The Washington Comedy Club has taken a brief intermission and will be back in session shortly to resume the show. Please enjoy the facilities of this great country, free of charge, while you wait. Ignore the “Nero” character in the far corner playing the fiddle. Apparently, he isn’t part of the show. Economic uncertainty emanating from fears of the U.S. fiscal cliff has been deferred but not avoided. Gerry Rice, Director of External Relations at the International Monetary Fund summed up the position well:
“We welcome the action by the U.S. Congress to avoid sudden tax increases and spending cuts, including through an extension of unemployment benefits during 2013. In the absence of Congressional action the economic recovery would have been derailed. However, more remains to be done to put U.S. public finances back on a sustainable path without harming the still fragile recovery. Specifically, a comprehensive plan that ensures both higher revenues and containment of entitlement spending over the medium term should be approved as soon as possible. In addition, it is crucial to raise the debt ceiling expeditiously and remove remaining uncertainties about the spending sequester and expiring appropriation bills.”
This highlights why uncertainty and fear persist. Investors have little confidence that our political leadership will take sufficient action to put rising U.S. debt-to-gross domestic product (GDP) levels back on a sustainable course. The chart below illustrates one of the issues mentioned in Mr. Rice’s comment; “containment of entitlement spending over the medium term should be approved as soon as possible.” The chart clearly shows the growth in the percentage of the U.S. population that will be over 65 years of age by 2060; what the chart doesn’t show is that those people will also live longer. Entitlement spending faces the triple whammy of volume (the number of citizens in the 65+ cadre), duration (the longevity of that cadre) AND the higher inflation of healthcare costs. The multiplier effect (number x longevity x healthcare inflation) is pushing the cost of the current entitlements beyond our ability to generate revenue to pay for them, thereby necessitating more and more debt.
I believe there is a relationship between economic growth potential and total indebtedness. The relationship appears to be inverse and nonlinear. The lower the level of starting debt, the higher and/or longer the growth potential of the economy. The higher the level of starting debt, the lower the growth potential. However, the negative or positive impacts of the starting level of debt are not constant. Similar to the weighted average cost of capital concept in corporate finance (which compares the cost of capital to an enterprise relative to the amount of debt it holds), there appears to be a sweet spot for leverage versus growth potential. The U.S. debt-to-GDP ratio was reasonably stable from the 1950s to the 1970s.
Following the oil shocks and high inflation of the 1970s, interest rates have been in a secular decline, in part prompting a commensurate surge in borrowing. The demand for continuing growth requires more borrowing. To encourage people to borrow more, interest rates are reduced until such time as the borrowing capacity of debtors is reached — which should, theoretically, coincide with zero interest rates.
Growth potential is structurally reduced by a lack of ability or desire to take on more leverage, at least in the private sector. Businesses have significantly delevered and consumers have also made progress. Assuming the private sector does not wish to repeat the mistakes of the last 10 years, they will not easily change course. Consequently, U.S. economic growth will be similar to the rate of income growth. In short, we will have to work and save for what we want, not just borrow more money. Instead of accepting this as part of the healing process, the administration and the Federal Reserve (Fed) appear to be promoting policies aimed at increasing borrowing. A case in point was the latest round of quantitative easing (QE). Real interest rates are negative, corporate borrowing costs are low almost regardless of credit quality and mortgage rates are already appealing. Financial conditions are not tightening — they continue to ease slowly and act as a support to growth. The minutes of the FOMC meeting stated, “Yields on speculative grade corporate bonds fell to historical lows…The pace of bond issuance by non-financial firms increased further in October and November after rising robustly in the third quarter.”
However, Jennifer Ponce DeLeon, Head of our High Yield Team notes that management teams are returning their focus to shareholders interests with increased dividends and share repurchases. Access to capital has been quite strong, allowing companies to refinance debt and push out near-term maturities, while macro related headwinds have generally kept management teams more conservative and focused on deleveraging. Therefore, what more is the Fed trying to achieve? The FOMC minutes also observed “notable”, “robust” and “brisk” expansions in Commercial and Industrial loans, leveraged loans and consumer credit, especially in auto and student loans. If this activity is as strong as the FOMC min-utes indicate, why do we need more QE?
The Fed must begin to realize it is investing heavily in the wrong problem. I have argued that additional rounds of QE will have diminishing impact — like a bouncing ball losing energy with each additional bounce. We should also remember that the minutes reflect the decision to increase the program. Still worried about deflation, the Fed will err on keeping the faucets wide open. Consequently, pushing down rates/yields further will only have a small effect on the economy relative to the massive increase in the Fed balance sheet. The FOMC minutes also state “Participants observed that growth in economic activity continued to be restrained by several persistent headwinds, including ongoing deleveraging on the part of households.” I believe this is a good thing long-term and the Fed should stop trying to prevent it. While QE may provide an offset to the ongoing deleveraging (helping manage the “J” curve effect), the J curve is inevitable and Fed action can only mitigate the impact. Our economy will be stronger if the public and private sectors reduce their levels of indebtedness rather than increase them.
Consequently, continuing global central bank action means the search for yield will continue. While prices for any asset with a yield will continue to rise, we think most of the price appreciation has already occurred. The fiscal cliff deal was a positive for equity income investors and municipal bond investors, at least versus expectations. Tax rates on corporate dividends will increase but not to the feared 40% level. Instead, dividends will be taxed at a less prohibitive effective top rate of 23.8%.
The Republicans seem to assume that the deal just announced has taken revenues off the table in the next phase of the fiscal debate. Obviously, the president and Democrats have a different viewpoint. The president does not appear to consider the next round of talks as an extension of the New Year’s Day agreement. He appears to be starting again, talking of a "balanced and responsible" budget compromise. I assume that will lead him to demand another $800 billion to $1 trillion in revenues on top of the $600 billion just enacted. So the comedy show will resume shortly on entitlement reform, the debt ceiling and hopefully tax reform. Another round of wrangling will exacerbate investor fears yet again. Both consumers and corporates are likely to sit on their wallets while the uncertainty persists.
Global equity markets reacted positively to the fiscal cliff deal, but I believe the reality of what has and has not yet been done is still being digested. I believe the impact of the measures agreed on New Year’s Day will equate to a drag of approximately 1.2% of GDP. The economy can likely sustain a fiscal adjustment of that level shaving U.S. economic growth for 2013 to below 1% in the first half of the year. There is a reasonable hope of stronger GDP growth in the second half. Indeed, we may record a quarter of 3% growth in the second half of the year. However, the ongoing political debacle may have a negative multiplier impact via confidence. On the positive side, the stabilization in employment and housing could provide a positive multiplier on confidence.
Politicians have perfected their brinksmanship skills. I suspect that financial markets may need to join the game and show serious volatility to force compromise. The U.S. bond market has begun to react, and I believe the 10 year Treasury yield will rise above 2.30% in 2013.
Retrenchment of 10 year yields may be very important to U.S. corporates with unfunded pension liabilities. Despite overall positive global equity market returns, U.S. pension underfunding likely ended 2012 as the worst on record according to Wolfe Trahan & Co who assessed the current pension landscape by estimating Russell 3000 companies’ unfunded pension liabilities at 2012 year-end and the impact of pension cost on 2013 earnings. Two key pension themes for 2013 will be the continued adoption of mark-to-market pension accounting and the annuitization of pension liabilities. Wolfe Trahan estimates that U.S. corporate pension plans were 23% underfunded ($523 billion) at 2012 year-end compared to an underfunding of 22% or $466 billion at 2011 year-end (current estimated 77% funding is based on $2.2 trillion in pension liabilities and $1.7 trillion in pension assets). Sectors most impacted are consumer discretionary and industrials.
I find Wolfe Trahan’s report intriguing as it notes “The Share Prices of Companies with Large Underfunded Pension Plans Outperformed their Sector by +7.9% in 2012 (with half of the outperformance occurring in December) in the Face of Higher Equity Markets and Lower Aa Corporate Rates. Pension relief notwithstanding, structural pension problems continue to persist for the most troubled companies and such companies remain potential new short ideas.” The outperformance by these shares seems counterintuitive. Falling yields represent an increase in their theoretical liabilities. This strikes me as yet another example of the Fed’s action having unusual impacts on financial markets. Fed action has herded investors into two corrals, yield investments and lower quality investments. That’s why I have been in favor of high yield fixed income despite my fear that 10 year Treasury yields will rise. However, there may be areas of the equity market which represent an intersection of quality balance sheets and reasonable (versus high) dividend yields.
The potential for U.S. economic growth to accelerate in the second half of 2013 leads me to a wide range of forecasts for the S&P 500. I am concerned about the bullishness of most forecasts. Our 2012 forecast was for strong performance of risk assets despite poor economic fundamentals and lingering event risk. I made a strong call for U.S. and European equities at the start of 2012. While recognizing the massive global debt and political issues, I tried to make the case that the risk premium would decline because of central bank actions and the good starting valuations. It appears that many are now using that “equation” as the part of their bullish equity calls. I would argue that most of the consequent re-rating has already occurred. The paradox of 2013 may be that economic fundamentals improve globally and tail risks decline, but the performance of risk assets is far more muted than last year, due in large part to less attractive starting valuations, especially in some areas of fixed income.
It isn’t difficult to create the case for a lower equity market in 2013. Renewed tension in the Middle East, failure to agree on a new budget ceiling in the U.S., the recovery in China stumbles, austerity in Europe causes double and triple dip recessions. That combination could easily push the S&P 500 to the 1,350 range at year end. More positive economic outcomes in the U.S., Europe and China will stoke inflation concerns — so these are not necessarily positive for markets either. In these circumstances, inflation will likely rise faster than unemployment will fall which may leave the Fed with a dilemma on resolving its dual mandate requirements. If economic growth and nominal interest rates are likely to remain structurally constrained as deleveraging continues, inflation expectations will play a higher than normal role in equity valuations. In 2012, the delta on global economic growth was negative leading to lower inflation expectations. Most of the renewed bullishness seems to fit the classic behavioral finance issue of recency bias. The recent equity market has been good so it will remain good. I will continue to argue that there is a massive difference between low valuations (current valuations versus long-term averages) and good value (current valuations versus reduced long- term growth potential). Too many investors are still relying on the first definition.
While equities don’t look all that compelling to me, they still seem like the best of an unexciting lot. I feel the yields on equities versus investment-grade bonds may cause some reallocation between these asset classes. On balance, I believe we will, especially in the second half, see slightly stronger global economic growth leading to rising earnings expectations and slightly higher multiples as we move toward 2014. I expect the S&P 500 index to end 2013 in the range 1,500 to 1,595 representing aggregate earnings of 108 to 110 and a multiple between 13.5 times and 14.5 times. I fear share buybacks may not be as beneficial to earnings per share as many think because rising markets tend to bring offsetting higher share issuance via options vesting in the money. Margins are high and have downside, but discipline is holding well across most sectors.
In addition to structurally slowing growth, high levels of leverage have made our economic systems less resilient to external shocks, a reality I suspect bad actors the world over fully understand. The areas of political risk highlighted in our 2012 outlook will persist in 2013. The tension between Iran, Israel, Saudi Arabia and the U.S. has not improved. Recently, the Iranians claimed to have successfully test fired a number of advanced missiles. While this isn’t a significant technological advancement according to the Brookings Institute, it is still a provocative action. Which leads to the rising possibility of Israeli airstrikes against Iran's nuclear program. The outcome of general elections in Italy and Germany will be significant to policy direction in the European Union (EU). Will Merkel survive? I suspect she will. How new leaders in China and Japan deal with the tension over disputed islands will be important. We are seeing increasing assertiveness by China in the region and it appears Japan is at the point where it feels threatened.
Argentina appears to be heading for a new economic crisis in 2013, and Venezuela faces a possible constitutional crisis if Chavez’ health keeps deteriorating. Territorial disputes ebb and flow but rarely go away. The UK and Argentina still dispute the Falkland Islands, India and Pakistan will dispute Kashmir, we mentioned the tension between China and neighbors, Iran asserts sovereignty over various islands in the Gulf and an old dispute between Armenia and Azerbaijan over the Nagorno-Karabakh region in the Caucasus appears likely to flare up again. Russia’s support for Syria is causing growing tension between Russia and the U.S. I assume the situation in Syria where the death toll has surpassed 60,000 will escalate further before resolution. I also worry about the U.S. regulatory environment. The Consumer Financial Protection Bureau is just starting and the EPA and Labor Relations Board are really just getting started on implementing the newly reelected president’s agenda without any legislative debates to be fought.
Ultimately, the uncertainty leads me to appeal to you to target an acceptable level of volatility rather than targeting maximizing your return. Equities will probably produce reasonable returns, but the ride will be bumpy. Also approaching equity investment with significantly more attention paid to after tax returns is going to be increasingly important to our clients.
There are a few important points to make on various equity sectors.
Consumer: The U.S. consumer, especially the mid to lower end, should feel an impact from a resumption of the payroll tax. Approximately 160 million workers will bring home less money with every paycheck. For workers earning $50,000 in annual salary, that means $80 a month in reduced disposable income. As one commentator noted “It adds up to one less bag of groceries each week.”
We are concerned about rising promotion expenses in household/personal care and tobacco. Our research team also sees weak trends in unit demand for staples across developing markets. The global high-end consumer has shown a few cracks against a backdrop of rising taxes. Housing themes in retail should continue building momentum in 2013. We are intrigued by two possible power struggles: 1) Who will win the battle for mobile card payments; the existing card networks, the new internet based players or the retail consortiums. 2) The future of the TV ecosystem: Will Netflix and Hulu go from being additive to the cable bill, to being replacements?
Energy and Basics: The Brent/WTI spread in oil prices should stay wider for longer as U.S. infrastructure lags. This should remain a positive for U.S. refiners and chemical producers. We believe there is a possibility the oversupply in oil and gas services should be worked out by Q1 2013, leading to improved pricing. Shale gas should keep commodity chemical margins higher for longer.
Financials: Property and casualty pricing appears to be hardening, but reinsurance rates have not moved. If this persists, it is good for P&C profitability. However, low interest rates remain a headwind to life insurers. For banks their older higher interest loans are rolling off. Deposit costs cannot really fall much more so we are concerned about net interest margin compression. Regulatory clarity will drive both redirection and return of capital.
Healthcare: Nobody likes the costs, but demographics will continue to drive healthcare spending. The managed care sector craves certainty as much as any particular outcome. Healthcare should remain cheap in general due to policy uncertainty. Biotech has lots of runway for appreciation via traditional innovation and consolidation.
Industrials: We need the recovery in China and commodity-driven demand to help heavy machinery demand. Engineering and Construction is showing good bookings with U.S. shale gas as a tailwind but EU austerity as a headwind. Home sales, home prices and pent-up repair/remodel demand should help building products.
Transports: Similar to energy, the industry does not appear to be pricing in a recovery. We are drawn to areas where supply is currently tight, such as trucking. It will be interesting to see how much the issues with water levels on the Mississippi will create sustainable positive demand in trucking.
Information Technology: Private enterprise spending is showing weakness — how bad will it get? Government IT spending is probably going to be a negative. Outsourced/Off-shore IT trends are likely to continue, as is “cloud” computing. Server, hardware, storage and infrastructure players will all come under pressure as enterprises work to cut costs and outsource more. We are concerned about possible spectrum shortages in next 2-3 years. Where does the PC go from here? What is the future for the darlings of the 1990’s i.e. Dell, Cisco, Microsoft and Intel? What is the future for the darlings of today, i.e. Google, Apple, Facebook?
Utilities: Will utilities face pressure on allowable rates of return in the face of low rates?
I expect high yield to generate returns in the mid-single digit range over the next 12 months, or a coupon plus or minus a little type of return. I am incorporating the potential for rising longer term yields and limited price appreciation given the high percentage of the market already trading to the first call. Our high yield team believes there are still solid risk adjusted values in the marketplace. We are not looking at stretching too far for risk given higher valuations. However, the higher quality part of the market is more susceptible to rising rates. Consequently, we are looking for best relative values across the market. While valuations have tightened considerably, they continue to provide additional compensation relative to default expectations. Current valuations of +524 basis points spread to worst and 6.01% yield to worst are pricing in a roughly 3.9% default rate versus expectations of 2% or less over the next two years. The limited upside on high yield has pushed my attention to the bank loan market with current pricing implying a default rate of approximately 8%.
I still like municipal bonds. The removal of the Bush-era tax cuts on the wealthy is a significant positive. Also, the ObamaCare levy of 3.8% on unearned income (rents, dividends, interest, capital gains) excludes municipals, which is a positive. Credit quality is improving, but federal “austerity” may undercut progress. Many states have largely recovered from the great recession with balance budgets through better revenue and expense restraint. Local governments are still struggling with anemic property tax growth and labor cost pressures. Improvement in housing is key, but there is a lag on property taxes.
The views expressed are as of 12/17/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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