The financial markets performed well last year, thanks largely to what did not happen. The European Union did not dissolve. Greece did not default. America did not hurtle over its fiscal cliff. The world did not end per the Mayan calendar.¹ The year gone by offers a couple of lessons for investors and perhaps a clue as to what lies ahead in 2013. The first lesson is that investments can appreciate merely because a risk perceived by investors does not materialize. Witness the run-up in stock prices that followed lawmakers' sidestepping of the fiscal cliff. The second lesson is that government policies, including those of the central bank, can have significant impact on the markets, as developments in both Europe and the U.S. demonstrate. In 2013 government policies could have a meaningful influence on investors' experience, much as they did in 2012.
We are tired of discussing the fiscal cliff, and we suspect you are as well, but there's a bit more to be said. While the tax side of cliff has been handled, the spending side has not. It may not be long before the lower right corner of our TV screens once again displays a countdown clock. So far at least one of our prognostications has come true. Congress waited until 2013 to pass the law addressing the cliff. In doing so, lawmakers can tell their constituents that they voted for a large tax cut, because rates technically rose at midnight New Year's Eve, even though the net effect is that taxes are going up for some. It came as no surprise to us that members of Congress would act in their own interest.
Where we're headed? We've been there
In a couple of months we will face another showdown, or a series of showdowns, related to the debt ceiling and spending. Following our previous logic, we expect Congress to raise the debt ceiling. They've done so about 80 times before. No one wins if the U.S. defaults. While many in Washington may talk about cutting spending and the size of the government, we expect the bulk of any cuts to occur in future years and that lawmakers will move to shave the rate of growth of spending largely by adjusting how inflation is measured. The government will operate; it will spend. The can of spending cuts will be kicked down the road. It's more difficult to predict how investors will react to additional uncertainty over U.S. fiscal policy. We were impressed and surprised by investors' equanimity heading into year-end. If they remain so composed, we might encounter a period of volatility in the next few months, but nothing too alarming to a long-term investor.
We expect U.S. economic growth of roughly 2% this year
We expect real (inflation-adjusted) U.S. economic growth of about 2% in 2013. The housing recovery appears sustainable, which will help drive growth. As the oversupply of homes is absorbed, demand will drive prices. The jobs recovery is not strong enough to create a strong housing market. There will be some demand due to household formation, but tight credit conditions and impaired balance sheets may prompt many to rent rather than buy. Business spending is unlikely to contract further. As deleveraging continues, we expect growth to remain weaker than is usual coming out of a typical recession.
The inflation-adjusted value of goods and services produced in the United States is higher than it was before the Great Recession of 2008-2009. While major stock indices, such as the S&P 500, remain below their all-time highs, the Russell 2000 Index, a barometer of the value of small-capitalization U.S. stocks, has reached new peaks. On average, U.S. employers added 160,000 workers to their payrolls each month during the second half of 2012, enough to keep the unemployment rate moving down. As the economy slowly returns to normal, investors are likely to be focused on the Fed and, specifically, when its easy money policies will end.
Of interest rates and "the big trade"
The minutes of the December meeting of the Fed's policy-setting Open Market Committee caused a stir. A sizeable number of committee members felt that the Fed's quantitative easing (QE) or financial asset purchase program could be stopped during 2013, due either to strength in the economy or to instability in the central bank's balance sheet. The yield of the 10-year U.S. Treasury note rose about 10 basis points (0.1%) in response to the news, but the rise needs to be considered in the context of a month-long trek toward higher rates that began in early December when the 10-year note yielded 1.56%. The 10-year nearly reached 2% in yield, which has raised the prospect that investors may be trying to find a higher trading range, perhaps in the 2.00-2.25% area. The prospect of the Fed ending its QE program earlier than expected due to better economics would be good news on many fronts. However, if the program ceases because the bank's balance sheet is too big, this would represent a limit to policy and perhaps be interpreted as a failure on the part of the Fed, an outcome that could spark a dramatic flight to safety.
For investors, the potential widespread sale of long-term bonds is the universal big trade. Some investors may already have moved out of long-term issues. When interest rates eventually rise meaningfully, they are unlikely to do so in a smooth trend. The economy faces numerous headwinds, including potential fiscal austerity, low real income growth, a consistent but potentially slow recovery in housing, tentative spending by large businesses, and skepticism about the prospects for small businesses. Any new weakness in the economy could depress rates anew, while an increase in interest rates could dampen economic growth. Our Investment Strategy Team has adjusted our model asset allocation strategies to reduce our exposure to interest rates and trim credit-sensitive areas.
Last year was a good one for stock investors; U.S. stocks returned more than 15%. Developed international and emerging markets rose even further. The overall U.S. market of taxable, investmentgrade bonds returned about 4%. We maintain our strategies' near-benchmark weights in stocks and would likely use a strong pullback as an opportunity to overweight them. Stock prices can increase for two reasons—because earnings increase or valuations (price/earnings ratios) increase, or both. We see singledigit percent increases in earnings in 2013. It is difficult to predict what investors will be willing to pay for earnings sometime in the future. Our inclination to invest more heavily in equities reflects our belief that they will do better than cash and bonds given low rates and our opinion that rates are more likely to move up than down.
¹ This happens to be the 100th installment of Market Notes. The headline of the first in January 2009 noted that the world had not ended. At that time we were commenting on the risk to the financial system.
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