12/18/12 - Outlook 2013: The Economy Returns to Normalcy - Where We Are Now (Part 1)

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Dec 18, 2012 10:00:29 AM

and tagged Fiscal Cliff, Outlook 2013

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At the end of 2012, the U.S. economy finds itself, almost, at the beginning of a sustainable recovery. Consumer spending has recovered to levels above previous highs and is on par with recoveries from previous recessions. Retail sales are also doing well. The housing market has turned, with most markets reporting price increases year-on-year, and the number of houses for sale in most markets is below historical averages, suggesting that price appreciation will continue.

Business has done very well, with corporate profits at high levels and profit margins at or close to all-time highs. The stock market has performed strongly this year, and there is potential for future appreciation.

The missing piece in the recovery is the average person. Much of the business recovery has been based on increasing productivity, which has resulted in fewer jobs, even as companies have done well. Wage levels have stagnated or declined in real terms, and the unemployment rate has declined more slowly than in almost any other recovery.

The performance of the real economy—that is to say, Main Street instead of Wall Street—in 2013 will depend on whether the average person starts to participate in the recovery, on whether hiring increases from current levels, and on whether a decline in the unemployment rate results in real wage increases. I believe that hiring has started to turn the corner and is poised to increase further in 2013. I also believe that wage growth is poised to increase as unemployment declines.

The end result will be an economy that transitions from government support to sustained, private sector-led growth. Although I believe that growth will be slower going forward than it has been historically, it should be steady and based on solid fundamentals.

A complicating factor is, of course, the fiscal cliff. The combination of tax increases and spending cuts will exert a drag on the economy, regardless of whether Congress comes to an agreement on how to proceed. The question is how large the drag will be.

This outlook is based on an assumed deal over the fiscal cliff that includes the commonly accepted terms—expiration of the 2-percent payroll tax waiver, imposition of the Patient Protection and Affordable Care Act taxes, and similar items—but that does not include full reversion to Clinton-era tax rates. Should the Republicans and Democrats be unable to agree, there will most probably be a substantial recession, rather than an ongoing recovery. We will issue updated guidance, if necessary, when we know more.

WHAT THIS MEANS FOR MARKETS

The ongoing recovery of the real economy will provide support for the financial markets, but risks remain. Interest rates are at or close to all-time lows, and any increases would adversely affect asset values. That said, I expect interest rates to remain close to current levels through 2013, based on the express intentions of the Federal Reserve (Fed), as well as on the fact that lending is still well below the level that might prompt rate increases.

Equity markets show higher risk levels. On longer-term metrics, U.S. equities are at historically high valuation levels. Although shorter-term metrics show fair valuations, any improvement would depend on sustained increases in corporate earnings per share. This is possible, but the most probable course will be stability or small price increases at best, with downside risk also very real.

Given the limited upside and potential risks for equity markets, not to mention the general economic risks from the fiscal cliff and other governmental issues, investors would be well advised to consider the following:

Regardless of the outcome of the fiscal cliff, it appears certain that taxes are going up. Strategies should emphasize tax efficiency.

  • Real diversification is key. Almost every asset class is now subject to some form of tail risk, and exposures should be well diversified.
  • Income should continue to be a focus for both demographic and financial reasons. Income sources should extend beyond traditional fixed income asset classes.
  • Although inflation is not on the immediate horizon, the possibility should be included in any plan.

While the real economy should continue to recover—barring governmental incompetence—financial markets continue to be exposed to multiple risks. As such, cautious optimism remains the appropriate stance across the board, with an emphasis on cautious in the earlier part of the year. Tomorrow, I’ll discuss the real economy in 2013.

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