whole, based on inflation-linked swaps.7 To be fair, the expectations have fallen a bit, so it is worth watching carefully.
Q: THE FED HAS FOUGHT DEFLATION THROUGH ITS QUANTITATIVE EASING PROGRAM WHILE THE ECB HAS BEEN RELUCTANT TO USE THE LONG-TERM REFINANCING OPERATIONS (LTRO) PROGRAM, WHICH IS ITS EQUIVALENT OF QUANTITATIVE EASING (QE). WILL THE ECB BE MORE ACTIVE IN 2014?
Brown: It's more difficult for the ECB to buy government debt because of political considerations. It becomes a question of whose debt does the ECB buy. If the ECB buys Spanish debt, the Greeks will want the bank to buy Greek debt. That's primarily what is holding the ECB from doing more asset purchases.
Ezrati: Think of it this way: If the eurozone were to break up, every member country, proportional to the size of its GDP, would be obligated to bail out the ECB. That means that Germany, with the eurozone’s largest economy, would have to put up the lion's share. But if the ECB has bought debt mostly from Spain, Italy, and Greece, then that would amount to a transfer payment from Germany to those countries. And, of course, the Germans don’t want that. So it makes for an awkward situation.
Brown: But the ECB still can use more conventional monetary policy. It still has some room to cut interest rates as a primary mechanism of easing. Unlike the Fed, which has cut rates to zero, effectively, the ECB has reduced rates to 0.25%. So the ECB still has some room to cut, and it might do that.
Sharon: The ECB could do another LTRO program, although that really only helped banks to build capital and countries to issue debt. I'd think a more targeted SME/consumer lending program may show up—it certainly did wonders in the U.K. housing market. So the ECB has the tools to battle a dip in inflation, and since there will be GDP growth this year—and the forecast for the next two years is for real growth of 1.2–1.4%, according to UBS—I think the ECB can avoid the worst effects of slowing inflation. Disparate levels of inflation in the different countries had to happen to rebalance the eurozone internally, but there are limits to those internal devaluations. Spain's labor costs, for example, are now very competitive. I can't, however, say the same for Italy yet.
With the national election behind it now, Germany has sorted out its politics, and I think Europe, not just the eurozone, is getting better. Certainly, places like France, Portugal, and Italy are still just creaking along and not contributing much, but the economy is generally getting better. And if you agree that austerity policies, while still in place, are becoming less severe, then you could make the argument for more gradual recovery and a long period of very low growth, but growth nonetheless. At some point, Europe can loosen its belt to attack unemployment, which it will have to do. Unemployment could lead to some social unrest in the summer (although we didn't see much in 2013), but I think we're clearly out of the danger zone for Europe, which is why the stock market in Europe has done so well.
Q: MOVING ON TO ASIA, MANY OBSERVERS BELIEVE THAT CHINA'S TRANSITION FROM AN ECONOMY BASED ON EXPORTS TO ONE CENTERED ON DOMESTIC CONSUMPTION COULD SOON START TO HAVE A MAJOR IMPACT ON THE GLOBAL ECONOMY. SHOULD WE EXPECT TO SEE AN IMPACT IN 2014?
Brown: China has some interesting proposals for structural reform, but it's open to question as to whether they will be implemented. One of the proposals is for greater land rights for rural citizens, for example, but that may conflict with the interests of municipalities, which have often taken over farmlands, developed them, and collected lucrative rents. So there is a culture and a historical precedent that opposes such reforms.
Another proposal is to open up financial markets. But all the major banks are state-owned, and they have a large amount of bad debt on their books, and the government can't let them fail. So before those banks are exposed to foreign competition by opening up the financial markets, the government really needs to fix that problem.
So China's economy is still driven by exports, and it's going to take a long time to shift the economy to one that is oriented to domestic consumption. In the meantime, the rest of the world is not growing fast enough that China can rely as much on exports. So it is going to be hard for the Chinese economy to maintain a 7–7.5% real growth rate over the next few years.
Linsen: I think the shift to domestic consumption is small but significant. Wages are higher, and the consumer market is developing. In addition, as China shifts away from infrastructure development, pricing pressures on commodities markets could ease, which would be good for Europe and the United States. So this transition will likely be beneficial for inflation, which should ease input costs in developed markets, and for the growth of global consumption.
Ezrati: But it's a very long-term story. So I think it is premature to think that the shift is going to have much of an impact this year. Still, the Chinese know this shift is necessary, so they're moving in that direction.
To give you an idea of another problem they face, in order to open up their financial system, they have to relinquish control of the yuan. They're not ready to do that yet. So there is going to be a constant tension, but this gradual shift may not have a significant impact on the global economy for several more years.
Sharon: The most startling development coming from all the recent meetings and the like is how quickly Chinese president Xi Jinping has centralized his power. He has become very powerful and is using that to root out corruption and rebalance the economy. He's definitely slowing down credit growth to squeeze out the "shadow banking." This will make it very hard for local and regional governments to get funding. In his economic plans, he kept stressing the importance of allowing "market forces" to accomplish resource allocation. To the extent that he starts chipping away at all the rules that make it hard for the market to work (and that favor state-owned enterprises), that should help China's productivity and growth.
I guess one drawback is that if the government is less concerned about the aggregate GDP level and more concerned about how and where it gets its growth, then there may be a little more volatility in China's quarterly economic numbers. That may scare us a little until we get used to it and learn to avoid reading too much into it.
The adjustment going on internally over how China grows and where it grows will not prevent it from contributing to world growth; it just won't contribute as much as it did in 2010–12, when it rescued the world with massive stimulus and debt buildup. The unwinding of that will keep the Chinese economy somewhat in check, but it's still a fairly large driver for the world—especially as nominal GDP is much, much bigger than in the past.
China's growth probably helps Asia a bit more than Europe or the United States. And from an investment standpoint, it's one of the few countries that is already tightening monetary policy. So at least investors will have the potential to make a little money on the stronger yuan. If China's investment is better and more efficient, given how badly the domestic market has done and how relatively cheap it is, the Chinese equity market may be decent this year.
A Note about Risk: 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 and in response to market movements. 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. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Foreign securities generally pose greater risk than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments may also 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. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions.
No investment 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.
There is no guarantee that the market will perform in a similar manner under similar conditions in the future.
Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
The S&P/Case-Shiller Index is a leading measure of U.S. residential real estate values. It tracks home prices nationally and in 20 metropolitan areas.
Gross domestic product (GDP): The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments, and exports less imports that occur within a defined territory.
The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.