INVESTMENT FORUM US ECONOMY: ON THE VERGE OF RENAISSANCE? EDITION

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1 INVESTMENT FORUM US ECONOMY: ON THE VERGE OF RENAISSANCE? EDITION

2 US ECONOMY On The Verge Of Renaissance? The world s largest economy is at an inflection point. With a range of monetary, industry and energy market initiatives to consider, Pioneer Investments experts examine how robust and sustainable the US economic recovery might be. The US recovery is finally getting some traction. Pioneer Investments estimates that US GDP will grow by 1.6% in 2013, rising to 2.7% next year and 2.8% in This is expected to contribute to global growth of 3.1% in 2013, rising to 3.8% and 3.9% for the next two years. The US thus looks set to become the major contributor to global growth, easing some of the burden from emerging markets. The US bounce back is a story of energy, manufacturing and technology. It is particularly impressive considering that neither Japan nor the Eurozone has grown to pre-banking Crisis levels. US real GDP, seasonally adjusted, was 7% higher at the end of the second quarter this year than it was at the time of the Lehman crisis. MICHAEL TEMPLE Director of Credit Research, US MARCO PIRONDINI Head of Equity, US % The Dragging Effect Of The Shrinking Public Sector Govt. Consumption and Invesmtent-YOY CHG Nominal GDP ex Govt. Cons and Investments-YOY CHG Source: BEA, data as of June 30, Despite this, Pioneer Investments experts are not taking the US renaissance for granted. Less than half of those present at the Forum said they believe the economy is on a new structural path of stronger growth. It has definitely entered a recovery phase, but doubts remain over whether we will see new economic models affirming in the future. The US economy has endured many headwinds, particularly in government spending, says Paresh Upadhyaya, Director of Currency Strategy, US. now working against what was the Baby Boomer economy. Today, the States has a rapidly aging population and the proportion of women entering the workforce is declining. The argument is not simply that the Baby Boomers are retiring; protectionist Bush and Obama era immigration policy has further exacerbated the labor supply shortage. Considering the second-order effects an increasing dependency ratio, more government spending on healthcare and pensions an aging economy throttles potential growth. PARESH UPADHYAYA Director of Currency Strategy, US In addition, the falling rate of investment and an increase in regulation has contributed to the rising cost of doing business, and that upsets productivity. Upadhyaya says that demography is Deleveraging Versus Leveraging When assessing the US, recovery it is important to consider the ongoing deleveraging process. US total nonfinancial debt as a percentage INVESTMENT FORUM 2

3 of GDP has stabilized below 260%. That is lower than the level in the Eurozone. In particular, private sector non-financial debt has undergone a significant adjustment. Households have managed to improve their balance sheets from the excesses, which contributed to triggering the financial crisis. Meanwhile, government debt has risen significantly since the crisis started. Although the US did see some fiscal tightening in 2013 when the sequestration triggered in March, the recent government shut down and the latest argument over the debt ceiling demonstrate how difficult it will be to stabilize the deficit and how US fiscal policy is acting as a source of uncertainty. Despite all the factors that may lower potential US growth, leading indicators are pointing to an economic expansion. Pioneer Investments specialists were asked to comment on what has become a contentious issue: the so-called renaissance in US energy and manufacturing. These themes look set to have a significant impact on future US growth rates, but how relevant are they to the current picture? Since 2007, the trade energy deficit was around 3% of GDP. As of September, the energy deficit is down to just 1.5%, says Upadhyaya. The US has been importing less oil and has even started to export. Over the last decade, cutting edge exploration and extraction technologies have allowed companies in the US to uncover and produce gas and oil resources which were previously inaccessible. After steadily declining for 30 years, in 2008 oil production began to increase. The potential impact of energy renaissance on future growth could be material: according to a study for Pioneer Investments conducted by Robert Wescott, former economic advisor to President Clinton and President of Keybridge Research, this new trend could add 0.3% to GDP every year between now and However, today this energy renaissance is not materially translating into higher growth not yet anyway, says Upadhyaya. Aside from some encouraging anecdotes, the manufacturing renaissance is similarly immature. Domestic manufacturing Watch the video interview US Economy output as a percentage of GDP is still very low when we look at the period since So it might be too early to describe it as a manufacturing renaissance it s more a shift from old industries to new ones. We have seen lower energy costs benefitting manufacturing, but at the same time, technological advancements in artificial intelligence and automation could have a long-term positive effect on GDP growth and create a structural breakthrough. Today, the path of innovation is not comparable with the past. At the current rate, computers will probably have the processing power of a human brain by the mid-2020s, says Michael Temple, Head of Fixed Income Research, US. According to BCA analysis, the goal of creating human-like artificial intelligence may become a reality. With advances in IT growing at an exponential rate and breakthroughs becoming commonplace, innovation could trigger a once-in-a-generation boost in productivity. The next frontier currently being researched is quantum and DNA computing, and these areas will extend the ability of computing to accelerate even faster. This has implications for all sectors, including education, where the US leads the world. Today, expensive face-toface tutoring can be circumvented if you can have a professor in Harvard who s not just reaching a thousand local students but a million students worldwide. We are on an exponential discovery curve in healthcare that could drive down costs and even provide tailored medicine, says Temple. United States may be again on the verge of the next great investment story of mainstream innovation. Boosting The Economy And The Market Gas, manufacturing, tech these are all chapters in the story of innovation-led US recovery. There was an insightful debate at the Forum about what this means from a market perspective, in particular what it means for equity valuations given that the S&P 500 has hit new record highs this year. Marco Pirondini, Head of Equity, US, takes a conservative view despite being quite bullish on US equity markets. He believes that with nominal GDP growth over the next few years expected between 4% and 5%, earnings growth could be at around 6%. This estimate does indeed seem conservative if we also consider that S&P 500-listed companies generate about 40% of their revenues from outside the US, giving them exposure to higher global growth. Pioneer Investments view on US Equities for the next three years, therefore, remains constructive, especially compared to the weak outlook for US Fixed Income. Two other elements stand out for Pirondini. Firstly, the trend of companies shifting their business model, becoming less capital intensive and achieving higher return on invested capital. Commentators are confused by high INVESTMENT FORUM 3

4 levels of investment in China, and, in turn, relatively low levels in the US, says Pirondini. You have to look at the two together one is the product of the other. In China, businesses are highly capital intensive, which contributes to a low margin. In the US, it is the opposite. The second important element is the amount of cash generated by firms pursuing such high-margin business models. And cash is primarily a vehicle to buy back equity. As the chart shows, a lot of companies are buying back more than 5% of their shares, and this is the case in almost every sector. All things being equal this puts the US in a favorable position with European corporates that have ratcheted up share issuance to meet their capital requirements. If this rate of buy back continues, remarks Pirondini, the entire US equity market will be private in the next 20 years. The US credit market also looks sound. We see valuable opportunities both in investment grade and in high yield debt. High yield spreads, which are theoretically a function of the default rate, are appealing, as defaults remain at low levels, says Temple. That said, the upside is not at 2012 levels. An overweight position on credit is more about identifying alpha than a beta approach this year. A Once-In-A-Lifetime Change in Interest Rates By contrast, the outlook for the Treasury market seems less encouraging. On the question of whether we are in a bond bear market, Michael Temple is on the fence. Yes, we have seen a bit of a bear market, but you d need a magnifying glass to see it on a 30 year chart after decades of falling rates. Although the 30-year Treasury is down almost 12% since the summer tapering talks, interest rates remain historically low. [Treasuries] are not sufficiently cheap for us to consider them versus equities or credit. However, Pioneer Investments doesn t expect a rise in interest rates to happen abruptly. What drives the rate up is inflation, and we don t currently see a signal for an inflation spike, says Temple. Companies are becoming more efficient, and even a fall in the unemployment rate will probably not translate into higher prices. Some argue that the huge amounts US Cash-Rich Corporates Buyback Shares Financials ex REIT Materials Information Technology Industrials Health Care Consumer Discretionary Consumer Staples Energy Telecommunication Services Utilities -15% -10% -5% 0% 5% 10% 15% 20% % Companies in Each Sector of MSCI US ex REIT Buying Back Over 5% Shares Source: Factset, Data as of September 30, of money injected into the system by the Fed will end up causing inflation, but if we look at the velocity of M2 money stock, it has fallen to 50-year lows, and hasn t really ticked up in any meaningful way. So this seems to tell a different story. In Temple s view, the Fed will carefully manage interest rate expectations. The Fed cannot afford to risk losing credibility by creating a negative feedback loop, and the events of the summer were a reminder of this. Given current levels of public debt, an interest rate shock could be disastrous for debt servicing costs. For this reason Temple believes there is an effective cap on US yields despite the worrisome uptrend. The possibility of rising interest rates is one of the factors that could benefit the dollar, especially if the Eurozone and Japan maintain their respective accommodative monetary policies. Recently, the Euro has been artificially resilient due to different factors. One is the deleveraging in the Eurozone s private sector which determined the selling of dollar-denominated assets and the repatriation of funds. Additionally, austerity measures in the Eurozone have led to a fall in imports, which drive a sharp turnaround in current account balances along the periphery. However, the conditions that drove a greenback secular bear market, one that began in 1973, with the end of Bretton Woods, should be over. In Paresh Upadhyaya s view, conditions are building to support a structural dollar recovery. Potential monetary policy divergences with Europe and Japan, slowdown in US Dollar diversification, and a noticeable improvement in the twin deficits (current account balance and fiscal balance) are the more convincing among them. INVESTMENT FORUM 4

5 Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of October 10, Unless otherwise stated, all views expressed are those of Pioneer Investments. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. Neither Pioneer, nor its representatives, are legal or tax advisors. In addition, Pioneer does not provide advice or recommendations. The investments you choose should correspond to your needs, goals, and risk tolerance. For assistance in determining your financial situation, please consult an investment professional. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: November 10, 2013.