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Equity Perspectives

While some significant concerns have been resolved, more remain on the horizon.

The markets can be volatile in the fall months, and with a long list of uncertainties accumulating at the end of the summer, investors were bracing for some turmoil. Fortunately, September clarified some of the uncertainties on the list, and without much turbulence. The choice of a new Federal Reserve chairman, for example, was narrowed when Larry Summers withdrew from consideration. Whether the Fed would begin to taper its bond-buying program in September was also answered, surprising markets, but leaving the exact timing of tapering uncertain. Imminent U.S. military involvement in Syria was taken off the table too, though the eventual outcome of negotiations appears murky. And Germany's chancellor, Angela Merkel, was reelected, removing what little doubt surrounded that issue.

Plenty of uncertainty remains, however. As of this writing, Congress was arguing over budget issues, the Affordable Care Act, and how to resolve the shutdown of the government. Overseas, worries persist that political tensions could erupt in Greece, Spain, Italy, and Portugal, bringing the eurozone's financial crisis into the foreground again. In Asia, while China's progress in reorienting its economy around domestic consumption remains an open question, Japan's resurgence could be derailed by a new consumption tax. Meanwhile, some observers worry that when the Fed begins its eventual tapering, emerging markets could experience a crisis similar to the one that occurred in Asia in the late 1990s.

Addressing these and other topics are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist, and Zane Brown, Fixed Income Strategist; and joining them is David Linsen, Director of Domestic Equity Research.

Q. THE DECISION TO DELAY THE TAPERING OF THE FED'S BOND-BUYING PROGRAM SURPRISED THE MARKETS, AND SOME OBSERVERS BELIEVE THAT TAPERING WILL NOT BEGIN UNTIL MID-2014. WAS THE DELAY THE RIGHT DECISION?

Zane Brown: The Fed certainly surprised the markets with its decision not to taper. The Federal Open Market Committee [FOMC] probably made the decision at its September 17–18 meeting. If the members had decided before then, and knew they were headed solidly in the direction of not tapering, they probably would have provided better guidance.

Though the decision probably hurt the Fed's credibility, it was justified, given the lack of progress on the economy. On the single most important metric, job creation, the situation has deteriorated. In the first few months of the year, job growth averaged about 190,000 per month, according to the Bureau of Labor Statistics, and some members of the Fed suggested that if that figure rose to 200,000 for three months, the Fed would be likely to taper. But in the last three months, that job growth has averaged only 148,000 per month.

Also, the economy has been slowing and the housing recovery has weakened a bit. According to a Bloomberg survey, many economists had been lowering their forecasts for 2013 and 2014. The Fed also lowered its outlook for this year and 2014. So the decision not to taper in September was justified from the standpoint of job creation and economic growth.

The low level of inflation also allowed the Fed to continue its bond-buying program. The core Personal Consumption Expenditures Index,1 which is the Fed's preferred measure for inflation, has been running at only about 1.2% year over year, well below the Fed’s unofficial target of 2%.

The FOMC was probably also taking the federal budget debate into account. There's the possibility of additional spending cuts coming from sequestration, which could slow the economy further.

Q. SINCE BERNANKE IS EXPECTED TO LEAVE THE FED AT THE END OF 2013, WHEN MIGHT THE TAPERING BEGIN?

Brown: If Janet Yellen becomes the new chairman of the Fed, the tapering is likely to be delayed longer than if Bernanke had remained in the position. Yellen is more dovish on inflation and is likely to favor more accommodation even at the expense of higher inflation. Tapering is also likely to take longer under Yellen. Bernanke said it would probably require nine months to bring the bond-buying program to an end, but with Yellen, it may take a year or longer.

Some observers have suggested that tapering could be delayed for years, but I don't think that is likely. With the progress that has been made in reducing the federal deficit, the Fed's $45 billion in monthly Treasury purchases is accounting for a larger and larger share of the total issuance. The Fed doesn't want to be in the position of being the only buyer of Treasuries. So tapering cannot be delayed for much longer.

Q. CONGRESS MUST ADDRESS THE DEBT CEILING BEFORE OCTOBER 17. LAST YEAR, THAT PROVED TO BE A CONTENTIOUS ISSUE. HOW WILL IT AFFECT THE MARKETS THIS YEAR?

Milton Ezrati: The Republicans are saying they want to defund the Affordable Care Act, which is impossible, but the president and the Democrats want a clean debt ceiling, which also is impossible. Because we need the debt ceiling raised to keep the government running, and both sides are making their demands contingent, it looks like there will be an impasse.

So I think the odds are that we will not have a compromise, but Congress will instead just postpone the debt ceiling, as they have done since President Obama took office. So by the end of October, we are likely to have a decision in Washington in which the two sides will agree to differ and will postpone the ceiling again for six to nine months.

The debt ceiling will be a big issue for a while, and there will likely be flights to safety during the debate. People will likely flock into Treasuries from equities and credit-sensitive bonds, and this should help Treasuries. David Linsen: Government shutdowns or debates over debt ceiling limits appear to be moments where the parties attempt to move their agenda forward, which will likely cause short-term headwinds for the markets.

Brown: But the deficit has improved by almost $300 billion as a result of rebounding corporate and individual tax receipts, according to the Congressional Budget Office.

Ezrati: But those improvements are no indication of what will happen in the next fiscal year. The improvement this year is due to tax hikes as a result of the Affordable Care Act and to the end of a tax holiday on the 2% payroll tax. It also reflects an extraordinary effort to pay dividends and bonuses in 2012 instead of 2013 (in order to avoid higher tax rates). These inflated 2012 taxable incomes and, therefore, the taxes paid in April. These will not happen next year.

Brown: So next year those will remain in place, but there won’t be big jumps in revenues as there were this year. The budget has also benefited from $75–80 billion in profits earned by Fannie Mae [Federal National Mortgage Association] and Freddie Mac [Federal Home Loan Mortgage Corporation], which go directly to the Treasury Department.2

Q. MOVING NOW INTO THE INTERNATIONAL ARENA, THE PROSPECT OF U.S. AIRSTRIKES AGAINST SYRIA SEEMS TO BE OFF THE TABLE FOR NOW. HOW IS THAT SITUATION LIKELY TO DEVELOP, AND WHAT WILL BE THE IMPACT ON U.S. MARKETS?

Brown: I think the best we can hope for is a situation similar to that in Iran and North Korea, where we [that is, the West] constantly press for verification and for an end to their nuclear weapons programs, and where they, in turn, stall and make promises. I think the idea that Syria would unequivocally turn over 100% of its chemical weapons is unlikely. So the issue is likely to be background noise for a long time.

There certainly isn't much support in Congress if this negotiation proposal doesn't work and the president decides it's necessary to launch Tomahawk missiles into Syria. But if we did decide to do that, it’s likely that we couldn't just walk away. Syria could retaliate by sending missiles into Israel. Israel, of course, would respond. Then the conflict could widen further, and the price of oil could rise to more than $200 a barrel.

David Linsen: In the meantime, the reduced probability of military action in Syria has had a positive effect on the markets, and a positive effect on American consumers as oil prices have come down.

Q. THE INSTITUTE FOR SUPPLY MANAGEMENT'S [ISM] MANUFACTURING INDEX3 POSTED VERY STRONG READINGS IN THIS SUMMER. DOES THIS SUGGEST THAT THE ECONOMY'S GROWTH RATE COULD BREAK OUT OF THE 2–2.5% RANGE IT HAS BEEN IN SINCE THE RECESSION ENDED?

Ezrati: The ISM Index can send some false signals. Earlier this year, it indicated for three months that the economy was contracting; then in July and August, it posted very strong results, a kind of catch-up.

Brown: Manufacturing employment was down 16,000 in July and then up 14,000 in August, according to the Bureau of Labor Statistics, so employment growth in that sector is uneven, and that suggests that those strong readings are not pointing to a breakout from the 2–2.5% range that the economy has been in.

Auto production has been strong because of pent-up demand due to the weakness of the economy. So U.S. consumers are spending more on autos, but they're not increasing their spending much on other things, except housing. So consumer spending, which makes up about 70% of the economy, continues to be mixed.

Linsen: To add a little to what Zane said, auto sales were strong this quarter, up an estimated 8.5% year over year, according to data from the U.S. Department of Commerce. That being said, our consumer analysts have been discussing a slowdown in spending in categories like apparel and restaurants, as we saw a pickup in consumer durables spending.

Brown: Retailers' same-store sales have been weak, whether high end at Nordstrom's or low end at Walmart or midlevel at Macy's, and the back-to-school season has also been anemic.

Ezrati: That is a standard pattern. When consumers spend on cars and other big-ticket items, sales of other items suffer. So when there's a big month in auto sales, the nondurables sales suffer and restaurants suffer.

Brown: One hopeful sign is that initial unemployment claims are pretty low, and that suggests there have been fewer layoffs. The average work week is also a little longer, and that suggests that at some point companies will need to do more hiring.

Ezrati: State and local governments are starting to hire more, and they're reducing their layoffs. Mass layoffs, tracked by the Labor Department, have declined too.

Linsen: The economy has created about two million jobs over the past 12 months, according to the Bureau of Labor Statistics. That's not enough to dramatically reduce the unemployment rate, but it's probably enough to keep the economy from falling below the 2% growth rate.

But it's not just the U.S. ISM Manufacturing Index that has improved. The global purchasing managers indexes4 have been rising as well, and improvements are occurring in Europe and in China. How do you all view these improvements? Do you think they are sustainable?

Brown: I'm a little skeptical about Europe. Germany is responsible for most of the improvement there, but there are still a lot of countries that are still seriously struggling. I'm more confident about China than I am about Europe.

The United Kingdom, however, does seem to be doing pretty well. Investors seem to be more optimistic about the United Kingdom than the Bank of England is. The bank has said it won't raise interest rates until 2016, but investors seem to be saying that the economy is growing strong enough that interest rates will have to rise before then.

Ezrati: Japan also has been doing well as a result of the monetary and fiscal stimulus plan [colloquially] known as Abenomics. But Japan may enact a consumption tax, and that could take the blush off the rose. Prime Minister [Shinzo] Abe has talked about the "third arrow" in his quiver [i.e., complementing monetary and fiscal stimulus], but he has not shot it yet, and we still don't know exactly what it will be. Apparently it includes reforms of various kinds, including agricultural reform and increasing women's participation in the workforce, but it's all very general.

Q. EMERGING MARKETS WERE HIT HARD BY AN OUTFLOW OF CAPITAL WHEN, BACK IN MAY, BERNANKE MENTIONED THE PROSPECTS FOR TAPERING. SOME OBSERVERS HAVE SAID THAT TAPERING COULD RESULT IN A FINANCIAL CRISIS IN EMERGING MARKETS SIMILAR TO THE ONE THAT OCCURRED IN THE LATE 1990S. IS THIS POSSIBLE—IS IT A CONCERN?

Brown: I think we should distinguish emerging markets that have gone through a boom, like Brazil, from those that haven't, like Mexico. Brazil has benefited greatly from the infrastructure build out in China, but China has completed much of that infrastructure and is now reorienting its economy toward domestic consumption. So companies in Brazil are in trouble. In many cases, they've borrowed in U.S. dollars, and because their revenues are in their own currency, which has been declining versus the dollar, they’re going through a bust cycle. This is also true for companies in other emerging markets that have experienced a boom, like India.

Ezrati: But the drop in the currency of Brazil and other emerging markets is reestablishing their tremendous cost advantage, although the effects of that will take a while to play out.

Q. WHERE SHOULD INVESTORS LOOK FOR OPPORTUNITIES IN THIS SLOW-GROWTH ENVIRONMENT?

Brown: High-quality, longer-term securities are not likely to do well in this environment, where eventual tapering leads to gradual normalization of interest rates. If the economy is going to grow at just 2–2.5%, high yield will probably do better than high quality. Investors should consider going down in quality and shorter in maturities. So high-yield, bank loans, and short-duration securities should do well.

But equities are more attractive. In an environment of 2–2.5% real economic growth, corporate earnings could grow by 6–8% nominally. And if the price-to-earnings [P/E] ratio5 remains unchanged, then investors should get a similar return. That may not sound great, but where else can investors get that? And if investors show more interest in equities, that could push up the P/E ratio, which could add to the return.

I think that in a slow-growth environment what will be key is the ability to select stocks, and companies with better growth prospects would do better than others.

Linsen: We’ve seen the P/E multiple, on a next-calendar-year basis, expand by about one point this year [from 13.2 to 14.3]. Why has that happened? There are many reasons, but a few are that economic growth has picked up, inflation has remained tame, and the tail risk associated with the European debt crisis has moderated. As we look forward, modest inflation matched with reaccelerating EPS [earnings per share]6 growth could lead to more P/E expansion.


1 The Personal Consumption Expenditures price index is an indicator of inflation compiled by the Bureau of Economic Analysis. Derived from the personal consumption component of the gross domestic product, it measures the average increase in prices for all domestic personal consumption.
2 Source: Federal Home Loan Mortgage Co. (Freddie Mac) and Federal National Mortgage Association (Fannie Mae).
3 The ISM Manufacturing Index is a purchasing managers index that measures employment, inventories, new orders, and supplier deliveries in manufacturing industries. It monitors conditions in the manufacturing sector based on surveys conducted by the Institute for Supply Management.
4 Purchasing managers indexes (PMI) are economic indicators that measure activity in the manufacturing sector. They are derived from monthly surveys of companies in 30 countries.
5 The price-to-earnings (P/E) ratio is the stock price divided by the earnings per share. It is a common measure of stock valuation.
6 Earnings per share (EPS) is the company’s profits divided by the number of shares outstanding.

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