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2012 Q2 Quarterly Investment Outlook: "Little Things Add Up"
While geopolitical and other challenging headlines have continued to capture our attention, many of the significant economic threats enumerated in 2011, have since moderated or been extinguished. Meanwhile, just under the surface, HighMark’s five drivers of potentially exceptional growth are contributing more to economic activity than lackluster U.S. GDP growth suggests, illustrating that many Little Things Add Up over time. For more info: www.nafcu.org/nifcus
2012 Q2 Quarterly Investment Outlook: "Little Things Add Up"
QUARTERLY INVESTMENT OUTLOOK SECOND QUARTER 2012LITTLE THINGS ADD UP below their new target of 2.5%. While 8.2% unemployment is uncomfortable, capacity utilization hasWhile geopolitical and other challenging headlines have risen from a 2009 low of 66.8% to 77.8%, nearing ancontinued to capture our attention, many of the average of 80.4%. Little Things Add Up, eventuallysignificant economic threats enumerated in 2011, have reaching a tipping point.since moderated or been extinguished. Meanwhile, justunder the surface, HighMark’s five drivers of potentially Global risks posed by the lingering European Sovereignexceptional growth are contributing more to economic Debt Crisis remain significant, but economic effectsactivity than lackluster U.S. GDP growth suggests, beyond Europe have remained limited. Other issuesillustrating that many Little Things Add Up over time. emerging in 2012 are concerning, even as many 2011 threats have moderated or been extinguished. AWhile stronger measures of economic growth and a worrisome threat is the U.S. Fiscal Cliff, which could14.8% S&P 500 earnings growth are consistent with undermine economic growth by as much as 2.0-3.5%, ifeach other, they are inconsistent with 2011 U.S. real no legislative action is taken. Confidence in governmentGDP of 1.7%. Consider why growth in industrial remains an issue as long as the nation believes theproduction (3.6%), retail sales (6.0%), business sales country’s leadership is on the wrong track, as Gallup(9.0%), exports (9.0%) and fixed investment (9.1%), recently revealed that a record low 24% of Americansduring 2011, netted against inflation of 3.0%, exceeds think the nation is on the right track. We are concernedreal GDP growth. Even improving unemployment has about consequences of ignoring increasing inflationaryfallen from over 10% to 8.2% since 2009. The translation forces (Q1/2012 theme), given excess global monetaryof economic growth into stronger earnings suggests liquidity, and which will be difficult to address quickly ifsomething isn’t being measured quite right, and we global confidence improves. Any necessity to hike U.S.suspect it is GDP, although composition differences of interest rates earlier than anticipated would surprisethe S&P 500 and U.S. economy are noteworthy. many fixed income investors. Only some unforeseen and significant exogenous shocks have the potential to derailEconomic measures above should correlate better to accelerating U.S. growth and inflation again.U.S. GDP, but they actually greatly exceed it. Futurerevisions may correct this anomaly, but we believe the Investment Reviewsource of this inconsistency lies in part in measuringchanges in inventory and net exports (trade). The A remarkable rally in global equities, over the last twoFederal Reserve must eventually normalize monetary quarters, was led by the United States, including apolicy as economic conditions trend toward equilibrium, firming U.S. dollar. Increasing investor risk tolerance hasincluding raising interest rates. Slowing growth and benefited from moderating threats, still compelling equityinflation are more likely due to the lagged effects of the valuations, low interest rates, and positive economic3Q/2011 slowdown, not endogenous weakness or a surprises. Emerging market equities (14%) continued toprecursor to another recession, as signs of outperform developed international equities, (MSCIreacceleration are evident. The Federal Reserve’s own EAFE: 11%). The S&P 500’s 12.6% rise in the firstforecasts suggest the U.S. will enjoy better than average quarter would represent a good year, but it was the bestpotential real growth, accelerating from 2.5% in 2012 to first quarter return since 1998. Typical early cycle3.6% in 2014. We assume that improving economic leaders with the strongest 2012 expected earningsgrowth can yield stronger earnings than expected. growth led in Q1/2012, including Financials (earnings growth of: 22%), Technology (12%), ConsumerInflation was accelerated faster than expected in 2011, Discretionary (12%), and Industrials (10%). Meanwhile,approaching 4%. Although inflation has moderated to defensive high yielding sectors with slow or negativejust above 2.5%, it should begin tracking higher again, growth expectations and high relative price/earningswe believe. Negative real yields (ref: interest rate – ratios were due for a correction, like Utilities (-1.6%) andinflation) are likely to persist until the Federal Reserve Telecommunications (2%). Investors are chasinghikes interest rates. The Federal Reserve maintains that dividend yields taxed at 15% versus income taxed at thelow interest rates are appropriate as long as inflation highest marginal rate (up to 35%), but they are alsoremains contained by slack in unemployment and increasingly focused on earnings and fundamentals,production capacity, but inflation is unlikely to retreat representing a change in leadership. 1
second time in 10 years by -10.6%. Diversification hopesThe stock market can rise and fall on fear or greed, to benefit most by negative correlation, yet theanticipation or apprehension, confidence or confusion, correlation of commodities with equities is 18%, and withas well as exuberance or panic. Lately, it seems that our bonds is -9%. The bullish case for real assets citesemotional biases are more important in driving returns exceptionally low interest rates, rapidly expandingthan in driving earnings, economic growth, inflation, monetary base, ballooning budget deficits, politicalinterest rates, and valuations. The unexpectedly wide gridlock, and higher oil prices, which have remained overdivergence between stocks and bonds in the first quarter $100, well after the Arab Spring conflict. However,left many investors surprised and confused, but global determining fair value is difficult with no cash flow, yield,equity valuations remain compelling. or growth potential beyond the cost of marginal production. The last time gold exceeded two times theThat Rear View Mirror Taking Its Toll CRB Index was in 1980, and it took 29 years before it exceeded that peak again. Gold exceeded the CRBInvestors should expect investment leadership will Index by three times in September 2011, (turmoil overchange over the next 10 years after a very unusual global fiscal deficits and U.S. debt ceiling extension,)previous decade. Firming economic conditions, including before it tumbled by -18.2% to $1574 by year-end. Goldrobust profit margins, suggest a trend toward a more is a volatile investment with a 21% standard deviation,normal macroeconomic equilibrium, not a “new normal”. compared to 15.8% for stocks, 13.8% for commodities,The transition from a Global Synchronized Recovery to and 5.8% for bonds. Historical commodity returns havean Asynchronous Global Expansion (Q1/2012: Are The averaged 2.6% (1900-2011), which equates to inflationNightmares Behind Us?) is underway. We expect high of 3.1% less holding costs of approximately 0.5%.return correlations to recede further and Eurozonecontagion risk to diminish, particularly for North America Changes in input costs can’t exceed changes in outputand Emerging Markets. We believe fundamental forces costs, thus commodity returns can’t exceed inflation overshould increasingly overwhelm emotional swings in the long-run. Supply-demand imbalances can persist forinvestor confidence, while unique country and regional awhile, but eventually exceptional returns drivedifferences, plus diverging monetary and fiscal policies, innovation and competition from reasonable substitutes,will encourage further decoupling. resulting in oversupply at a lower price. Windfall profits of producers can’t be sustained forever, but the financialThe approaching 10-year anniversary of the accounting crisis did forestall credit needed for investment. Withscandal that embroiled Enron, WorldCom and Arthur improving financing options, commodity and energyAnderson in mid-2002, and led to Sarbanes-Oxley, as prices should eventually moderate as productionwell as other financial regulation, will define the prior increases will rise to meet demand, and the marginaldecade low for equity indices. The technology bubble cost of production falls.was nearly deflated by then. Relative differential assetclass returns are already improving dramatically, as Taking Stockseen in the rear-view mirror. A coinciding reversal inrelative stock vs. bond valuations over the last decade A reversal to more normal asset allocation ranges wouldhas benefited from strong earnings growth and plunging cause one of the most significant rebalancing of assets.bond yields. Annualized returns over the last decade Why might this happen now? Investors have tended toshow 10yr Treasury returns of 6.8%, exceeding S&P 500 reduce equity exposure after bonds outperformed stockstotal annualized return of 2.9% through the end of 2011. over the last decade, however relative valuations haveThe S&P 500 rolling decade return increased to 4.1% by gone through a significant reversal. Any re-rating ofMarch 31st, and should exceed 7.6% by Q3/20112, if global equities would provide upside to stocks.equity indices are flat or higher. This compares favorably Normalization of investor risk tolerance also would haveto both 10yr Treasury and commodity returns of 5.0%. a positive influence on global equities.The perspective of improving performance over the last Investor risk aversion seems to have increased further,decade will reflect a more normal equity risk premium despite a strong rally in equities and declining globalevident in 20-year, 30-year, and longer horizon historical equity market volatility. The cause is likely two significantperiods. Convergence toward a theoretically consistent and closely separated equity bear markets in 2001-2002equity risk premium, over all key measurement periods, and 2008. We think that volatility will remain moremay be sufficient to alter financial planning inputs, and modest this year transitioning toward an Asynchronousinduce investors to increase equity holdings at the Global Expansion. This theme is bolstered by uniqueexpense of bonds, supported by relative valuations regional economic and policy differences increasing infavoring equities. Over the next year, potential changes significance again. With diverging sovereign interests,in investor confidence could be material, and compel including monetary and fiscal policies, the fading forcesinvestors to finally rebalance their asset allocation. that drove the Global Synchronized Recovery beginning in 2009, are being supplanted by economic and financialGold prices rose 5.7% in the first quarter, while market decoupling. Contagion risk should moderate ascommodities tacked on 1.8%. Despite an 11.1% well. Our research shows that relative asset classincrease for gold in 2011, commodities fell for only the valuations are fundamental drivers of differences in 2
asset class returns, over an investment cycle. Our Equity allocations below suggest that many pensiontactical and strategic expected returns suggest that funds never fully rebalanced after the Financial Crisis ofequities will likely outperform bonds by a wide margin. 2008, given changes to their funded ratio and year-end equity exposures. Many plans appear to have beenDalbar 2011 results: Dalbar recently published its 18th letting their asset allocation drift, up to the most recentannual Quantitative Analysis of Investor Behavior in equity allocation decline. Amidst record planMarch, measuring mutual fund cash flow effects of contributions and only an 80% average funded ratio,individuals’ investment decisions on their holdings. Their plans have increased bond exposure.objective is to measure the effects of decisions related toasset allocation and specific fund selection. As noted inpast surveys, individual investors suffer most from avariety of cognitive and emotional biases that driveunfortunate investment timing decisions. Dalbarobserves: “Most of this loss in performance is due topsychological factors that translate into poor timing oftheir buys and sells (investor behavior).” Individualinvestors failed to reap the benefit of rebalancing, adiscipline beneficial in volatile markets. The resultsbelow highlight the cost of not having or sustaining aconsistent investment discipline. Investors should bemindful of how intuition can be led astray by spurious Source: Milliman 2012 Pension Fund Studycorrelations. Well-defined investment disciplines canhelp individuals overcome many behavioral biases that Pension funds have reduced equity and increased bondcan lead to subpar investment performance. Dodging exposure at a valuation extreme that is unparalleledinformational shrapnel these days is particularly critical since 2001, but this time valuations favor equities overto investment success. bonds. A 2% Treasury Yield is equivalent to a Price/Earnings ratio of 50X, compared to forwardDisappointing investor performance in the 2011 survey earnings multiple of 13X for the S&P 500 today. Wewas even worse than 2010, which Dalbar attributes to suspect increasing bond exposure was not limited to justexceptional volatility in August 2011. Investor decisions pension funds, but extends to endowments, foundations,to take losses in stocks had adverse consequences. and other investors. After a 30-year bull market in bonds,Equity investors realized a disappointing -5.7% average 10-year Treasuries yields that peaked over 14.9% havereturn versus a 2.1% return to the S&P 500 for a -7.8% plunged to a 50-year low of 2%. This shift is particularlyshortfall in 2011. A blended equity benchmark returned - troubling given negative real yields across the yield1.1% (Ref: 65% S&P 500, 15% Russell 2000, 20% MSCI curve with inflation over 2.5%. Highmark’s strategic bondEAFE), but still outperformed the average equity investor return forecasts suggest a difficult and more volatileby 4.6%. The shortfall for the average fixed income decade ahead for fixed income investors, since recentlyinvestor was even greater, realizing a -1.3% return updating our strategic expected returns. Over the next 5-versus the Barclays Aggregate Bond Index return of 7 years, we expect annualized returns for bonds of less7.8%. The Dalbar results over 20 years conclude that than 2%, with inflation exceeding 2.5%. Equities shouldadverse market timing decisions resulted in the largest return over 8.5%. Thus, an unprecedented shift into ashare of the -4.3% annualized equity investor shortfall higher fixed income exposure could have severeversus the 7.8% S&P 500 return, and -5.6% fixed repercussions for pension funding, but also holds theincome investor shortfall versus the 6.5% Barclays potential for a significant asset allocation swing back to aAggregate return. We are fortunate our clients have more normal strategic policy. Plans have never been somanaged to perform much better by rebalancing exposed to rising Treasury yields, and could realizedconsistently to our tactical asset allocation targets. significant losses if bond yields moved toward the average 6.8% yield.The recent Milliman 2012 Pension Fund Study,representing $1.3 trillion in assets, reported fixed income Although equities returned 88% and bonds returned 22%holdings of 41% for the 100 largest plans exceeding over the last 3 years, the average plan’s 80% fundingequities (38%) for the first time ever. Five years ago, ratio hasn’t changed much. Plan contributions mustallocations of 60% equity and 29% bonds were more increase in underfunded plans, particularly those nowconsistent with historical averages, so there could be a adopting lower expected returns, in order to hold higherdramatic rebalancing (buying equities, selling bonds) if fixed income exposure. Low interest (or discount) ratesplans shifted toward a more conventional equilibrium also increased pension liabilities. The new money thatweighting, held up as the prudent pension allocation. has flowed into U.S. bonds over the last three years isThis study highlights concern about asymmetric risk just as likely to flow back into equities. This imbalance isaversion behavior that is increasingly apparent. gaining national attention as states and municipalitiesAlternative investments, including real estate, make up wrestle with soaring defined benefit pension costs.the remaining allocation, trending toward 20%. 3
Plans pursuing liability-driven investment (LDI) strategies and increasing revenues. A record 81% of S&P 500are increasing fixed income allocations at generational companies have exceeded Q1 earnings forecasts by alow bond yields, even as funding ratios have fallen back remarkable 9% so far, although only 113 companiesto historic lows of 80% in 2002 and 2008. A LDI strategy have reported. Analysts have revised estimates lowerseeks to reduce annual accounting volatility of corporate since September 2011, but various economic andliabilities from changes in interest rates and inflation, but geopolitical headwinds appear to have been overblown.return expectations must also be reduced significantly. Earnings 2014e 2013e 2012e 2011e 2010 2009 2008 2007 HighMark 7.1% 6.7% 7.2% 14.8% 40.3% -7.1% -23.1% -3.5% Consensus 12.0% 12.6% 7.9% 14.8% 40.3% -7.1% -23.1% -3.5%Cyclical Themes HighMark $ 120.00 $ 112.00 $ 105.00 $ 97.92 $ 85.12 $ 60.80 $ 61.48 $ 85.12 Consensus $ 133.26 $ 118.96 $ 105.63 $ 97.92 $ 85.12 $ 60.80 $ 61.48 $ 85.12The 2011 economic slowdown now appears to have Financi als 15.9% 15.2% 21.5% 5.2% 288.2% 106.9% -1 30.8% -2.1%been a mid-cycle transitory pause, similar to 2010, rather Non-Financials 10.6% 12.1% 6.5% 15.7% 28.1% -18.6% 7.2% 3.2%than a precursor to another recession. Monitoring Source: HighMark Capital estimates and Thomson DatastreamHighMark’s five drivers of exceptional growth has helpedus better understand and explain the effect of key forces S&P 500 earnings exceeded $97 in 2011, up 16% lastdriving the economic cycle. Four of the five drivers year and higher than the $93 forecast two years ago.exceeded expectations in 2011, including growth of This important milestone surpassed the previous $88consumption, exports, investment and housing starts. earnings record of 2006. Since Sarbanes-Oxley andOnly inventory re-stocking disappointed in 2011, but now Regulation Fair Disclosure became effective in 2003-04,inventories are even leaner because consumption sell-side analysts have tended to revise estimatesexceeded expectations. We expect continuing growth in higher, in a noteworthy departure prior to corporatecapital investment, consumption, and export growth in accounting reforms, except during the Financial Crisis.2012, with a pick-up in hiring and housing starts. Overall, Robust earnings growth is expected through 2014.construction activity rebounded dramatically from acontraction of -15% in 2009 to a growth of 5.8% recently, Shovel-Ready Housingwith both commercial and housing sectors contributing.Re-stocking inventories and housing starts are mostlikely to provide an upside surprise to U.S. growth. Housing starts are an important driver of construction, but have languished since 2006. The recent rate ofEconomic Forecasts 2008 2009 2010 2011e 2012e 2013e 2014e about 700,000 is less than half the average volume ofU.S. GDP (Y/Y Real)Earnings Growth -3.4 -23.1 -0.5 -7.1 3.2 43.4 1.7 14.8 2.5 7.2 2.5 6.7 2.8 7.1 1.5 million in the chart below, and just 57% of theCPI Inflation (Y/Y) -0.0 2.8 1.4 3.0 2.3 2.5 2.8 average household formation rate of 1.2 million sinceUnemployment 7.3 9.9 9.4 8.5 8.0 7.5 7.2Fed Funds Target 0.25 0.25 0.25 0.25 0.25 1.00 2.00 1960. About 20% of housing starts or 300K homes areTreasury Notes-10yS&P 500 Target 2.25 903. 3.84 1115. 3.31 1258. 1.88 1258. 2.75 1440. 3.50 1520. 4.0 1650. replacement due to fire, floods, hurricanes, earthquakes, and decay. The natural demand for housing startsSource: HighMark Capital estimates and Thomson Datastream should exceed 1.5 million, including second homes. New Home StartsCPI inflation increased from 1.3% to nearly 4% during 3,000 * Peak: 2.2M (12/2005)2011, although it has recently stabilized between 2.5- 2,500 -- Demand = 1.5 M + Second Ho mes3.0%. Higher inflation has now become entrenched with 2,000rising prices for commodities, transportation, food, 1000s 1,500energy, imports, and shelter now working their way intocost of living increases, which could exceed 3% this 1,000 800Kyear, similar to last year’s CPI inflation. Weekly earnings 500 698K Demand = Household Formation + Replacement + Second Homeshave increased 2.2% and personal income rose 3.9%. 1.65 million = 1.2 million + 300,000 + 150,000 0Companies are reporting that new price increases are 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010holding in many of their markets. While this is good newsfor profit margins, it suggests the Federal Reserve is Source: HighMark Capital and Thomson Datastreamalready lagging behind the curve, and may have to raiserates sooner and more aggressively than anticipated. Household formation is the most correlated leading indicator of housing starts, so depressed increases ofEarnings growth is expected to slow this year, but the 398K in 2009 and 357K in 2010 have coincided with wellS&P500 consensus earnings forecast still suggests below average housing starts of about 700,000.growth approaching 10%. Our $105 estimates are a little However, housing starts have accelerated to 35%lower than the $107 consensus expectation, but equity recently, and the annual U.S. Census householdvaluations are still very compelling, in our opinion, after formation rate released in March exceeded 1.1 million inthe recent six-month rally in global equity markets. 2011, which suggests increasing demand for housing,Small-cap earnings concensus shows even greater already evident in escalating rental demand, fallinggrowth potential of 28% in 2012 and 29% next year. vacancies, tumbling inventory, rising rent of 4-6%, andPrice/Earnings multiple expansion potential provides better home sales volume. Median home prices haveupside to equities. Earnings growth and high profit been range bound between $150-175K since 2009.margins have benefited from above average productivity 4
Normalizing housing starts has a significant potential to Indicators of US Economic Activityreduce unemployment and boost economic growth. 20% 15% Household Formation (1947-2011) --- Average: 1.2 Million/year 10% 140,000 4,000 2008 772K 5% Household Formation (000s) 3,500 120,000 2009 398K 2010 357K 3,000 0% Households (000) 100,000 2011 1,114K 2,500 -5% Total 118.6M 80,000 2,000 -10% Business Sales: 7.6% 60,000 1,500 Construction: 5.8% -15% 1,000 40,000 500 -20% 20,000 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 0 0 -500 Total Con struction Business Sales 1955 1965 1975 1985 1992 2001 2011 New Household Formations Households Source: HighMark Capital and Thomson DatastreamSource: U.S. Census The U.S. savings rate has fallen to 3.7% after peakingThe increase to normal household formation rate, after over 8.3% in 2009. Household net worth and corporateyears of families doubling and tripling up generations balance sheets, including the banking industry, haveunder one roof, is yet another observation how the Little improved as asset values recovered and debt levelsThings Add Up, supporting our expectation of a resilient were reduced. Refinancing loans has reduced interestU.S. economic recovery. expense, while strong cash flows bolstered balance sheets. Investment spending has remained strong, even National Housing Inventory if companies were reluctant to expand their workforce 4,500,000 18 4,000,000 16 given increased regulatory, legislative, and labor cost 3,500,000 14 uncertainty. Credit card balances continue to decline, but Housing Inventory Months Inventory 3,000,000 12 non-revolving credit, often used to buy durable goods, is 2,500,000 10 expanding again; both results can be interpreted as 2,000,000 8 signs of economic strength. Mortgage liabilities were 1,500,000 6 reduced by paying down principal, possibly to re-finance 1,000,000 4 into a conforming loan, or the result of short-sales and 500,000 2 foreclosures. In contrast, government liabilities continue 0 0 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 to expand rapidly with U.S. Treasury debt rising from Housing Inventory Months Inventory (Right) $14.1 trillion last August to over $15.5 trillion, and it is fast approaching the next debt ceiling of $16.4 trillion.Source: National Association of Realtors 2002-Present vs. 2007 Household Balance Sheet ($B) 2007 2011 A.G.R. A.G.R. 1-YearHousing inventory continues to decline, but shadow Total Assets 79,545 72,229 | 4.7% -2.4% -0.7% Tangible Assets 27,970 23,162 | 2.3% -4.6% -1.3%inventory concerns remain. The long-feared inventory Owner-occupd Real Estate 20,855 15,964 | | 1.2% -6.5% -3.7%surge has yet to materialize. If the concentration of Financial Assets (inc. retirement) Deposits (Bank + Money Funds) 51,575 7,406 49,067 8,172 | | 6.1% 5.7% -1.2% 2.5% -0.4% 4.9% |foreclosed properties is high only in certain regions with Liabilities 14,346 13,774 | 5.5% -1.0% -0.9%poor job growth, which we suspect is the case, it may Home Mortgages Consumer Credit 10,546 2,555 9,841 2,521 | | 6.1% 4.8% -1.7% -0.3% -2.1% 3.5% |explain why concerns of shadow inventory remain, Household Net Worth 65,198 58,455 | 4.5% -2.7% -0.6% Disposable personal income 10,424 11,721 | 5.0% 3.0% 3.4%despite falling inventories. Why else would banks hold Source: Federal Reserve, Flow of Funds (Table B.100)back properties when the market seems to be clearinginventory, and there are increasing instances of bids Source: Federal Reserve, Flow of Funds (Table B.100)over asking prices in other regions? Concern about leverage tends to focus on incomeWill Deleveraging Persist? versus debt levels, but interest rates are also important. In the case of fiscal deficits, we compare gross domesticDeleveraging has been observed since 2007 across the product (GDP) to outstanding debt. Debt/GDP nowcorporate, banking, and household sectors, but it is a exceeds 100% in the United States, while manytransitory state which appears to be reversing. Growth in countries in the Eurozone and Japan far exceed 100%.business sales and construction indicate that leverage is The ability to service debt is a function of income versusnow increasing. Commercial and industrial loans interest expense. U.S. Treasury yields on 10yr bondsincreased 12.2% over the last year, suggesting bank average over 6%, but today are closer to 2%. After 10credit terms are improving, while private fixed investment years, the interest plus principal would grow to 47%expanded by 9.1%. Retail sales of 6.3% suggest more at 6% than at 2%, but after 20 years, the debtconsumers are spending in excess of 3.4% disposable would compound to more than double the lower rate.income growth. Below we observe a high level of Thus, homeowners and businesses seek to refinancebusiness sales (7.8%) and the dramatic rebound in higher fixed interest rates, if they qualify, even with pre-construction, growing 5.8%. These statistics all suggest payment penalties. Any tipping point for a nation’sstronger growth than real GDP suggests, of course. sustainable debt level varies depending on its interest rate. Unfortunately, Europe has learned that the cost of 5
higher debt can result in higher interest rates, particularly Investors must balance a logical interpretation ofin periods of crisis, and crowd out other fiscal needs. economic conditions, consistent with higher interestThe Eurozone’s central bank can and should cut interest rates, with the old adage: “Don’t fight the Fed”.rates from 1.0% by 25-50 basis points. The chart below is interesting because it shows twoWhy Is Ben Still So Gloomy? important relationships. First, the yield curve isn’t much different from what it looked like during the FinancialU.S. interest rates are unsustainably low. With most of Crisis on December 31, 2008. With growth and inflationits monetary policy tools deployed, the Federal measures hovering close to historical averages, how canReserve’s latest initiative is to “manage” inflation and current monetary policy be justified given how muchinterest rate expectations to contain any increase in economic conditions have improved? Second, comparebond yields. This effort included publishing individual the current yield curve to April 2004, just before the FedFOMC member economic and interest rate forecasts started to raise interest rates during the last cycle, duringthrough 2014. Given more upbeat commentary following which 10yr Treasury yields rose about 3%. In 1994, onethe March FOMC meeting, expectations for the first of the worst performing years for Treasuries, Treasuryinterest rate hike pulled back to mid-2013 and bond yields rose just 2.5% to 7.8%, while CPI inflationyields rose from 2.0% to 2.4% over the following week. averaged 2.8%, similar to current inflation. An increase in Treasury yields of 3% would only align with 2004, justEconomic conditions don’t justify continuing current before the Fed started to raise interest rates. Yield curvemonetary policy stimulus or a new round of QE-3. We comparisons illustrate how far interest rates must rise tobelieve current economic conditions justify much higher restore equilibrium (“average”).interest rates when we apply the Taylor Rule, widely Treasury Yield Curverecognized in central bank policy making, approaching 8.03.4% with a low 2.5% inflation estimate. The Taylor Rule 7.0 Averageillustrates how much conditions have changed over three 6.0years. This contrasts with the current 0-0.25% target, 2004 5.0and an April 2009 calculation of -3.6%. With measures of Yield (%) 2007 4.0growth and inflation exceeding normal economic 3.0conditions, the Federal Reserve may compromise its 2008credibility by trying to justify maintaining current 2.0emergency monetary policy stimulus. 1.0 Current Dec 2008 Dec 2007 May 2004 Avg:1962-2010 0.0Negative real bond yields can’t be sustained for long 0 5 10 15 20 25 30periods without causing financial system imbalances. Maturity (years)There is also a growing risk of moral hazard as interest Source: HighMark Capital Management and Datastreamrates are held artificially low for what has already beenan extended period. Assurances of “low rates for an Minutes of the Federal Reserve’s mid-March meetingextended period” by the Federal Reserve may kicked the potential of another round of quantitativeencourage excessive risk taking as investors extend easing (QE-3), beyond the foreseeable future. We thinkfixed income durations, underestimating the potential Operation Twist will be winding down by June. Lessinterest rate risk of their holdings. The range of creative buying support for Treasuries may tend to drive up bondmonetary stimulus made available during the Financial yields, but there is little economic reason for equities toCrisis improved liquidity and stabilized credit markets, be affected much. Some investors have associatedbut there is an increasing risk of spiking bond yields winding down QE-1 and QE-2 with equity marketwhen expectations change. The Federal Reserve never corrections in 2010 and 2011, but coincidence is notbefore communicated its interest rate expectations to always causality. There are many other likely reasonsthis extent. We believe that monetary policy changes are that explain last summer’s economic slowdown, in ourmost effective when massive and unanticipated to opinion. We’ve highlighted how ten unrelated Littlesurprise markets. The ability to do this has been Things Add Up to a significant global economiccurtailed with their increased emphasis on transparency. headwind in 2011. We are more concerned about tax increases and other effects of fiscal drag in 2013.If Chairman Bernanke were more upbeat about theeconomy, we believe the Federal Reserve couldn’t During the debt ceiling debate, we discussed howdangle QE-3 or maintain that interest rates will remain canceling Treasuries owned by the Federal Reserve can“low” until the end of 2014. The Federal Reserve is increase Treasury debt capacity under the debt ceiling.attempting to manage both inflation and interest rate The debt ceiling stands at $16.394 trillion, and it is likelyexpectations lower, because nearly all other monetary to be exceeded by early 2013, if not sooner. The Federalpolicy options are used up. Unwinding Quantitative Reserve’s balance sheet remains between 3-4 timesEasing and low interest rates will be a challenge without larger than in 2007, bloated by an additional $2.3 trillionundermining economic growth and increasing risk of worth of Treasuries, mortgages, and other creditstagflation. Growth in the monetary base has ranged securities. Other than selling securities, it is possible toabove 30-110% since 2008, but recently fell to 11%. 6
let bonds mature or simply cancel Treasury debt held by Obviously, the issue is very complex and contentious,the Federal Reserve. The Federal Reserve already based on many assumptions. It is unclear how much ofrebates interest received back to the U.S. Treasury, the Fiscal Cliff has already been discounted in modestincluded in most of the $77.4 billion earned last year economic expectations for 2013.from interest payments on securities held and sellingappreciated assets on its balance sheet. Maturities also Government spending is currently 25% of GDP and atcould be accelerated by reversing Operation Twist (i.e., least 5% over our sustainable rate, based on Hauser’sreplacing longer maturities with shorter maturities). Law (i.e., tax revenues haven’t exceeded 20%, irrespective of tax rates). Simplistic subtraction modelsUnwinding the Federal Reserve’s enlarged balance from baseline GDP estimates is misguided, we believe,sheet and restoring interest rates to a normal spread but it would be wrong to dismiss the correlated effects ofversus inflation will likely be a difficult transition that is all these changes impacting the economybest started slowly and early in order to allow for gradual simultaneously. Unfortunately, it has proven difficult toevolution. We think that hiking interest rates 1% would agree on budgets and difficult legislation most of thehave little effect on fixed mortgage rates, as otherwise time these days, so gridlock may well continue to be thefeared, unless inflation or interest rate expectations norm during this election year.increased. However, it should also decrease risk ofmoral hazard and restore normal function to short-term Sequestration mandates across-the-board spending cutsfixed income markets. Money supply normally expands totaling $1.3 trillion over 10 years, beginning in 2013. By5-6% per year, but it will likely contract for a sustained law, both houses of Congress are required to submit andperiod, unless the Federal Reserve allows Treasuries to pass a budget resolution by April 15th, so it is possible tomature without re-investing the proceeds. reconfigure planned sequestration and turmoil over another debt ceiling increase. The Senate has failed toQuantitative easing (QE-1) and other creative monetary pass a budget resolution for the third year, andpolicies initiated during the depths of the Financial Crisis apparently has no intention of doing so, although thewere effective at stabilizing credit markets and restoring House has met its deadline. In an election year, this willliquidity. Subsequent easing efforts appear to us to be certainly be an issue. It appears the only hope is amisguided, and this view is shared to greater or lesser “grand compromise” in Congress that slows spending,extent by a wide range of economists, other country’s incorporates the sequestration target, and raises thecentral bankers, and even several vocal members of the debt ceiling enough to deal with it again after mid-2013.FOMC. The combined balance sheets of the six largestmajor central banks have increased $8 trillion since 2007 Differentiating between economic effects of temporaryfrom $5 trillion to over $13 trillion. Increasing money and permanent tax policy changes is well-documented.supply may not directly and immediately boost U.S. or Individual households change their behaviors well beforeglobal inflation, but it has been shown that investors implementation of known adjustments. So if the payrolloften boost their inflation expectations as the economy tax holiday is not renewed, increasing social securitygains traction. As increasing inflation expectations withholding from 4.2% to 6.2%, there is likely to be lesssolidify again, it will be difficult to reverse the trend once impact on growth than the full 2% difference assumed.wage growth accelerates enough. Since the tax break is highly progressive, higher-income households didn’t benefit, and will not be as impacted byThe Fiscal Cliff Of 2013 expiration. Thus, many other variables are likely more important to the forecast of U.S. growth in 2012-13.Many temporary tax cuts are legislated to expire over thenext year, increasing concerns about the likely economic Conclusionimpact. Several expiring tax cuts and stimulus measuresmust be extended, made permanent, or addressed in the HighMark’s five drivers of exceptional economic growthfiscal budget before year-end or they could have a have provided an effective way to communicate how thenegative impact on growth in 2013. The Economic U.S. economy has and could continue to surprise to theGrowth and Tax Relief Reconciliation Act of 2001 upside. The strength of these drivers, however, has(EGTRRA) provided reform to marginal income tax been inconsistent with lagging real GDP growth, even asrates, estate exclusions, and retirement savings, which a significant rotation in investment leadership appears towere designed to be phased in through 2010. The be underway. It is convenient that HighMark’s globallegislation included a sunset provision so that tax law tactical asset allocation forecasts come directly fromchanges weren’t subject to PAYGO rules (i.e., maintain interpreting various economic measures, thus avoidingdeficit neutral), impacting the fiscal budget beyond 10 several layers of compounding uncertainty.years. Tax increases also taking effect in 2013 include:financing new heath care reform, expiring payroll tax Periods of exceptional productivity have sustained aboveholiday for social security withholding, expiring extended average real growth and rising profit margins.unemployment benefits (up to 99 weeks), and increasing Encouraging innovation has been vital to U.S.burden from the alternative minimum tax (AMT). The competitiveness. Last quarter, we identified nineCBO estimates the 2012 “Fiscal Cliff” impact to be 2% of potential drivers of exceptional productivity, which haveGDP, but other estimates have ranged as high as 3.5%. the potential for significantly boosting long-term growth. 7