The U.S. Economy
Despite all of the fanfare surrounding “fiscal cliff” debates and the advent of cleanup in the northeast following super storm Sandy, December turned out to be a relatively quiet month in financial markets. There was a mixture of new macroeconomic data, much of which was generally encouraging, although some reports showed signs of incremental weakness. Several near-term factors were at play during the month, and likely contributed to the areas that saw softness in certain measures. For one, the after effects of Sandy probably had an impact. Some of this could be reversed in the months ahead, as rebuilding efforts take shape, but we do not anticipate that Sandy will have a meaningful impact on economic growth as we move through 2013. Meanwhile, ongoing uncertainty surrounding the fiscal cliff continued to weigh on the market psyche.
To rehash some of December’s more positive macroeconomic developments, during the month we learned that nonfarm payrolls rose a healthy 146,000 in November. The employment situation report also showed that the unemployment rate dipped to 7.7%. A 0.2 percentage point drop in the labor force participation rate to 63.6% was partly responsible for the lower unemployment rate. On the plus-side, temporary employment grew by 18,000 workers, above the previous month’s gain of 13,900. Growth in the number of temporary workers tends to lead growth in permanent employment, so this aspect of the report was good news.
The Bureau of Economic Analysis (BEA) released its third estimate for third quarter growth in U.S. gross domestic product (GDP). The report included another upward revision, this time to an annualized growth pace of 3.1%. Details of the report discussing various contributors to growth were not materially different from the BEA’s second estimate. Consumption remained the largest contributor to domestic economic expansion during the three month period.
Some other data points were a bit weaker, such as downticks in several confidence measures, namely consumer sentiment and small business optimism, all of which had been rising steadily in recent months. The Thomson Reuters/University of Michigan consumer sentiment index dropped back to 72.9 in December, a five-month low, after reaching a post-recession high of 82.7 during November. Similarly, the attitude of small business leaders soured incrementally. The National Federation of Independent Business’ Small Business Optimism Index declined to 87.5 in November from 93.1 the prior month.
There were some noteworthy changes to domestic monetary policy that emerged from an eventful meeting of the Federal Reserve’s Federal Open Market Committee (FOMC) in early December. With the current Maturity Extension Program (i.e., Operation Twist) expiring at the end of 2012, the FOMC announced that it will purchase $45 billion in long-term Treasury securities in addition to the $40 billion in monthly agency mortgage-backed securities the Fed was already buying as part of its third round of quantitative easing (QE) announced in September. This latest development was widely anticipated by the market, and essentially amounts to another layer of policy easing. The primary goal of quantitative easing remains largely unchanged. As a reminder, the Fed is working to promote a stronger economic growth environment that is conducive to improving conditions in the labor market.
While significant, the announced replacement to Operation Twist was arguably not the biggest news coming out of the FOMC meeting. The committee also decided that it will no longer provide date-based guidance as to when it expects to move away from an exceptionally low Fed Funds interest rate target. Instead, the FOMC will employ a conditions-based threshold. December’s post-meeting press release stated that the policy rate will remain low, “as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored.” We view this development as a logical step in the FOMC’s push to improve its communications strategy and overall transparency.
The Global Economy
In Europe, Greece secured its next installment of much needed bailout funds during recent weeks. International finance ministers agreed to the disbursement as part of a broader deal. The generous new package consists of reduced interest rates on Greece’s bailout loans, extended maturities (15 years longer), a 10 year moratorium on interest payments, and a provision requiring some Eurozone governments to surrender and remit back to Greece profits that were earned on Greek bonds held at the European Central Bank (ECB). The deal also required Greece to offer to buy back EUR 10 billion of its debt in a Dutch auction format. Now, Greece is targeting a reduction in its debt to GDP ratio to 124% by 2020. Finance ministers were previously projecting that this ratio would reach 190% by 2014. Standard & Poor’s recently raised the credit rating it assigns to Greece’s sovereign debt by six notches (from selective default to B- with a stable outlook). Greece still has a long road ahead in terms of rectifying its fiscal situation, but these latest developments are a very clear indication that the international community is willing to continue working with Greece, and further reduces the likelihood that it would exit the common currency bloc. Across Europe, economic conditions remain weak, albeit with some pockets of strength.
Encouragingly, after about two years of capital fleeing European countries including Italy, Spain, Greece, and Portugal, recent data is looking more positive. For example, Italy and Spain have seen inflows and Portugal’s outflows have stopped. It is still much too early to declare victory in battling the sovereign debt crisis, but given the contagious investment outflows that were taking place, the latest indications are certainly good news.
In Asia, Japan’s political landscape experienced some noteworthy changes during December. The results of a snap election on the 16th placed Liberal Democratic Party (LDP) leader Shinzo Abe as the victor and will return him to the position of prime minister, an office he held previously from September 2006 to September 2007. Abe will take over for outgoing Prime Minister Yoshihiko Noda, whose tenure as Japan’s leader was similarly brief, lasting about 16 months. A lack of political stability has been the norm in Japan for much of the last decade as the country struggled to create a healthy and lasting environment for economic growth. Abe’s primary campaign pledge was to push for aggressive monetary policy easing beyond what the Bank of Japan (BOJ) is already doing. Previous attempts by the BOJ to weaken the Yen in an effort to spur Japan’s export economy proved largely unsuccessful. Given the BOJ’s history of policy impotence, the effectiveness of a new push to devalue the Yen remains to be seen, but we think investors should expect some amount of more forceful monetary ease in Japan as Abe returns to office.
The pace of rising prices in the U.S. slowed during November. On a year-over-year basis, the headline Consumer Price Index advanced 1.8% and the core index (which excludes food and energy prices) rose 1.9%. A noteworthy decline in gasoline prices was responsible for the bulk of the deceleration in the headline measure. Outside the U.S., the latest data show that inflationary pressures remain generally benign. With the new year upon us, the global economy continues to be characterized by a series of lows: low growth, low interest rates, low bond yields, and low inflation. That being said, a variety of national central banks remain squarely in policy easing mode. This argues for ongoing vigilance in monitoring inflation because upward pressure on prices can build rapidly once underlying economies gain firmer traction.
During 2013 we expect a continuation of the current slow growth economic environment. The majority of our economic indicators are signaling neither the negative extremes that typically represent great buying opportunities, nor the excesses associated with an economy at risk of collapsing on itself. From a valuation perspective, various pricing indicators are showing a modest degree of undervaluation in U.S. equities, although in some markets and regions (e.g. Europe) equity valuations are very attractive. Relative to bonds, equity valuations are highly compelling in our view. Market sentiment is largely neutral, particularly with respect to short-to-intermediate term measures, whereas longer-term investor sentiment measures are generally negative toward stocks.
For clients with a long time horizon and a need for growth to meet their investment objectives, we continue to focus on companies that can grow in an otherwise growth challenged global economy. We believe businesses that are positioned to expand faster than the broader economy provide the best risk/reward opportunity for long-term investors in the current environment. In our view, reinvestment rate risk is the main challenge facing such investors today, and long-term investors who maintain large exposures to traditionally “safe” investments are unlikely to earn absolute returns that are sufficient to meet their investment objectives.
Our focus in fixed income markets is centered on spread sectors (i.e., fixed income securities that trade at attractive yield spreads relative to a similar maturity Treasury). While we continue to pursue opportunities in investment-grade corporate bonds, a very selective approach to the below investment-grade space is helping us find value there as well. In terms of government debt, our preference continues to be U.S. Agency securities, as Treasury yields hover near historic lows. With regard to municipal bonds, discernment is critical, but opportunities still exist for value conscious investors.