Outlook on the United States

Transcription

1 Outlook on the United States JAN 2013 In 2012, progress occurred on many fronts. The household sector continued deleveraging. Mortgage rates fell to record lows, giving borrowers yet another opportunity to refinance. Gasoline prices returned to levels consistent with those in early 2011, offering additional relief to consumers. House prices rose over 9% through the third quarter, providing a welcome boost to the middle class as well as to state and local governments that rely largely on funding from property tax revenue. The US Federal Reserve (the Fed) gave markets more context regarding the circumstances that might lead to higher interest rates and companies subsequently took advantage of this incentive to term out debt and lower interest expense. In spite of the Fed s efforts, companies continued to face lethargic demand growth in developed markets. In response, companies have responded by actively reducing costs and capital expenditures to ensure strong profitability and cash generation, even in a lackluster economic environment. From an equity investor s perspective, 2012 was the opposite of In 2011, US companies delivered double-digit earnings growth, whereas the S&P 500 Index s total return was basically zero. In contrast, in 2012, earnings growth ground toward zero but the total return for the index was in the mid-teens. The most logical explanation for this apparent discrepancy is that investors had more confidence that future earnings could be sustained as the tail risk from the euro zone and fears of a hard landing in China dissipated. European Central Bank (ECB) announcements in late July and early September that it would be willing to intervene in sovereign debt markets under certain circumstances were particularly crucial. Based on the ECB s assurances, investors were able to decrease the discount rates they applied to their expectations of future earnings. In light of these factors, the US economy is entering 2013 in the healthiest condition in several years. The critical exception to this positive prognosis is the failure of politicians to plot a course to resolve the burgeoning US federal debt. In terms of the equity market in 2013, we expect that there will be a divergence between the companies that have the balance sheet strength and cash flow that will allow them to grow earnings in spite of a lethargic demand backdrop, and those that do not. The Year in Review We view the following as the distinguishing features of 2012: 1. The private sector deleveraged further: The secular trend of deleveraging continued in the private sector throughout the year. The household sector is particularly encouraging as debt outstanding has declined from a peak of 97.5% of GDP to 81.4% of GDP at the end of the third quarter, as illustrated in Exhibit 1. This deleveraging has been accomplished through growth in nominal GDP (5.1 percentage points of the 16.1 point decrease) and actual reductions in debt outstanding through payments and defaults. The net result of this deleveraging and of record low interest rates is that the household financial obligations ratio (a comprehensive assessment of debt service) is the lowest it has been since Exhibit 1 US Debt by Category 2009 Q Q Q1 vs Q3 ($ trillion) (% of GDP) ($ trillion) (% of GDP) (change in % of GDP, in basis points) Total Debt Government Debt Financial Debt Consumer Debt Corporate Debt GDP* * Annualized As of December 31, 2012 Government debt is the sum of federal, state, and local debt. Source: US Federal Reserve, Haver Analytics, Bureau of Economic Analysis RD12134

2 2 2. House prices turned: We believe the absolute low point in the housing bust occurred at the end of As measured by the S&P/Case-Shiller 20-City Home Price Index, prices have increased by 9% since the beginning of In the first three quarters of the year, this rebound translated into an increase of over $1 trillion in the value of housing and a 19.6% increase in owners equity in residential real estate. 1 For more detail on our expectations for house prices in 2013, read our Update on the Improving Foundations of US House Prices. As we have previously indicated, for the middle 50% of American households (as measured by net worth), the residence is the biggest asset, accounting for over 60% of total assets for the average household. 3. Quantitative easing (QE) continued: The Fed extended Operation Twist and introduced QE3. Moreover, the Fed indicated that it will likely sustain QE until unemployment falls below 6.5% and/or until inflation is expected to remain above 2.5%. These actions drove financial asset prices even higher, taking household assets to a record level as of the end of the third quarter. 2 Presumably, the increase in financial asset values combined with a rebound in house prices should boost consumer confidence in 2013, and ultimately drive consumer appetite for spending. Moreover, persistently low interest rates have already boosted corporate profits by lowering interest expenses for the indebted, albeit also reducing interest income for those companies with substantial net cash on the balance sheet. 4. Public sector debt increased: Unfortunately, the driver for a meaningful portion of private sector healing has been the socialization of debt at the federal government level. The US federal fiscal year ended on September 30, 2012 with a deficit of $1.09 trillion, or 7.0% of GDP. While this is an improvement from the 9.9% of GDP recorded in fiscal 2009 (which was inflated due to the way in which TARP spending was accounted for), it is still unsustainable. 5. Elections delivered mixed signals: President Obama won a clear reelection with room to spare from an electoral college perspective. The Democrats, surprisingly, gained seats in the Senate, while the Republicans retained control of the House of Representatives. The most important outcome of the elections may be the internal conflict currently on display within the Republican Party as the Tea Party coalition competes for influence with the historically more mainstream part of the GOP. 6. The Supreme Court ruled on the Affordable Care Act (ACA): While the ACA no longer makes headlines, the US Supreme Court s ruling was positive in that it removed another element of uncertainty that clouded the outlook for investors. Now that it is clear the law will remain in place, we can better assess the winners and losers and focus on the rollout of health-care exchanges, as well as monitor the need to fix inevitable problems stemming from the legislation. The Year Ahead Entering 2013, all eyes are on the impending fiscal cliff. While awaiting the outcome of negotiations in Washington, we have shifted our focus away from the timing of a resolution toward the composition of what will be ultimately agreed upon. Defining a positive outcome is not as simple as it might appear. We will judge the resolution based on the following criteria: 1. Scale of deficit reduction: One of our concerns relates to the magnitude of deficit reductions under discussion. The figure most frequently cited is $4 trillion over ten years. While we believe this is a good starting point, it is not a complete long-term solution as it implies that the United States will accumulate nearly $6 trillion of additional debt over the next 10 years. The basis for our calculation is as follows. The Congressional Budget Office (CBO) has forecast an additional $9.98 trillion of deficits from 2013 to 2022 assuming that all tax rates are extended at the current levels and that spending cuts are not imposed (including the sequestrationrelated cuts scheduled to begin in 2013). Under this alternative fiscal scenario, federal government debt held by the public would increase from approximately 73% of GDP at the end of fiscal 2012 (September 30, 2012) to almost 90% of GDP by the end of fiscal Note: debt Exhibit 2 CBO GDP Expectations Appear Too Optimistic Year Real GDP growth (%) Nominal GDP growth (%) Estimated GDP ($ billion) , , , , , , , , , ,992 Calendar year estimates as of August 2012 Source: Congressional Budget Office

3 3 held by the public excludes debt not owned by the government, such as the Social Security Trust Fund and other retirement vehicles. We have excluded these figures as, theoretically, the government can cancel or change the terms of the debt it owes itself. Our view that $4 trillion of deficit reduction is only the starting point arises in part from our concern that the underlying economic growth assumptions used by the CBO are too optimistic. The CBO assumes the GDP growth figures from 2013 to 2022 as shown in Exhibit 2. To be fair, the expectations from 2018 to 2022 are based on demographic and productivity assumptions, rather than on an attempt to estimate actual GDP. That said, our concern relates specifically to the period from 2015 to If deficits over the next ten years total $6 trillion rather than the nearly $10 trillion under the CBO s alternative fiscal scenario, this implies that debt held by the public would remain at 73% of the CBO s estimated GDP in 2022 rather than increase to 90%. As mentioned, our concern is that the GDP assumptions for 2015 to 2017 appear unreasonably optimistic. These estimates are based on closing the gap between current GDP and CBO economists estimate of potential GDP. The gap between the two is very large given how little the economy has grown during the financial crisis. Hence, the assumed growth in the next five years is very high as the CBO assumes the gap will be closed. The CBO s approach generally makes sense, but we would argue that the historical trend growth rate was exaggerated by the credit bubble during the secular era of leverage. From the 1980s to the financial crisis, consumers pulled forward their future consumption by financing it. This means growth going forward will be lower as borrowers repay the debt that funded the mirage of exceptional underlying growth. However, we believe the deleveraging currently underway will translate into a lower growth rate than the average of 4.4% in real terms and 6.3% in nominal terms from 2015 to If nominal GDP growth is only 4% during that period, it implies that GDP would end 2017 at $18.7 trillion, a meaningful shortfall from the nearly $20 trillion assumed by the CBO. Applying that logic to 2022, if nominal GDP growth remains at a constant 4%, we calculate a GDP of $22.8 trillion. This would imply that a $4 trillion deficit reduction program would leave the US federal government debt held by the public at 80% of GDP rather than 73%. This level of debt would leave very little flexibility for dealing with the recession that is likely to occur during such an extended time frame, much less exogenous variables, such as the potential risks emanating from Iran or other geopolitical hot spots. 2. Timing of spending reductions and tax increases: At the same time that we are worried about the inadequacy of a $4 trillion deficit reduction program, we are also concerned that too much fiscal austerity too soon could tip the United States back into recession. The CBO has also estimated that if the United States were to go over the fiscal cliff and not change course, real GDP in 2013 could shrink by 0.3%. We have written before about the current untenable situation in which the United States is spending near the highest levels of GDP since World War II at the same time that it is collecting taxes at levels near the lowest levels in 60 years. Clearly, tax rates will have to increase and spending will have to be reduced. The question is how quickly this can be done without pushing the country into a negative feedback loop similar to what has occurred in peripheral Europe where austerity has led to reductions in GDP, which has then translated into even higher debt-to-gdp ratios given the reduced denominator. 3. Realism: Another factor to monitor is realism in relation to spending cuts in particular. Once tax revenue changes are agreed upon, we can estimate revenue with a higher degree of confidence as rate and deduction changes will generally be transparent. Spending cuts, on the other hand, are typically more opaque when legislated. To be credible, we believe spending cuts should be delineated by government agency or purpose, in order to provide some evidence that real decisions have been made, as opposed to promises of future decisions. 4. Timing: We believe it is very important to agree on a fiscal plan as soon as possible. In our view, one of the single largest headwinds to US economic growth is a lack of visibility as it relates to tax policy. Eliminating this uncertainty should be a top priority for all elected officials in Washington. However, removing uncertainty by agreeing on a solution that is unsustainable, or that merely promises that decisions will be made at a later date is almost as bad as not making a deal at all. Our fear is that leaders will agree to avoid the tough decisions and give the voters an easy solution that merely temporarily delays the tax increases and spending growth reductions required to balance the US budget. Based on this argument, we would prefer that Congress and the President eliminate the uncertainty regarding tax rates and deductions now and embrace a program of long-term tax reform and simplification during 2013 so that employers, investors, and consumers can make informed decisions regarding their major capital outlays. This view would imply that tax rates would increase in 2013 and deductions would likely be limited to generate sufficient incremental revenue to make long-term deficit reduction and elimination feasible. The most sensible approach might even be to immediately raise tax rates for the highest-earning Americans and then phase in or even grandfather limits on the deductibility of certain household spending over time to allow families to adjust their consumption patterns. The downside of such an approach is that it foregoes some revenue in the implementation phase, but the upside is that it would be less of a shock to the economy and less of a headwind to growth. Conclusion From an investment perspective, we believe an important lesson of 2011 and 2012 is the ability of a company to grow earnings even when real GDP is sluggish. Consider the hypothetical situation in Exhibit 3. This table illustrates that company revenue growth expectations should take into account real GDP, inflation, market share gains, capital management, and international growth. Together, these factors imply it is realistic to assemble a portfolio of companies that grow earnings by 5% to 11% even in a weak economic environment. (These figures clearly assume active management as the revenue growth would be lower for sectors with no international exposure.) From a medium-term perspective, this implies that through a cycle, US equity investors could reasonably expect to earn a return of 7% to 8% (on average over 3 to 5 years) even with no price-toearnings expansion. Compared to the alternative of fixed income in particular, this is an appealing opportunity even after the rally in 2012.

4 4 To the extent the United States successfully addresses its fiscal challenges, we believe there is substantial upside for US equities. We remain confident that, over time, political leaders in Washington will make decisions that will place the United States on a more sustainable fiscal trajectory than at present. However, it is critical that decisions are made to remove the fiscal uncertainty from the economic horizon. By agreeing on a substantial package for deficit reduction, the government will also provide increased room for flexibility to address risk factors that might arise in the future even if the package does not represent a complete fiscal solution. We will continue to monitor the progress on deficits with hopes of a resolution. In the interim, we continue to focus on identifying companies with solid balance sheets that can generate strong organic cash flow growth for shareholders, and that have the operational flexibility to deal with any fiscal scenario. Exhibit 3 US Equities Are Attractive Even in a Slower Growth Economy Potential Growth Contribution (%) Real GDP 1 3 Inflation 2 3 Market Share 0 1 Capital Management 1 2 International Growth 1 2 Total 5 11 Addendum In the first week of the New Year, Congress and President Obama agreed to a bipartisan plan to address the fiscal cliff. The plan will generate less incremental revenue than we believe is necessary to reach a sustainable long-term fiscal path, but we believe the agreement is a good start on the path to fiscal rebalancing. Importantly, federal expenditures remain to be addressed, in all likelihood alongside the debate over raising the debt ceiling that will occur over the next two months. There appears to be room for meaningful reductions in government spending growth, particularly for entitlements, and we are hopeful that these adjustments can be implemented with minimal risk to economic growth. We are concerned that the underlying assumptions regarding future US economic growth are too rosy and, hence, future deficits are likely to be worse than predicted by the CBO. That being said, we think the immediate imperative is to sustain US economic growth as the nation s ability to support its debt is contingent on national income, or GDP. More revenue growth combined with definitive spending cuts and a greater reduction of future deficits would have been desirable; but given the choice between less deficit reduction and a higher certainty of sustaining growth versus more deficit reduction and a higher risk of recession, we choose the former. Another positive aspect of the fiscal cliff deal is that it sets tax rates on a permanent basis. Recent tax changes have often been set to expire at a pre-determined date. This allows the CBO to assume that tax rates will revert to higher levels at a later date, and the increase in the deficit from lower rates would be mitigated. By making tax rates permanent, Congress and the administration are taking a more transparent approach to tax policy, which enables investors to make decisions based on a higher level of confidence in the rules that will apply to future profits. We intend to carefully monitor the ongoing debate over US fiscal policy; but we believe that the government has already begun to make progress that should reduce federal deficits in 2013 to 6% of GDP or less. Within the next three years, we believe it is realistic to expect a further reduction to 3% of GDP. If this is the case, we expect investors to embrace a more optimistic perspective on US equities as uncertainties continue to be addressed and confidence in future growth increases.

5 Outlook on the United States Notes 1 Source: Federal Reserve Flow of Funds 2 Source: Federal Reserve Flow of Funds Important Information Published on January 8, This report is being provided for informational purposes only. It is not intended to be, and does not constitute, an offer to enter into any contract or investment agreement with respect to any product offered by Lazard Asset Management, and should not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. The information and opinions presented in this report have been obtained from sources believed by Lazard Asset Management to be reliable. Lazard Asset Management makes no representation as to their accuracy or completeness. All opinions and estimates expressed herein are as of the published date, and are subject to change. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging-market securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging-market countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging-market countries. Past performance is not a reliable indicator of future results. Lazard Asset Management LLC 30 Rockefeller Plaza New York, NY