As a reminder, we position our portfolios to try to address potential rates of economic growth and inflation. Stocks tend to do well in periods of growth, while bonds tend to do better in periods of economic slowing. We expect real assets, such as inflation-linked bonds and commodity- and real estaterelated securities, to provide a hedge against rising inflation and stocks and bonds to do well in periods of falling inflation. We believe the global economy will continue to expand in 2013, albeit with tepid growth for most developed economies and at more attractive rates for many emerging economies. We do not expect material increases in interest rates, though positive economic news could spur some increase in rates. The labor and excess productive capacity issues around the globe should continue to mute inflation for the time being. We fear a rise in rates—particularly real (inflation-adjusted) interest rates—more than falling rates, but we acknowledge that it may be a long time before a material rise occurs.
For equities, it might surprise some to hear that the S&P 500® Index is within a few percentage points of its all-time high in October 2007. Equities are impacted by the earnings that companies generate, and the price investors are willing to pay to own shares of those earnings. Bloomberg reported this week that S&P 500 companies, in aggregate, are poised to make more than $1 trillion in 2013, the first time that has ever happened. Those forecasted earnings are not aggressive. At the current price/earnings (P/E) ratio, that would reverse the decline in the index level due to the financial crisis, marking a nearly six-year peak-topeak recovery. Interestingly, the current P/E on the S&P 500 is almost 10% below the long-term average. Certainly, there are reasons for that, including the current low interest rate environment. But should multiples expand and profits hold up, there is certainly upside potential for stocks. The biggest overhang to earnings would be another economic recession, which appeared a reasonable possibility as the nation's lawmakers wrestled with the fiscal cliff. That resolution has led to a forecast drag of about 1.1% on likely 2013 economic growth, which still leaves positive prospective growth, but barely. The next drama to unfold will feature the federal debt ceiling and its connection to spending and the sequestrations— automatic spending cuts that could, according to The Washington Post, reduce the budgets of many government programs by 8–10%. We believe lawmakers have a greater appreciation of their actions than they showed in the last two rounds of budget talks, with the potential extension of the discussion into the second quarter a sign of their increased sensitivity. In the end, we are confident that the debt ceiling will be raised; we are guessing by about $2 trillion, which amounts to two years of deficit spending at our current rate and another election cycle for the House and a third of the Senate. The question is how much spending will be cut, either currently or in the future, to support such a move. Republicans have hoped for $1 of spending cuts for each $1 in increased debt limit, but their position may not be strong enough to reach that goal. We think there will be some spending cuts, and that they could include some impact to entitlements. This is likely to be viewed as good news for both the economy and stocks.
The economy has been helped by the recovery of an old friend. Housing numbers have been improving, and housing's contribution to economic growth should be positive and could grow in 2013. Households have seen an uptick in their total wealth, as house prices rose in 2012. On average, home prices improved 4% over the previous year, in part on increased sales related to increasing demand. We have not seen a material increase in household debt levels yet, and no net new mortgage borrowings so far. Increased borrowing means additional demand and the potential for more and faster price increases. However, increased sales tend to be linked with increased spending in related areas, which should mean a slight tailwind for the U.S. this year.
Fed Chairman Bernanke has mentioned he is confused about the lack of mortgage growth in light of the central bank's efforts to maintain very accommodative interest rates on all forms of debt. We do not see that accommodative stance changing anytime soon. The question we continue to ask ourselves is whether we will see material movement in interest rates in spite of the Fed's actions. Rates would increase either on inflation fears or due to improving economics, as investors look to move assets away from lower yielding fixed income into other securities. While we continue to be less concerned about inflation, an improving economy could push interest rates higher. Global conditions, particularly Europe's troubles, could limit such upward pressure.
Europe removed the financial market's fear of a banking system collapse with the European Central Bank's (ECB) implied promise to be the buyer of last resort for sovereign debt. This step certainly took long enough to evolve, but it helped to soothe concerns in markets. Europe's recession is likely to continue for much of 2013. The next major event we are watching is the German elections this fall. Angela Merkel has proven to be a strong supporter of the European Union (EU), its single currency, and economic stability; her reelection would be considered a material reinforcement of the EU.
Of course, risks could materialize. We see the events in North Africa, as well as the tension and uncertainty of the Iranian/Israeli standoff. In both cases, the seriousness is clear, but the immediate financial impacts are mostly small. North Africa currently represents a very small part of the global oil supply; the unrest there probably will continue for some time to come but will tend not to impact financial markets. Israeli leaders have made clear that they will not stand idle on the possibility of a nuclear Iran, but the ability of their military to stop the process is questionable. The pressure of the global community has a better chance of success, but national elections in Iran may be needed to position the country to better interact with the world. If diplomacy fails, we would look to see the extent of any military action. Israel's expectation of U.S. support could make a regional conflict a more global event; barring such intervention, the biggest impact to financial markets probably would be an increase in volatility.
Currently, investors seem to see fewer storm clouds than they have in recent years. The CBOE Volatility Index, or VIX, a measure of anticipated equity market volatility, is at an extremely low level. Periods of anticipated low volatility tend to coincide with somewhat muted returns, and we have seen a number of single-digit equity market return forecasts for 2013, which seems consistent with the current level of the VIX. However, what everyone expects is usually not what transpires, so we continue to hold a diversified portfolio, spreading our bets in preparation for the market ahead of us.
As always, we appreciate your questions and comments.
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