2013 Economic and Financial Market Outlook

Transcription

1 2013 Economic and Financial Market Outlook Reflections on the economic recovery to date The economic recovery that began in the third quarter of 2009 is now three and a half years old. During this period, economic growth has occurred in fits and starts, with periods of weakness in 2010, 2011 and 2012 that each resulted in additional monetary or fiscal policy support. Monetary policy support has come through the Federal Reserve guiding interest rates lower for a more extended period to push long-term yields lower and progressively increasing securities purchases. Fiscal initiatives include the payroll tax holidays implemented in 2011 and These ongoing efforts have generally kept the economy moving forward, but have not produced a more robust expansion. By most macroeconomic measures, the recovery has been and remains fairly lethargic. Changes in economic relationships since the downturn have become more apparent over the past few years. Economic growth has consistently undershot consensus forecasts and averaged just 2.2% on an annualized basis, while the unemployment rate has fallen from 10% in October 2009 to its current level of 7.7%. The relatively steady decline in unemployment in conjunction with roughly 2% economic growth suggests that the potential economic growth rate slowed dramatically following the downturn. Federal Reserve Chairman Bernanke acknowledged this post-crisis development in a recent address to the Economic Club of New York. In his opinion, this decline in the economy s potential growth rate is transitory. As the headwinds from the crisis dissipate, he thinks the economy should return to a higher potential growth rate. Whether the slowing in the economy s growth potential is transitory or longer lasting is very important over the intermediate term, but it is not particularly relevant to the 2013 outlook. The economy is nowhere near its productive capacity. Therefore, the economy s capacity (or the potential growth rate of the economy s capacity) is unlikely to restrain economic growth next year and beyond. The economy continues to suffer from demand weakness originating both domestically and abroad. We have argued that this weakness is due to the misallocation of resources, particularly in credit markets, during prior expansionary periods. For example, nonfinancial debt obligations as a share of gross domestic product (GDP) are not materially different today than at the onset of the crisis and downturn in the United States and many other developed markets. The high level of indebtedness will likely continue to restrain demand growth. The decline in labor force growth associated with the aging of the U.S. population (even more so in Europe) is critical to the economy s growth potential over the coming years. Even with improved productivity in the future, the decline in the economy s growth potential is not likely to be as transitory as the Chairman s comments imply. The implications for the economy s growth potential will become very important for the timing of monetary policy normalization in future years and the intermediate-term return potential for financial markets, but it should not be a significant factor in JANUARY 2013 Keith Hembre Chief Economist To state the obvious, the 2013 outlook depends heavily on the outcome of fiscal policy negotiations. Ending 2012 on a soft note Bloomberg s quarterly investor poll completed in late November showed the most optimistic view of the global economic outlook since May 2011 among global investors. This optimism in part reflects revised data showing a 2.7% gain in real GDP during the third quarter,

2 consumer confidence at its best level since 2008, homebuilder sentiment at its highest since the housing bust and financial market conditions that have turned much more favorable in response to policy actions globally. But a closer look at a broader set of indicators suggests that optimism may not be fully warranted. We will likely see a material deceleration in growth during the fourth quarter, with GDP likely to show flat to 1% growth. This reflects the slow underlying trend of domestic demand growth, weak external conditions and some interruptions to activity from Hurricane Sandy should continue the 2012 growth trend, provided our elected leaders reach agreements to avoid the majority of fiscal policy contraction that will occur without action. With fiscal policy set to become more restrictive in 2013, even under the most favorable set of conditions, the Federal Reserve (Fed) will continue to enhance the level of monetary accommodation through its securities purchase program. We will most likely see the pace of unsterilized purchases accelerate to about $85 billion per month following the expiration of Operation Twist. Previously these purchases were sterilized, as the Fed had been buying long-term Treasuries and selling short term Treasuries (sterilizing purchases so as not to create new money). For now, the domestic inflation environment remains benign, owing to weak global resource demand and substantial unemployment that continues to drive private wage growth lower. Most leading indicators of private employment growth continue to show a decelerating trend as we move into Outlook depends on Fiscal Policy Negotiations To state the obvious, the 2013 outlook depends heavily on the outcome of fiscal policy negotiations. To form a baseline for the 2013 outlook, we assessed current trends and likely economic performance in the absence of any policy changes. Then we factored in assumed fiscal policy effects. If the policy outcome differs from our assumptions, we can reassess the broader economic forecast. We continue to look for fiscal tightening of roughly $200 billion in 2013 as a result of higher payroll, dividend income, capital gains, health care and income taxes on the highest income earners. We also expect modest reductions in discretionary spending. Any material deviations in the actual policy outcome will result in forecast changes. In particular, lack of policy action would make a recession in early 2013 a virtual certainty, as fiscal tightening would equate to approximately $600 billion. Income and consumption growth trends should remain modest in 2013 Consumption spending has grown at a 2.1% annual rate over the first 13 quarters of the economic recovery. Growth has held relatively steady at 1.8% during the past year and has slightly outpaced real disposable income growth during the period. Modest income growth in the coming year, with risks around reductions in disposable income due to tax policy changes, should anchor a fairly sluggish trend in consumption spending in Labor income makes up the majority of personal income, and trends in labor income growth are likely to be modest in Most leading indicators of private employment growth continue to show a decelerating trend as we move into 2013, although changes in employment regulations in 2013 to fund health care benefits could lead to greater part-time employment. This would bias total nonfarm employment numbers higher and average weekly hours lower. The economy likely added around 1.8 million new jobs in 2012 (1.666 million through October), or produced growth in headcount of 1.4 percent. In the coming year we will likely see a slower pace of employment growth. This is based on our framework of assessing employment growth as a function of its trend and as a lagging function to corporate profit growth, which has slowed sharply in recent quarters. Average weekly hours worked rose

3 modestly in 2012 relative to 2011, but have been stable for the past several months. Private sector average hourly earnings growth has continued to descend and stands at 1.3% over the past 12 months ending in November. Consumption Spending Growth has Outpaced Real Disposable Income Growth 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 1996 Real Consumer Spending (Y/Y Change) Real Disposable Income (Y/Y Change) Homebuilding activity should remain the fastest growing sector of the economy in Source: Bureau of Economic Analysis. Data from 1/1/94 to 10/31/12. Looking to 2013, these labor market trends look as though they should remain firmly in place, with the product of changes in employment, hours worked and compensation resulting in a modest pace of pre-tax, pre-inflation income growth. Real spending power will be subject to material deviations in taxes and inflation, as wage rates are unlikely to adjust along with price levels. It is virtually certain that tax rates will increase in The payroll tax holiday that supported disposable income growth in 2011 and 2012 is likely to end in 2013, reducing disposable income growth by just less than one percent. Higher marginal income tax rates on upper income earners, dividend income and capital gains will also reduce growth in disposable income in 2013, but lower savings rates will likely provide a partial off set to the spending outlook. Lower inflation should aid real spending power in 2013, but nominal income growth looks as though it will remain sluggish and taxes will likely take a bigger bite of those income streams. Homebuilding should continue growing Homebuilding activity should remain the fastest growing sector of the economy in 2013, but its overall contribution to economic growth will remain modest given its very small share of GDP. Housing starts have accelerated from 720,000 units in December of 2011 to 894,000 units in October of this year, and should move toward 1 million units in The overhang of housing stock in recent years has been significantly reduced and demand conditions have been supported by lower prices, policies that have driven mortgage rates to historical lows and the general improvement in economic conditions. Home prices have stabilized as supply and demand conditions have moved more closely into balance. Some of the more bullish economic forecasts for the coming year suggest a steadily rising trend in home prices will bring a return to the home-equity-induced consumption patterns that preceded the downturn, which is not an element of our forecast. Home prices have recently been supported by investor activity, support that will likely diminish as prices rise and the economics for these types of purchases are reduced. Furthermore, the link between home prices and median family income growth that was reestablished following the housing bubble collapse should remain in place in the coming years, and homeowner s equity remains very low from a historical perspective. This, along with more normalized lending standards, suggests reduced capacity for re-leveraging housing assets.

4 Link Between Home Prices and Median Family Income Growth Should Remain FHFA All-Transactions Home Price Index vs. Median Family Income 0.7% 0.6% Business fixed investment spending has been particularly soft in recent months. 0.5% 0.4% Source: U.S. Census Bureau, Federal Housing Finance Agency. Data from 12/31/76 to 12/31/11. Businesses investments will likely be muted While housing investment trends have improved, business fixed investment spending has been particularly soft in recent months, slowing from double digit annualized growth rates in mid-2011 to relatively fl at activity on average over the past couple of quarters. In part, the recent softness in business spending likely reflects uncertainty over the fiscal outlook for 2013 and beyond. Businesses may have chosen to defer discretionary investments pending more clarity on the policy outlook. There could be some catch up in investment spending following policy outcomes, but there are other factors that explain recent weakness in business spending. Businesses have Deferred Discretionary Investments 30 Non-Defense Capital Goods ex Aircraft Orders Source: Standard & Poor s, U.S. Census Bureau. Data from 3/31/93 to 9/30/ Fundamentally, final demand growth remains very sluggish in the United States and abroad. Slower output growth reduces investment needs and slower sales have resulted in fairly paltry revenue growth for the corporate sector. To maintain profit margins, companies have generally maintained fairly tight cost control. The historical relationship between profit growth and capital expenditures is very similar to the relationship between profit growth and employment. Changes in profit growth on a year-over-year basis have had a leading relationship to capital expenditures. The sharp slowing in profit growth in recent quarters suggests the 2013 outlook for business fixed investment is fairly muted.

5 Net exports unlikely to contribute to economic growth The economy s external sector has performed reasonably well given Europe s slip into recession in 2012 and the slowing growth trend in China. Export growth and import growth have each slowed sequentially in each quarter of 2012, reflecting the deceleration in global economic growth. This has resulted in a modest narrowing of the trade deficit and a modest positive contribution to GDP growth each quarter in The Eurozone recession is expected to deepen in the fourth quarter and China s data improvement is tentative, both likely stalling the improving trade trend during the final quarter of the year. While weak economic conditions in major economies abroad will limit export prospects, the likelihood of domestic demand conditions also remaining soft should limit import growth. Net exports are unlikely to make a meaningful contribution to economic growth, either positive or negative, while growth rates for both exports and imports will likely remain low. This reflects the below-trend global growth environment likely to prevail in The softer growth trend in China has provided relief on the inflation front and allowed the Fed to be more aggressive with monetary policy. Net Exports Unlikely to Drive an Acceleration in Global Economic Growth U.S. Export Growth (L) OECD World Leading Indicator (R) Source: U.S. Census Bureau, Organisation for Economic Co-operation and Development (OECD). Data from 11/30/96 to 9/30/12. Stresses in the European credit situation have eased as authorities provided Greece with the latest aid installment, thus reducing the near-term risks of a disorderly departure of Greece from the Eurozone. Other periphery bond yields have fallen in response to the potential backstop of the European Central Bank s open market transactions program should it be requested. Although structural fears have eased and financial conditions have improved, economic indicators suggest that the downturn in economic activity has probably deepened during the final quarter of 2012, with composite purchasing manager indices pointing toward a contraction in GDP of between a 1.5% and 2.0% annual rate in the final quarter. While the German and French economies expanded slightly during the third quarter, that doesn t appear to be the case in the fourth quarter. Indicators suggest that the weakness in economic activity will carry into the first half of The proximate cause of poor European performance lack of economic competitiveness and over indebtedness in the periphery economies remains in place. The slowdown in China has been ongoing throughout much of 2012 and an ongoing source of disappointment for more bullish global growth forecasts. It has also been a source of weakness in corporate profit reports. However, the softer growth trend in China has also provided significant relief for global resource prices, particular where China represents a large portion of global demand. This has also provided relief on the inflation front and allowed the Fed to be more aggressive with monetary policy. China s policymakers have taken incremental steps to support economic growth in recent months, and there has been

6 moderate improvement in some growth indicators. But intermediate-term financing to support longer duration stimulus projects remains limited, and there is very little economic slack in China s economy. The proximity to full employment limits the amount of support authorities are likely to administer. The potential growth trend in China has likely slowed by more than is generally believed and a rapid acceleration in growth is unlikely. But China doesn t appear to represent a major downside risk to the broader outlook in Overall government spending still a headwind State and local government spending has represented a fairly persistent drag on economic growth since the final quarter of 2009, with spending growth negative in each quarter. With improved state and local tax receipts, we would look for less contractionary pressure from state and local governments and project a slightly positive pace of growth in aggregate state and local government spending in Federal government spending should remain in contraction mode in terms of the direct purchases of goods and services that are categorized as the federal government s contribution to economic growth in GDP accounting. The massive federal deficit trends in recent years have not contributed to growth in federal government spending during the past couple of years from a GDP accounting perspective. Much of the deficit spending has been oriented toward transfer payments and income support. The primary effect of any meaningful deficit reduction should appear within the other components of the GDP accounts. Overall, the contribution of direct government purchases to economic growth in 2012 should be roughly fl at to slightly negative, again contingent upon policy developments. Overall, the contribution of direct government purchases to economic growth in 2012 should be roughly flat to slightly negative, again contingent upon policy developments. Deficit Trends have Not Contributed to Growth in Government Spending from a GDP Perspec 26% 24% 22% 20% 18% 16% 14% 12% 10% 1968 U.S. Federal Government Spending as a Share of GDP Federal Tax Revenue as a Share of GDP Source: Standard & Poor s, U.S. Census Bureau. Data from 12/31/68 to 12/31/11. Market reaction to the latest round of quantitative easing has been muted Headline inflation has fallen from nearly 4.0% on a year-over-year basis in late 2011 to roughly half that pace as we close The decline in inflation served two purposes: 1) it supported real disposable income (and therefore broader economic growth) during the past year and 2) provided a more favorable inflation backdrop that permitted the Federal Reserve to undertake yet another round of quantitative easing in late There has historically been a strong link between labor costs and overall inflation trends, and current wage data suggests very benign inflation pressures in the labor market. Global resource prices have also seen relief in 2012 as a result of the weakening economic growth environment abroad. If global growth conditions improve, resource prices will almost certainly see upward pressure, and overall inflation levels are likely to move higher given the vast amount of liquidity provided

7 by balance sheet expansion by the major central banks. This would seem to be the primary near-term risk to the Fed s latest policy move, notwithstanding concerns about the longer term efficacy of the price and credit allocation distortions the policy moves have produced. Current Wage Data Suggests Very Benign Inflation Pressures in the Labor Market Private Nonfarm Payrolls Average Hourly Earnings (Y/Y) Consumer Price Index (Y/Y) 2010 There is little evidence that these quantitative easing actions have materially improved the economic growth environment over the past couple of years. Source: Bureau of Labor Statistics. Data from 1/31/90 to 10/31/12. Despite arguments by the Federal Reserve officials to the contrary, there is little evidence that these quantitative easing actions have materially improved the economic growth environment over the past couple of years. GDP and employment trends have been generally steady to mildly decelerating even with the quantitative easing program in late 2010, Operation Twist last year and now the latest, unlimited quantitative easing program. We have not changed our forecasts for economic growth in response to the latest actions. Perhaps this will be too conservative, but the financial market reaction to the latest quantitative easing program has been much more muted than past experiences and other central banks have questioned the effectiveness of this policy tool in their own monetary policy deliberations. Market views and investment strategy GDP growth of roughly 1.5% in 2013 with inflation rising by about 1.5% should produce a nominal GDP growth environment of approximately 3% for the year. This should not inhibit the Federal Reserve from abiding by its pledge to maintain near zero short-term interest rates or continue its balance sheet expansion policy. Long-term yields will likely remain extremely low in the coming year, although even under these conditions there will be scope for rates to move higher from today s very depressed levels. At best, broad investment grade bond allocations are unlikely to return much more than the very low yields of today. Any material upward movement in yields will produce negative returns for broad investment grade bond allocations. Municipal bonds seem well positioned to benefit on a relative basis from higher marginal tax rates at both federal and state levels of government. The very low level of yields and their implications for return potential and risk holds important implications for asset allocation and portfolio structure. Fixed income allocations are typically appealing for their low volatility, income potential and (in times of risk aversion) negative correlation with riskier assets. On each of these levels, the potential benefit of a bond allocation is reduced. The low level of yields is an obvious negative, but bond prices are much more sensitive to yield movements when yields are low. Their upside price performance is now severely truncated relative to past downward movements in yields experienced during periods of risk aversion, so a bond allocation s potential diversification benefit in periods of stress is significantly reduced given current yield levels.

8 more sensitive to yield movements when yields are low. Their upside price performance is now severely truncated relative to past downward movements in yields experienced during periods of risk aversion, so a bond allocation s potential diversification benefit in periods of stress is JANUARY 2013 significantly reduced given current yield levels. GDP Growth Should Not Inhibit the Fed from Maintaining Near Zero Short-Term Rates 20% 15% 10% 5% 0% Nominal Gross Domestic Product (Quarterly) 10-Year Treasury Yield growth is likely to fall well short of current consensus estimates in For U.S. equities, corporate earnings growth is likely to fall well short of current consensus estimates in % Source: US Treasury, Bureau of Economic Analysis. Data from 6/30/63 to 9/28/12. For U.S. equities, corporate earnings growth is likely to fall well short of current consensus estimates For U.S. equities, in With corporate fourth earnings quarter results growth still is to likely be reported, to fall well look short for of full-year current consensus estimates in in With of $99 fourth per share quarter for the results S&P 500, still and to be modest reported, growth we next look year for full-year in line earnings in earnings with 2012 nominal of $99 GDP per share expectations for the to S&P $ , per and share. modest Prospective growth share next price year gains line in with domestic nominal GDP equities expectations will depend to $102 primarily per share. on earnings Prospective valuation share changes price in gains 2013 in under domestic this forecast. equities will depend We primarily continue on to earnings favor large valuation cap stocks changes over small in 2013 cap under stocks this in the forecast. domestic We markets. continue to favor large Modest cap stocks Corporate over small Earnings cap stocks Growth in in the Line domestic with Nominal markets. GDP Expectations for 2013 Stock Market Capitalization As A Percentage Of Nominal GDP 200% Modest Corporate Earnings Growth in Line with Nominal GDP Expectations for 2013 Stock Market Capitalization As A Percentage Of Nominal GDP 150% 200% 100% 150% 100% 50% 50% % Source: 1926 Bianco Research Data 1946 from 1/1/ to 9/30/ Source: Certain Bianco foreign Research. equities Data markets, from 1/1/26 like to 9/30/12. the Association of Southeast Asian Nations (ASEAN), are likely to benefit from 1) secular growth trends oriented toward their domestic economic developments rather than global growth trends, and 2) valuations in a number of markets. European markets and Japan have seen valuations compress dramatically over the past couple of years. On an intermediate basis, these markets should be outperformers, and we have steered our equity allocations modestly in favor of international equities. 09 Some of the more bullish arguments for equities are that yields are so low that investment funds will have to move to equities. But equities should probably be evaluated on their own merits as well as in relation to other asset classes. Simply allocating to equities as a default asset class based on the limited potential from fixed income would not exactly have been a panacea for portfolio performance in Japan, the country that pioneered the zero interest rate policy nearly 15 years ago. Alternative approaches to asset allocation are likely to be more effective in the coming years than the traditional balanced approach.

9 Broadly, in our asset allocation strategies we remain moderately underweight equities and significantly underweight core bonds and inflation protected securities in favor of higher income producing market segments such as corporate high yield, municipal high yield and our real asset income and tactical market opportunities strategy as both return enhancing and volatility mitigating strategies. These strategies have been effective in 2012, and will likely be more effective in 2013, as price returns in 2013 are unlikely to match those of 2012 across asset classes. Source: These views were prepared by Keith Hembre, Chief Economist for U.S. Bank. U.S. Bank is not responsible for and does not guarantee the products, services or performance of affiliates or third party providers. This information is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or be construed as an offering of securities or a recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their situation. U.S. Bank and its representatives do not provide tax or legal advice. Each tax and financial situation is unique. Consult a tax and/or legal advisor for advice and information concerning a particular situation. Past performance does not guarantee future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and not available for investment. The S&P 500 Index is an unmanaged, capitalization weighted index of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Investments in high-yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer s ability to make principal and interest payments. 1/13 Investment are insurance products are NOT A DEPOSIT NOT FDIC INSURED MAY LOSE VALUE NOT BANK GUARANTEED NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY