Success in 2012 seemed to be mostly about staying the course: not reacting to each bit of news out of Europe or China or, heaven help us, the fiscal cliff negotiations. We should have expected our politicians to copy their European counterparts by doing the absolute minimum at the last possible moment to avert a crisis and deferring bigger decisions until later. This exercise in procrastination did achieve two important things, however: (1) the new tax law made the income and estate tax rates permanent, providing some certainty about tax policy and (2) by deferring any action on spending cuts, they delayed the economic impact of the cuts to a later date, making a recession much less likely.
We had been concerned that higher income taxes and the expiration of the payroll tax holiday, combined with spending cuts, could be an immediate 1.5-2% hit to our economy. This could easily have thrown us into a mild recession. While the hit from the tax hikes (mostly the expiration of the payroll tax holiday) will be about 1%, we are pretty confident now that spending cuts will get pushed into the future. And, some of the short term impact of the tax hike will be mitigated by lower gasoline prices. Bottom line, intransigence may prove to be just what we needed to avoid recession – isn’t it incredible how Washington can work this magic!
We should caution that we are by no means out of the woods. When you govern by brinksmanship, there is always the risk of a major self-inflicted wound (like the 2011 debt ceiling debacle). So we will be watching the spending and debt ceiling debates closely. But for now, we believe that “absolute minimum at the last possible moment” is the governing philosophy.
So what of our burgeoning deficit, insufficient revenues and unrealistic social promises? They are left to another day. We can only hope that these words from the preamble to the report of the National Commission on Fiscal Responsibility and Reform (Simpson Bowles) prove prophetic: “We believe that far from penalizing their leaders for making the tough choices, Americans will punish politicians for backing down – and well they should.”
For nearly four years now, we have been talking about the legacies of the Great Recession: high unemployment, consumer savings and debt payoffs, reduced bank lending and the housing drag.
Chronically high unemployment is certainly still with us. Even though the “headline” rate is 7.8%, down a long way from the peak, much of this has been accomplished by a drop in the labor participation rate. This participation rate – currently at 63.6% – is near a 30 year low. Recently, the Federal Reserve has set its monetary policy targets based on achieving a 6.5% jobless rate, an interesting target given that there is little evidence that the aggressive Fed policies have spurred job growth to date.
Speaking of the Fed, its low interest rate policies have helped consumers deal with their debt issues. So far, most of the progress has been made on debt service costs (now near historical lows, as a percentage of income) rather than principal reduction (about halfway back to the long term average, also as a percentage of income). Because consumers have limited the growth in debt very sharply even while incomes have expanded, we expect slow but steady progress.
Almost left for dead by many, real estate has staged an unexpectedly strong turnaround. In particular, demand for multi-family housing is very robust and prices reflect that dynamic. Single family housing inventory is now only five months, well below long term average of seven. Most importantly, residential real estate is no longer the financial and psychological drag it once was.
Finally, banks are coping with greater capital requirements and huge regulatory burdens, not to mention very low interest rates. So lending isn’t a big priority now and, honestly, demand for loans isn’t high either. Consumers don’t want to take on a lot of debt and larger companies have more cash than they have had in a very long time. Instead, fee income has taken precedence. Recently, we had a major bank charge a client $40 for returning a wire that was sent to them in error. To us, that showed just how far banks are searching for new fees to charge. Get used to it!
Except for high unemployment, we believe the other legacies of the Great Recession will fade as new trends replace them. We see four long term trends emerging that will drive our economy forward in the next few years. These are: (1) substantial progress toward energy independence; (2) rebound of the residential real estate market; (3) dramatic productivity improvements resulting from mobile capabilities; and (4) the emergence of the echo boom generation (boomers’ children) as the driving force in the economy, reinforcing all three of the other trends. So while Washington dithers, there are trends in the real economy that will drive growth, which is the best prescription of all for reducing the deficit.
Mired in recessions, severe in the south and moderate in the north, Europe is largely in a holding pattern, as the Eurozone slowly debates the type of new structures needed for closer unity. In the meantime, the European Central Bank has clearly stated its intent to do “whatever it takes” to keep the Euro in place. Knowing that the Eurozone is about promoting prosperity while preserving peace, Germany will ultimately provide the leadership needed but only once it believes the correct structures have been established. How long this will take is anyone’s guess. So the weaker economies are left to struggle with austerity while the stronger economies likely begin to recover from a mild recession.
China continues to be the big question mark in Asia. How will the new leadership team stimulate the economy? How will it deal with excess debt accumulated in the real estate sector? Will it become more territorial militarily as it looks to secure energy resources? These and hundreds of other questions are waiting to be answered as the once-a-decade transition of power continues through March.
One thing is clear, however. China and its emerging Asia neighbors will continue to grow much faster than the developed world. But how that translates into future investment returns remains to be seen. Already, spreads on emerging market sovereign debt have plummeted to historic lows. And, Asian stocks posted a strong 2012. That said, we believe that there is opportunity in the uncertainty surrounding China and will look for ways to take advantage of that for our clients.
Caution is warranted on fixed income investments. Even a moderate recovery in global growth will pressure prices. Combining that pressure with excess supply (particularly once the Fed stops buying) will cause rates to rise. From these levels, the loss to principal from higher rates could be substantial. We don’t expect a sudden move but we could look back a year from now to find Treasury and corporate bond rates at a meaningfully higher level.
Among stocks, we still like the prospects for large multinational companies with diversified revenue streams, particularly those with substantial emerging market exposure. And, with the continued uncertainties we face in the US, we continue to like a mix of absolute return oriented strategies (such as long short debt and equity) combined with shorter term fixed income investments.
January 8, 2013 © Essential Investment Partners, LLC