Do you remember the "fast-forward" button on cassette tape decks and VCRs? Better question: Do you remember cassette tape decks and VCRs? The good news is with everything digital, we no longer have to put up with the high-pitched whine of a tape fast-forwarding, nor do we have to attempt to guess when to hit the stop button. But, given all of the noise and hot air surrounding the fiscal cliff, the idea of a fast-forward button is very alluring. It would be such a satisfying button to push.
The challenge is knowing when to hit "stop." In fact when the news first broke about a fiscal cliff resolution, we wanted to insert a chip into this newsletter that would launch Etta James’ "At Last" upon opening. On second thought, that did not seem to be an appropriate tribute to Etta. And it may have led readers into thinking worries were over, at last.
We have news for you. The fiscal cliff resolution is not a resolution, and investors will soon be turning their attention to the debt ceiling debate. In fact, we already hit our debt limit of over $16 trillion on December 31, 2012. Creative accounting and delay of pension payments allowed the U.S. government to continue to operate. Uncertainty is our prevailing wind, momentary respites notwithstanding. The debt ceiling debate is actually only one part of the "troika" that faces investors. Analysts and news anchors are already giving names to these new old challenges a la "fiscal cliff." We have heard "three gorges," "fiscal drag," "FC-2" and "apocalypse now."
In addition to the debt ceiling debate, Washington gave itself a March deadline to deal with the sequestration challenge and the final resolution of the 2013 federal budget. The sequestration challenge refers to the scheduled $1.2 trillion of total government spending cuts that were to have been initiated on January 1, 2013. (No wonder the cliff moniker came into play.) Given the stock market’s record-breaking euphoria on the first trading day of 2013, one would think this economic challenge was resolved. Actually, the deadline was simply pushed ahead to February 28, 2013.
Here is another cliff-worthy statistic. According to The Wall Street Journal®, the Congressional Budget Office estimates the white-knuckle, incomplete resolution to the cliff will add another $4 trillion to our national debt by 2022. And, that assumes the $1.2 trillion of spending cuts mentioned above will be implemented. It is not worth the real estate in this newsletter to even comment on that assumption.
Brace yourselves. We believe the fiscal cliff wrangling was just a warm-up to the troika. Washington’s two sides are very far apart on the debt ceiling debate and the holiday season did not exactly yield good will toward men. Brinksmanship and grandstanding will be the course de rigueur, and the fiscal cliff debate may pale in comparison.
Hmm, and a Happy New Year to you, too! Where is that fast-forward button when you need it? Well, consider this. In 2012, headlines were loaded with bad news. Geopolitical troubles enveloped Greece, Italy and Spain. Remember when the Spanish 10-year government bond yield surged past 7.6%? (It is below 5% right now.) The Middle East cauldron threatened to bubble over into weapons of mass destruction. Saber-rattling grew louder in China and Southeast Asia. Newsworthy developments also included shooting rampages, hurricanes, the Mayans’ grand finale and the demise of the Hostess® Twinkie®.
Despite all that and more, the U.S. stock market provided patient investors with a 13.4% return. U.S. gross domestic product (GDP) grew at a 3.1% annualized rate in the third quarter. These are good numbers! And they are a worthy reminder to investors to rise above the splashy headlines and pay attention to underlying economic conditions and investment opportunities. If you are a day-trader or speculator, enjoy those headlines and get ready for some big ones. If you are an investor, hit the fast-forward button. Or, as Wayne Gretzky is credited with saying, "Skate where the puck is going."
Exactly where is that puck going? We believe the U.S. economy will continue to be in growth mode. As we have maintained for the past several quarters, however, that growth will be subdued. Its long-run annual growth potential is about 3.25%, and we expect about 2.0% GDP growth in 2013.
Our political morass and the uncertainty it has spawned are only part of this story. Looking beyond the cliff, we have an aging economy. The median age of the baby-boomer generation is now 56. According to the Pew Research Center®, the 2011 U.S. birthrate was the lowest ever recorded. That means fewer shoulders to carry the burden of that extra $4 trillion in debt mentioned earlier.
Adjust the volume
Oops, we slipped up! We are trying to look beyond the cliff. Another reason for subdued growth continues to be the BIG DIG. We are referring to digging out from beneath mountains of household debt rather than a certain tunnel project in Boston. As discussed in prior newsletters, this process takes a long time and has lasting effects on human behavior. The good news is U.S. consumers are well on their way through this process. Financial obligations have dropped to 10.7% of disposable income, a level not seen since 1993. The cost of servicing household debt has also fallen to near-record low levels.
These debt service levels have dropped primarily because of our low interest-rate environment, which we will address later. They have also dropped as a percent of income because we have seen some improvement in personal income over the last year. Growth has been slow but steady at about 3.5% on a year-over-year basis.
It is precisely this fragile growth rate, however, that makes rising taxes especially concerning. Just the payroll tax moving from 4.2% to 6.2% of income represents an average tax increase of $700 on all U.S. households. The focus has been on households with annual incomes greater than $450,000, but the Tax Policy Center estimates an American worker with annual income between $50,000 and $75,000 will pay $822 more in total taxes in 2013 than in 2012. Ouch.
Meantime, thanks to our elected officials, if you own a NASCAR® race track or a plug-in scooter you will receive some sort of special tax dispensation in 2013. Pork was alive and well in D.C. this past holiday season! Oops, back to the Washington saga again. But can you see why? Our economic recovery has been less than robust and we just put it in shackles.
Know what we heard at the digital water cooler recently? That maybe low growth is good enough. Hmm. Better to avoid that water. Why? Consider this. Over the long run, when an investor owns a well-diversified portfolio of U.S. stocks, that investor is expecting to participate in the growth of the U.S. economy. And, interestingly, over the long run, the average return from a stock portfolio has been very close to the average growth rate of real U.S. GDP plus inflation plus productivity gains plus dividends.
Low GDP growth affects the returns of stock portfolios. That affects future retirement plans for today’s aging baby boomers! Pension plans, which are already using very high rates of expected return in their actuarial assumptions, will need to be supplemented. Taxes will need to increase. A lot. So, we do not want to sit idly by and accept low GDP growth.
Can we not accept it? As mentioned earlier, some decline is normal in an advanced economy. One trump card remains our ability to generate productivity improvements. Simply put, we are amazing! The U.S. economy has proved its mettle in terms of productivity improvements. The most recent report showed an annualized gain of 2.9%, which was 100 basis points above expectations and the fastest pace of growth in almost three years. This prowess is part of our cultural heritage. It is incumbent upon us to maintain its integrity.
This is one reason why we are in need of an understandable tax code that encourages long-term investment. Rising productivity helps all citizens, and ultimately it helps support government budgets and spending. Now, let’s move back to our low interest-rate environment. Given the brinksmanship and hubris in Washington, Federal Reserve Chairman Ben Bernanke has been working overtime. We realize this is not news. It has been a topic of these pages for years.
The pause button
Recent shifts in Dr. Bernanke’s strategy are "news" and they portend a continued very low interest-rate environment. In an effort to be more transparent to the investment markets, the Federal Reserve now bases its rate-making decisions on specific inflation and unemployment targets. Its most recent statement indicated no intention to raise the federal funds rate while the unemployment rate remained above 6.5%. The Fed also bumped its inflation pain target to 2.5% from 2.0%. Additionally, it will continue to buy U.S. Treasury notes and mortgage-backed securities at a pace of $45 billion per month.
These policy decisions spell low interest rates. This is a global phenomenon. There have been more than 360 worldwide central bank easing moves in the last two years. Last summer, European Central Bank president Mario Draghi announced the central bank would do "whatever it takes" to support the euro. (Greece’s stock market ended the year up 33.4%!) Japan’s newly elected prime minister just announced his intentions to pressure the Bank of Japan to provide "unlimited" monetary accommodation. The country’s stock market jumped 20% in the 10 weeks since his election.
When central bank policy calls for target interest rates to be at or near zero, it is only natural to expect the next move in interest rates to be up. We have been saying that for some time. Given the amount of global monetary easing and the 6% output gap in the U.S. (the difference between current GDP and potential GDP at full employment) we now see the possibility of rates remaining low for quite some time. Some economists estimate the Federal Reserve has given itself until at least 2018 before it may raise rates!
Not to belabor the point, but when U.S. fiscal policy is considered, Ben Bernanke’s position is very understandable. He is well aware of the impact of GDP growth on investment returns. He is equally aware of the power of productivity improvements on economic growth. Capital investment fuels productivity. Bernanke is well-versed on the impact of higher taxes and uncertainty on savings rates and capital investment. His determination to keep rates low, pump up investment and support the stock market takes on new significance especially when the upcoming debt ceiling debate is considered.
The Fed’s intent to boost investment activity has resulted in an almost punishing environment for any investor to maintain excess cash. There is no yield! Ben Bernanke’s policies are aimed at pushing investors to take on some risk. Imbalances such as this almost never end well. We advise investors to be cautious in their fixed-income portfolios. At the same time, we recognize the lack of yield in the money market arena.
Our response is to diversify our fixed-income portfolios similar to the level of diversification in our stock portfolios. Beyond a base of high-quality, short- to intermediate-term corporate or municipal bonds, we are looking internationally for quality bond investments. We are constructive on diversified holdings that can bring our portfolios some exposure to diverse areas like emerging market debt, real estate investments abroad and certain commodities that are attractive. Given our outlook for a slowly growing economy and extremely low corporate default rates, we are also considering revisiting the corporate high-yield bond market.
And now here we tread lightly, fixed-income investors may wish to have a heart-to-heart with their portfolio managers. It may be appropriate to allocate a sliver of fixed-income money into the stock market, specifically stocks with above-average dividend yields or dividend growth rates. We have discussed this strategy in past newsletters, and it definitely requires careful thought and introspection. Opportunities exist, and they merit investigation.
This type of investment discussion is definitely part of Fed Chairman Bernanke’s plan, even though support for the stock market is not an official mandate of the Federal Reserve! Given the positive stock market responses when central bankers issue "whatever it takes" announcements, the strategy does work. In recognition of this support and our outlook for steady U.S. economic growth, we remain constructive toward the stock market.
Our diversified stance continues and we are more optimistic about increased exposure to the developing markets again. Last year, China’s pace of economic growth slowed. Its stock market was down more than 10% through early December. China’s new leader just announced a commitment to pro-growth policies and definite support for increased urbanization. This is significant, in our opinion. It offers a boost to the Chinese economy and, because of the magnitude of that economy; the boost will spread to the global economy. It also offers support to U.S. companies. Urbanization in developing countries leads to a higher standard of living.
The newly wealthy (by local standards) want to buy stuff. Typically, American stuff. Your writer had the opportunity to witness this quest first-hand last fall in Vietnam. It is unceasing. Once that genie is out of the bottle, he does not go back.
Maybe he can grant us our wish for a fast-forward button!
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