Looks so Good, But Feels so Bad
“The job market is still far from normal by many measures, and millions of families continue to suffer the day-to-day hardships associated with not being able to find suitable employment.”
– Ben Bernanke, March 2012
Dear Investor –
Despite the sneers, we’ve stuck to our guns about the improving economy. It’s getting better. Corporate profits are high. Consumers are spending more. Inflation is low. And economic growth, although far from robust, is happening here and globally. But despite the proof being in the pudding, the pudding is simply not something the broad public seems enthusiastic about consuming (even as the professional investors have been feasting of late). While the equity markets have charged forward despite all kinds of headwinds, most investors, still reeling from 2008, have stayed home. Skeptics, meanwhile, will insist that our circumstances today aren’t all that different from this time last year when, just as the economy appeared to be poised to really pick up steam, the combination of a weak recovery and turmoil in Europe staggered both economic prospects and the markets. The fact of the matter is that this economy has proven and continues to prove its resilience. Yes, there remain significant risks in Europe, China, the Middle East, and here, in Congress. Barring a major geopolitical event, however, we expect continued growth in both the economy and financial markets. It’s time for the largely timid investing public to begin to join in the feast.
Where To Begin?
With so many events in the headlines these last few months, it’s hard to fathom where to start. (We promise to tackle but a few.) The 900 pound gorillas in the room last year -- Europe and, in particular, Greece -- appear to have shrunk back into the woods. The potentially cataclysmic impact of Greek bond defaults, a collapse of the already frail European banks, and a cascading impact on the banking industry in the US has been avoided, at least, for now. Cooler heads prevailed. And while Greece is probably not long for the Euro, the contagion does not appear to be spreading to the other European nations on less than solid ground, namely Spain, Portugal and Italy. Whew. Yes, Europe is heading into recession (and Greece, something far worse), but calamity has been avoided.
While the Republican presidential sideshow has been taking some of the focus off an absurdist group of anarchists posing as Republican Congressional representatives, Congress has actually been getting some work done: making reasonable efforts to continue spending, not close the doors, and even appears poised to pass, please sit down for this, a bipartisan JOBS Act. (Note the clever acronym.) It’s certainly a far cry from what’s needed, is clearly inspired by a Republican desire to take the Job Destroyer label off the November election table, and represents Congress at its most kludgy. But still, it is legislation that may actually pass.
From an economic point of view, the central word – jobs – is front and center. While the politics of jobs is powerful, the perception is everything. It’s behind how we feel, spend, plan. Typically after a recession, job growth is vibrant, with the economy usually recovering lost jobs within a year. Far from it now. At this rate, we’ll need nearly three more years to get back to where we were at the beginning of 2008. But this was no ordinary recession. Indeed, this was a humongous credit crisis driven in part by enormous over-leveraging on every level: housing debt, personal savings debt, commercial debt, insurance on debt, and government debt. The good news is that job growth, often the last economic facet to turn around, continues to improve, with private sector jobs being added at an average rate of over 250,000 per month. And even with continued downsizing of government, new unemployment insurance claims are substantially down. So while things still feel bad, and frankly are, for the many unemployed, underemployed, and those employed at much lower pay than before, sunlight is returning, albeit slowly.
Meanwhile, the equity markets have been on a tear since the last quarter of 2011, a dive of nearly 20% last fall on concerns about Europe. Indeed, the broader market indices are up nearly 10% this year alone, driven in part by continued corporate profits, a rebounding economy, and perhaps most of all, relief that the skies, in this case over Europe, were not going to fall.
And what story can better speak to optimism and economic success than Apple? What was once the little engine that could, the David standing up to the Microsoft Goliath, has grown to dominate both the business headlines and water cooler tête-à-têtes. “Do you have the new iPad?” God forbid your answer is “no”. That said, someone might happily have traded owning that iPad for owning a share of Apple stock a few years ago, with the stock price having more than doubled over two short years alone, and six-fold since the dark hole of the recession.
But another story that may not elicit the same sort of smile, is the story of a former Goldman Sachs broker, whose March 13th NY Times op-ed spoke shockingly of a rather depraved culture that seems rife in the brokerage community. According to Mr. Greg Smith, a formerly staunchly loyal Goldman Sachs higher level broker, the values in the industry border are bankrupt, with brokerage firms’ interest solely the pawning of their worst products on the most unsuspecting clients; brokers focused on selling those same products which elicit the largest commissions upon the very clients – “Muppets” is the oft-used industry terminology say this piece -- whose trust they are exploiting. What was most surprising to us was not that this was going on at America’s most until-recently revered financial firm. What was most astounding was the shock feigned by the Wall Street and main stream media. News? Really! Certainly, there are many commission-driven brokers who take their financial responsibilities to their clients seriously – I’ve met more than a few. But all of us in the industry have known about this tomfoolery for years. Indeed, this is the reason why investment advisers and non-commission planners exist and have adopted a much higher fiduciary standard of responsibility. So the sense of shock, particularly after Wall Street’s incessant greed sounds at tad, shall we suggest, disingenuous. That doesn’t change the fact that perhaps finally, the call to clean up Wall Street will finally be heard, or will at least ward off a few unsuspecting investors who could otherwise be Muppets in waiting.
Strengths, Weaknesses, Threats
Economic growth has once, again picked up, more than many economists predicted in 2011, as 4th Quarter GDP jumped from a 1.8% rate in the 3rd Quarter to 3% in the last, driven by a strengthening consumer spending sector, real estate, inventories, and exports. This is expected to continue, although many feel that GDP growth will temper somewhat and move closer to 2.5% (we’re inclined to think it higher, on the other hand.) What’s impressive about this growth is that it is happening while government spending continues to dwindle, Europe remains mired in recession, and China’s growth is slowing. The resilience of the US economy never ceases to amaze.
Likewise, corporate profits continue to shine, and remain near all-time highs. While this high profitability level is likely unsustainable (as productivity and cost-cutting have maxed out), profits should remain solid as retail and industrial sales continue to strengthen and exports remain strong. Car sales, in particular, have been extraordinarily vigorous, and far exceeding analysts’ expectations. Keep in mind that over the longer term, corporate stock prices reflect corporate earnings: if earnings continue to grow, so generally will corporate stock prices.
With 70% of GDP based upon consumer spending, what will drive growth most is a consumer who will spend. Consumer confidence continues to improve, and with good reason. Household income and net worth are up, household debt is down. With jobs numbers improving, with fears of future financial collapse receding, consumers are spending, and spending in turn is what drives, and will drive, corporate growth and then, future hiring. Dare we say it -- the consumer is back!
Interest rates remain low, making for an enticing opportunity for those able to obtain credit, and allowing homeowners to refinance at historic-low interest levels. Inflation, although ticking up slightly (and gas prices increasing significantly), remains low and very much in line with expectations and the Federal Reserve’s comfort zone. Indeed, Fed Chairman Ben Bernanke has been emphasizing in his many recent public appearances his disappointment in job growth and the Fed’s need to be “accommodative” – to keep the money flowing. He hasn’t gone as far as to say he intends to undertake another round of monetary easing (“QE3”), but he hasn’t taken that option off the table.
The weaknesses remain persistent however, and at the top of the list is the obstinately high rate of unemployment, still hovering around 8.3%. It is, as we’ve discussed in the past, a deceptive number as well, as it doesn’t reflect those who have given up and left the workforce, those working part-time, and those who are working for lower pay than in the past (it also includes some “seasonality jiggering”). With young people entering the workforce, we wouldn’t be surprised to see that figure tip upwards over the next several months. The fact remains that the jobs picture, although improving, remains a real challenge in a number of areas: many white collar jobs continue to be outsourced, boomers can’t afford to retire and open up positions for younger workers, there is a shortage of appropriately educated and trained workers in certain industries, among others. Some of these issues are the result of the business cycle and recession impacts, but some are deeply structural and will be slow to improve, especially with a government loathe to invest the funds to facilitate improvement in these areas.
While bank credit availability is increasing slowly and interest rates are low, credit is still relatively unavailable for many of the small and mid-sized businesses who need it most. As the saying goes, “If you don’t need a loan, you can get one.” But loan demand is also tepid – as businesses are reluctant to invest in producing widgets that the consumer may not buy. So until it becomes increasing clear and certain that the consumer – whether retail or commercial – will be a reliable purchaser, businesses would prefer to sit on the sidelines, creating a rather non-virtuous cycle. The credit markets are a very far cry from the lockup in 2008, but this remains a frustratingly-slow go.
And of course, threats abound. Geopolitical comes first to mind. While the sabre rattling between Israel, Iran and the US seems to have abated (it was only a few months ago that Defense Secretary Leon Panetta was prognosticating an Israeli invasion in April, May or June), the implications of a military strike against Iran are difficult to predict for those of us lacking the appropriate war games computers. That said, an incident of this nature, or uncertainty about an incident of this nature will be deeply troubling to markets. With Brent Crude oil already tipping the scales near $120 per barrel, a conflagration, which could result in such a consequence as the stoppage of all oil shipments through the Straits of Hormuz, could sharply impact oil shipments for possibly weeks. That kind of shock could send oil prices to stratospheric levels, with all kinds of ripple effects. Let alone the impacts of a protracted war.
Let’s also not forget about Europe. While Greece’s problems are only partially off the table (the Greek debt still remains an enormous issue), Spain, Italy, and the much smaller Portuguese and Hungarian economies remain major concerns. Although problems in these nations are not quite on the same scale as Greece, they present a continued source of anxiety. (Spain, given its size, is particularly unnerving.) Even should these issues be dealt with – and ultimately we believe they will be – cost-cutting, and perhaps austerity will be a prime tool, and banks may, once again, take further beatings on the bonds they own from the problem nations, creating further stress on Europe’s financial markets. With much of Europe already mired in recession, things could worsen still, further limiting US exports to Europe. In any case, Europe will remain a drag on the US economy for the foreseeable future. And as for old Europe, with birth rates in continued decline, there will be a continuing challenge to find mechanisms for growth, particularly with a culture historically more interested in preventing inflation.
It should be pointed out that, fortunately, the formerly stop-inflation-at-all costs-tune has finally been changing in Europe. Mario Draghi, the new head of the European Central Bank has begun to follow the lead of his American counterpart, Ben Bernanke, in ushering in badly needed stimulus measures. If his guidance continues, we wouldn’t be surprised to see slow growth return to Europe sometime in 2013.
One irony we can’t help but opine on relates to the political rhetoric these many months from one of the political sides (we don’t need to say which one) that feels compelled to liken the US economy of tomorrow to that of the economically distressed nations of Europe today. It seems almost comical to cite Europe’s struggles as a potential nightmarish future for America on one hand, while not recognizing that it is precisely the absurd austerity measures those same US politicians would visit on the US that are being cruelly practiced by the European Central Bank and other leaders, further limiting prospects for their future. You don’t get yourself out of a recession by cutting deeper. It is, as Economist Paul Krugman has suggested, akin to digging your way out of a hole by digging deeper. Duh.
While on this international bent, let’s look at two other factors that have been of concern to the economists, market analysts, and exporters: China and India. Both of these nations are enormous consumers of raw materials, commodities, and exports, and both have economies that have been slowing from double digit GDP growth, to 7.5% and 6% respectively. It’s more or less a given that India will continue to languish, but China remains a question mark. A soft economic landing that keeps China at or near the 7.5% GDP level would not threaten to destabilize other economies in the globally interconnected world. On the other hand, should China’s growth continue to weaken more, it could have strong negative implications to the US economy. Our bet is that the Bank of China and its central planning have the ability to bolster development to prevent a major slowdown, or “hard landing”, particularly given the low inflation in China and the apparent willingness of the Chinese central bank to stimulate growth. Other nations, notably, Brazil and other Asian nations are similarly following suit.
And, of course, there’s oil and gasoline. The price surges and speculation that revolved around emerging markets demand along with geopolitical turmoil in Iran and in other oil producing nations has kept oil above the $100 per barrel price point for some time, and we’ve seen that even minor skirmishes or geopolitical issues can spook prices higher, and rapidly so. As high as oil prices are, gas prices are higher still, historically speaking, as any SUV driver would be especially quick to complain about. High oil and gasoline prices, as we’ve pointed out in the past, effectively act as a tax on consumption – people buy less of other things when gas prices skyrocket and the costs to fill up tap discretionary dollars. The US was especially lucky, therefore, to have experienced a mild winter which kept heating oil demand low. As our good friend Dr. Paul K points out, a cold winter could have driven oil demand much higher, and created a further increase in costs and misery. Fortunately, as well, natural gas prices have been moving in the opposite direction as oil, reaching historic lows. So for those so fortunate as to have been heating their homes with natural gas for the last couple of years, heating costs have been especially low.
That said, with average gasoline prices around $4 per gallon nationwide, and likely to increase during driving season, gas prices could impact general consumption. Furthermore, as fuel and transportation costs rise, corporate profits are eroded. Finally, high gas prices could be a political hot potato come the elections. While the general feeling is that nothing truly sinister is likely to happen unless oil passes the $150 per barrel mark (or gasoline hits the $5 per gallon mark), we all need to keep our fingers crossed on this one.
Closer to home, perhaps as much as any other factor, housing remains a critical component to economic strength and consumer confidence. Besides losing a job and a stock market crash, nothing makes someone feel poorer than a significant drop in the value of their home. With home values today roughly a third lower nationwide than before the financial crisis, and with values having bounced along the bottom for a couple of years now, homeowners remain unconvinced despite enticing mortgage rates that things are improving. We’ve been right on a good number of things, but not this one. Frankly, the turnaround in housing has been far slower in coming than we expected. Hopefully this time it’s different -- we believe the nation may finally be on a positive path. Housing permits have been ticking up, homebuilder stocks have been skyrocketing, and banks are slowly working through their foreclosure inventories. Further deterioration of housing prices remains a threat, but more likely, housing is an opportunity waiting to happen. We think it will.
Congress and Tax Rates. So here’s another opportunity for Congress to redefine “haywire”. As many of you probably know, the Bush tax cuts are set to terminate this year. Which means that, yes, higher bracket earners, currently at a 35% tax rate (those making over $379,500), will now be forced beyond all possible comprehension to return to the 39.6% rate. We can think of little that can bring on greater end-of-election-year histrionics than this. What further rankles the political right is the coming capital gains return to a 20% rate, and dividends returning to the personal tax rates. Frankly, if the 39.5% rate does kick in, as will an increase in the capital gains rate, it’s likely to spark some selling at the end of the year. This could provide an additional, although probably minor headwind for both the equity and bond markets. The upside is that the budget deficit will be sharply reduced – and not the way anyone in Congress intended.
Given the fact that the US appears to have both the currency of choice (the Dollar), and among the major nations, the most respectable economy in terms of growth, it makes sense that it will continue to attract some of the greatest attention from investors around the world. Emerging markets, too, appear to be working their way to increasing prosperity. And even select European countries will become increasingly enticing as the contaminated shroud on the Euro begins to disintegrate.
Despite the strong run-up in stock prices, the S&P500 index remains reasonably priced at 16 times earnings, even cheaper than this time last year. Moreover, the breadth of the market rise has been very broad, as even the financial industry has continued strengthening domestically. Given the sharp run-up, it should not surprise anyone if the markets begin to look for reasons to pull back somewhat – events in Europe and China have been some of the strongest triggers in that regard, and will probably continue to be so. Even so, the market fundamentals are solid, not only for domestic equities, but in select international and emerging markets as well, and bode well for equities generally.
On the heels of rising oil and commodity prices, an increase in interest rates, and the “whiff” of inflation in the air, bond markets, particularly longer term maturities, are being impacted. This is a natural and fairly predictable response, especially in an improving economy, and one we’ve been expecting and concerned about for some time. Long term bond holders, therefore, have seen and are likely to continue to see their principal values decline. In many cases, these declines are temporary, as new bonds will likely be purchased at the new, higher interest rates, and providing a higher amount of income. Still, it’s important for income investors to take a more cautious approach in this environment, and those concerned about short term losses should emphasize shorter term maturities, and seek less sensitive alternative investments that provide higher yields, but carefully monitor for credit quality.
In addition, with equity markets reasonably priced, and with an abundance of large quality companies offering dividend yields greater than the 10 year Treasury (which hovers just over 2%), high quality dividend stocks continue to remain attractive alternatives for those with even some risk tolerance.
Over the last several months we have been moving clients back to their target portfolios, increasing exposure to equity markets as appropriate, and reducing long term bond positions. We expect this trend to continue. Portfolios should continue to be diversified, and vigilance is still the rule for those investors who are not tolerant of volatility. Geopolitical and political risks are just some of elements that could change things quickly.
The Upshot. The last year has, overall, been one of continued, slow economic growth, and the markets have responded in kind. That said, over much of that period, numerous events – in Europe, the Middle East, China, in Congress – could have had tremendously negative impacts on both the economy and the markets, as investors big and small remember well the trauma of just a few short years ago. With Europe going through again in 2011 much of what the US experienced in 2008, a cautious approach was the appropriate path, and smart investors who could ill afford significant drops in their assets did move cautiously. Many investors who fled the bond and equity markets during the turmoil in 2008 and 2009 are perhaps unlikely to return. Many will outlive their assets, and that is too bad.
This economy is growing, though it’s clearly not nearly running on all cylinders yet. Eventually, it will. Yet even though we remain optimistic, we’re sober about the very real threats extant, and will continue to take an approach that marries opportunity with care.
Wishing all a Happy and Vibrant Spring.
Ron Stein, CFP
Good Harvest Financial Group