Fourth Quarter 2012 PerspectiveDecember 2012
Big Questions Are Getting Settled
Black Friday has come and gone and the season for forecasts and predictions is now hard upon us. There is a yearning for certainty although none ever exists, especially for investors. Our core view remains unchanged:
• The U.S. is on a moderate growth path currently underwritten by the Federal Reserve but showing more and more signs of being self-sustaining;
• China’s growth appears on track to settle at around 7% as it slows from unsustainable double-digit rates;
• European leaders will not scuttle the euro, embrace autarky and relegate the continent to also-ran status as the BRICs accelerate their growth and the U.S., with its dropping energy costs and relatively young population, recovers from the 2008-2009 recession.
A DISCONNECT BETWEEN EXPECTATION AND REALITY
Having a positive strategic view and managing the day-to-day are quite different. As the strong global equity rally continued through the summer, our anxiety grew to a point that in late September we reduced equity exposure across accounts, keeping the proceeds in cash.
This tactical ‘risk-off’ move recognized what appeared to us to be a huge disconnect between expectation and reality. Company earnings—the reality—have weakened to a point where they show little year-over-year growth.
Third quarter earnings were just 2.7% ahead of third quarter 2011; sales rose just 0.05% (CHART 1).1 Clearly, rising prices and flat earnings cannot last—either earnings must start to rise to validate the prices or prices fall.
SOME UNCERTAINTIES HAVE BEEN SETTLED
Influential in our tactical caution was the then unknown outcome of the U.S. election and the complexion of the incoming Chinese leadership. These are settled, and we have the first glimpse of how each will behave. As best we can tell, Xi Jinping will continue to pursue China’s stated goals: steady 7% to 8% growth and development of the interior. Exports will be important, but not as important in coming years. We can also reasonably expect the renminbi to rise in importance and value as China’s trade grows, especially among its Asian trading partners.
POLICY UNKNOWNS REMAIN IN FULL FORCE
At home, the administration—so far—seems quite aware of the stakes should the impasse over tax rates and federal benefits not be resolved by December 31. The linguistic shift by administration and congressional leaders to stress ‘increased revenue’ in place of ‘higher tax rates’ in public comments is encouraging and suggestive of an effort to reach a compromise.
Although U.S. taxes are low by world standards, it seems premature to add pressure to a fragile recovery. The Japanese learned in April 1997 how misguided increasing taxes can be as their economy was beginning recovery.2 Raising taxes may be appropriate long term, but this is not the time. The non-partisan Congressional Budget Office summarized the impact of the U.S. surfing off the fiscal cliff, “ growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects—with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession (emphasis added).”3
Indeed, some cynical, realpolitik observers suggest it is in both parties’ self-interest to allow this debacle to happen: the influential extreme right can stand on principle while the left can then take credit for engineering a recovery following a 2013 recession, but in time for the 2014 mid-terms and then the next presidential campaign. We are living through an epic contest where the argument is whether to reduce an unsustainable deficit now at the cost of a recession, or do it later, but with the added risk of a loss of confidence in the dollar.
The prospect of recession is serious: the average equity market decline has been 29.6% in the eleven post-World War II recessions. The length of the equity price declines has varied widely from 1.4 months between January and March 1980 to a staggering 30.5 months between March 2000 and October 2002.4
In our view, however, a shallow and short market correction feels more appropriate today given the Fed’s and European Central Bank’s ‘do what it takes’ programs, the growing evidence of recovery and the massive cash levels sitting in investors’ accounts and corporate treasuries. Faced with this uncertainty we remain tactically cautious near-term.
SOME THINGS ARE GOING RIGHT
It is easy to only focus on what is wrong, or what could go wrong, and ignore what is going right. The rancorous debate strongly suggests the U.S. is sorting out the short-term/long-term issues of higher taxes, spending and unsustainable entitlement-driven debt. Democracy is indeed messy. Important measures of economic recovery, however, continue to improve:
Housing. The data suggests this pivotal sector of economic activity has corrected and begun to recover:
• Home sales have risen at a 16.6% annual rate, a total of 41.3%, from the December 2006 low through October 2012.5
• New home sales bolted upward at a 19.5% annual rate (a total of 34.8%) from their low in February 2011 through October 2012.6
• Lastly, the Case-Shiller index of U.S. house prices made a low in June 2011 and has steadily risen since.7
Government Spending. One could certainly be forgiven if you missed the fact that federal and state government spending has been trending down since 2010 (CHART 2).
At the same time, income tax revenues have been rising—up by nearly 36% from the low for the 12-month period ended January 2010 to the most recent 12-month period ended October 2012 (CHART 3).
DESPITE POSITIVE DATA, INVESTORS ARE FEARING WHAT COULD GO WRONG
What do these conflicting messages mean? An obvious first take is that the consensus is wrong and more reasonable voices have not yet been heard. Equity prices dropped 7.7% in the immediate run-up to the U.S. presidential election to the low on November 15th. The election’s outcome no doubt scared equity investors for three apparent reasons:
• The worry about massive fiscal tightening as tax policy reverts to higher rates while government spending gets cut on January 1st;
• The concern that Congress finds a way to compromise, BUT the president achieves his stated goal of raising taxes by $1 trillion over the coming ten years;
• The fear that the tax code will tilt against capital gains, inducing many to take gains now at the historically low 15% long-term rate.
The first and second points do not square with history. The third describes quite rational investor behavior. Why Congress would inflict austerity on a fragile U.S. recovery and likely another banking crisis on the world is hard to explain except via psychoanalysis.
ARE WORRIES OVERBLOWN? HISTORY SUGGESTS THEY ARE
Equity prices began to recover after mid-November, confounding many experts and suggesting that some of these worries are overblown. Higher taxes, should they happen, may not be the severe headwind to equity prices. History is instructive. The average tax paid by the top 1% of U.S. taxpayers based on adjusted gross income made a low in 1990 at approximately 23%, and subsequently rose to a peak of approximately 29% in 1996. After an initial fall in equity prices after July 1990 following the Bush tax increase, prices began a 108% rally to a peak in December 1995 even though the tax burden was rising. Equity prices rise and fall for many reasons, but this single recent example suggests that higher taxes may not upset an equity market recovery.
HEADWINDS APPEAR TO BE WANING
We are moderately more optimistic than when we last wrote, although the prediction by many experts of 2% or lower real growth for the developed world over the foreseeable future seems correct. We are watching for earnings growth to revive after the two recent disappointing quarters. Dropping energy costs from U.S.-sourced natural gas is already reviving manufacturing and productivity. Robotics is gaining traction throughout industry and is another increasingly important support for productivity. Lastly, there is accumulating data that the huge drop in house values and construction along with the related declines in wealth and consumption are over. What was previously the big headwind to expansion is shifting around to be a tailwind.
1. Yardeni Research, Inc.
2. The Journal of Japanese Studies, 1999, vol. 25:1, “Manipulation Behind the Consumption Tax Increase: The Ministry of Finance Prolongs Japan’s Recession.”
3. Congressional Budget Office, Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013, 5/22/12.
4. Strategas Research Partners, “A Typical Recession Sees Equities Down -30%. Perhaps the Fed Can Cushion That Blow?” 11/17/12.
5. Bloomberg, U.S. Existing Home Sales.
6. Bloomberg, U.S. New One Family Houses Sold Annual Total.
7. Bloomberg, Case-Shiller U.S. House Prices.
STRATEGIC ASSET ALLOCATION
Our View Is Cautious in the Near Term
WE HAVE POSITIONED PORTFOLIOS TO REDUCE RISK
• We have decreased our equity allocation recommendation due to our belief that risks will outweigh rewards over the next several months as the confluence of global macro uncertainties may increase volatility in the near term.
• Additionally, given the historically low capital gains tax rate in 2012, we believe preserving gains in portfolios can be beneficial.
• We stress that this shift is temporary and does not imply we have changed our favorable view of the emerging markets and our belief that the U.S. will reform and see growth return to historical norms in the long term.
• Our fixed income allocation recommendation remains underweight and unchanged from last quarter due to the persistent low income environment.
• Municipal bonds remain attractive relative to Treasuries.
• We believe high-yield corporate bonds are still somewhat attractive on a relative basis versus Treasuries and investment-grade bonds, although we are increasingly cautious based on high valuations.
• We have made a tactical shift to increase cash in an effort to reduce portfolio risk and to seek to protect any gains achieved during the year.
FIDUCIARY TRUST FORUM
Managing Through a “Lower for Longer” Interest Rate Environment
With the Federal Reserve anticipating that it will maintain a low interest rate environment through at least mid-2015, income available from many areas of the bond market will be limited for some time. Our Fiduciary Trust Forum provides insight into what investors can expect through this prolonged low-growth, low-rate economic cycle.
Q. Why is the low-rate environment persisting for so long?
Ron: The shift to near-zero rates was triggered by the 2008 credit crisis. Individuals began to deleverage and businesses retrenched in response to a decrease in asset prices, sales and margins. The Federal Reserve reacted by initiating several quantitative easing programs, lowering interest rates with the goal of stimulating growth. In the meantime, investors flocked from the stock market to the safety of U.S. Treasuries.
Fast forward to today, and things have changed in some regards but not in others. Deleveraging by individuals is well underway and some level of financial stability has been achieved. However, the three economic pillars of 1) employment 2) income and 3) home prices have all been slow to respond to various forms of stimulus. To date, general improvement can be described as slow to moderate at best. Investors remain nervous due to the high level of uncertainty surrounding the global economic and political environment.
Q. How is this prolonged low-rate cycle affecting investors?
Ron: This has been—and continues to be—an exceptionally challenging environment for income generation. Risk-averse investors who rely on investment income have received the short end of the stick, so to speak, of the Fed’s rate-lowering stimulus programs. For example, before the credit crisis investors could earn about a 5% coupon from a 10-year U.S. Treasury bond. That yield has dropped to about 1.75% today. Investors in short-term bonds fared even worse.
Frank: While persistent low rates have adversely affected individual investors, they have greatly benefited corporations. Access to capital has been abundant and very low interest rates combined with cost-cutting has led to improvements in balance sheets. Corporate America may be in the best financial position since the 1950s as moderate growth, high productivity, low borrowing costs and an emphasis on cost controls has contributed to strong cash flow and wider profit margins in many industries.
This shift has presented investors with the unusual opportunity to earn higher income from the stock market than from many areas of the bond market. Many corporations have initiated dividends or increased dividend payouts due to their stronger financial positions. In fact, in the first three quarters of 2012, firms in the S&P 500 initiated or increased dividends 266 times, up from 259 and 187 times respectively during the same periods in the past two years. Companies in the S&P 500 paid shareholders a total of $69.5 billion in dividends—the highest amount on record—in the third quarter of 2012. Dividends among S&P 500 companies have historically increased at an approximate 5% annual rate, thus stocks could also provide an important source of potential future income growth.
Q. How are you adjusting client portfolios for this environment?
Ron: As rates have remained lower for longer, it has been very tempting for investors to try to regain pre-credit crisis income levels by assuming the risks that they were trying to avoid in the first place. Many are reaching for yield through lower-quality bonds or bonds with longer maturities that can pose just as much risk—or even more—than some areas of the equity markets. We continue to favor a cautious approach and carefully evaluate any opportunity to add incremental yield to portfolios in the context of additional risk.
We made adjustments to capture yield through what we believe have been relatively low-risk opportunities in taxable bonds. For example, we significantly increased exposure to both investment-grade and high-yield corporate bonds beginning in 2009 due to lower credit risk as corporate fundamentals improved. Investments in both these asset classes have served their purpose well to date. However, after strong performance, these sectors appear fully valued and, while we are comfortable with existing holdings, we are no longer finding widespread opportunities to establish new positions at these price levels.
Ahead of the tax rate increases slated to go into effect on January 1, 2013, we have slightly adjusted our tax-exempt and taxable bond mix in favor of municipal bonds.
Frank: We have increased our focus on U.S. large-cap equities, with a specific emphasis on firms that have strong track records of increasing dividends over time. These stocks have not only outperformed the S&P 500 in general, but they have also been less volatile historically, providing some downside protection in times of slower earnings growth.
We are watchful of the tax implications on dividends under the new laws. Some high-income investors could see taxes on dividends increase from 15% today to as much as 43.4% on January 1st if the new laws go into effect. Even so, we believe that dividend income will remain an effective way to bridge the gap left by many areas of the bond market. Namely, with bond yields at near historic low levels and an aging baby boom generation that needs income growth as a hedge against future inflation, dividend-paying equities as a source of income will likely continue to be an important investment theme.
Q. What is your outlook for the rate environment?
Ron: Overall, we believe we are near the bottom of a multi-year cycle that most likely has a number of years left before interest rates begin to normalize. As a result, we do not expect the same price appreciation or total return opportunities across the fixed income markets that have been achieved over the past several years. We remain focused on making well-researched investment selections at the right price—without overexposing portfolios to the areas of the bond markets that we feel will suffer from eventual rate increases and/or a drop-off in demand once the economy comes out of this cycle.
This communication is intended solely to provide general information. The information and opinions stated are as of December 5, 2012, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.
Vice Chairman and Chief Investment Officer
Executive Vice President
Director of Fixed Income Strategies
Senior Portfolio Manager
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