Investment Insights

Jeff Benjamin

After the cliff, what's next for investors?

Jan 27, 2013 @ 12:01 am

The following is an edited transcript of the Jan. 8 webcast, “Beyond the Fiscal Cliff: What's Next for Stocks and Bonds,” moderated by InvestmentNews deputy editor Greg Crawford and senior columnist Jeff Benjamin.

InvestmentNews: As we all know, we have gotten through the fiscal cliff — in one fashion or another. There are still a lot of uncertainties out there, so we're going to take a look at stocks, bonds and perhaps some other asset classes, as well as investment opportunities outside of the United States, given the macro environment we're in.

Certainly, clients are expecting advisers to have a handle on where to put their money, so that's a big question that we'll be tackling today. Some of the talking points that we'll specifically be covering: the macro view, stocks versus bonds in 2013, sectors or companies, other asset classes that advisers should consider, and different pockets of opportunity in Europe and elsewhere.

We are going to have each of our panelists give his macro view, and we are going to start out today with Jim Russell from U.S. Bank Wealth Management.


Mr. Russell: From a macro perspective, U.S. domestic growth is probably realizing its low ebb for the year right this minute. I think we're all aware of the increase in payroll tax, the uncertainty right around the raising of the debt ceiling, and additional legislative and congressional debate that's going to occur before too much longer regarding the spending cuts.

Unfortunately, that will have a little bit of a hangover effect on business confidence, as well as consumer confidence. But we do think that the [gross domestic product] run rate will accelerate from about 1% in the first quarter and perhaps end the year in the 3% range. So look for a weak first half and a much stronger second half.

Inflation should remain low all year long. The labor markets will remain sufficiently weak and won't drive inflation much higher. There's a little bit of inflationary pressure in the housing market, farmland and perhaps in the commodity complex, as well. Some of the highlights from a macro perspective will include housing, auto, sales and production.

Earnings in the S&P 500 will grow at about 6% or so, and we look for an earnings number of $108 per share on the S&P 500 for the year. The math would indicate a year-end target in the 1,570 range for the S&P 500. Throw in a dividend yield of 2%, and we're looking at a projected total return for the S&P 500 in the 10% to 12% range.

There will be higher global growth, but Europe will remain stuck in first gear and either in recession or near recessionary types of conditions, but there will be no brush fires this year, unlike last year. Some of the excitement that we see in the year ahead will come from China. The growth rates there are high and accelerating. A lot of that growth is due to public spending and not export-driven just yet. China is transitioning to an internal-consumption type of profile, but that transition is a longer-term type of project.

The emerging markets actually will be an exciting place to return to in 2013. We would include Latin America within that emerging-markets profile. A lot of that optimism is centered on China maybe operating at a higher run rate as we move through 2013, as well as a lift in commodity prices on a global basis.

The only hesitation we have on commodities would be in the energy sector, especially given the supply-demand dynamics operating in the oil and natural gas markets on a global scale. Although we are concerned about the politics and possible military action in the Middle East, we think that energy prices will remain relatively well-behaved.

Capital spending should begin to increase as we hit the second half, but it will be a modest improvement and tied to revenue growth by the S&P 500. That expectation is in the 3.5% to 4% range for the year.

We are positive on domestic equities, positive on emerging-markets equities; we are less positive on developed-markets equities; and we are negative on the bond market, by and large. Bonds are very expensive at current run rates, and the path of least resistance on rates is up, not down. We do like municipal bonds; we think there's a semipermanent bid under municipal bonds in the higher-tax-rate environment that we foresee.

InvestmentNews: Nick, what is your macro view?

Mr. Colas: Let me just add a couple of nuances.

The first point would be more of a caveat. I don't think it's easy to tell what economic impact the incremental 2% Social Security tax is going to have on the American population. Keep in mind, this is $1,000 for every household that makes $50,000 a year. During the fiscal cliff negotiations, it was very well-publicized that the rich would be getting much higher taxes. It was much less well-publicized that the tax rates of every working American are going higher. Given the fragility and slow-growth nature of this recovery, I think the jury is out as to what effect that's going to have on consumer confidence and spending.

Point No. 2 is related to money flows. I think it's really critical to understand what the Federal Reserve policy is going to be as it relates to quantitative easing over the course of 2013. My concern is a scenario where GDP growth expands to a level we all think is appropriate, say, 2.5% to 3% or even 3.5%. What is the Fed's approach going to be? They've told us that they've got a 6.5% unemployment rate as the base case from which they start thinking about removing quantitative easing. But the minutes of the last Fed meeting also betrayed a bit of unease among the different folks on the board as to what policy should be in 2013. That, to my mind, is going to be the most important macro factor for the direction of both equities and bonds this year. My concern is that an end to quantitative easing creates a shock to the system.

The final point I would make is more towards the near-term fundamentals. The most fundamental concern that I have about equities right now is that analysts' expectations for fourth-quarter revenue growth are too aggressive, and so, too, are expectations for sustainable earnings. If you look at what analysts expect for revenue growth, it's on the order of 1.1% revenue growth for large multinational companies.

That sounds like a very achievable number, but remember that the third quarter was -2%. So analysts are expecting revenue growth to kick back into gear, to turn positive again. My most fundamental concern — and this is why I think the market is going to tread water here — is that it's hard to see how the fourth quarter could be that much stronger than the third quarter, given the economy globally was not much improved.

I would say that equities will outperform bonds, but the two are really tied at the hip for 2013. If bonds sell off very quickly from some exogenous shock, I wouldn't think that money will flows into equities all that quickly. So, to a degree, I'm favorable on equities, but it does require bonds to tread water.


InvestmentNews: Brian, how do those two macro outlooks meld with what you are thinking at this point?

Mr. Gendreau: Our view is pretty much the same as the two previous speakers,' which happens to be pretty much the consensus. That is, another year of slow growth with the growth picking up toward the end of the year to about 3%.

We take a sort of sector-by-sector approach, looking at different components of GDP. Housing is picking up across the board. We see it in existing-home sales, new-home sales, housing starts, pending sales — the trend is intact all the way along.

Basically, house prices stopped going down. Inventories of unsold homes have gone down, although it's important to emphasize that the recovery in housing is coming off a very, very low base. It just makes sense for people to buy an asset that is no longer falling in value.

In terms of sectors? We've seen fairly strong numbers on consumer spending, retail sales and the like, and we think we're going to see more of the same — moderate growth. It's been surprising, because some of the numbers have come in a little better than expected.

Business investment faltered for a while there, though we got a pretty strong durable-goods report last month. So we're looking for more moderate growth there.

Trade has been a surprise, in the sense that the dollar has been trendless for the last couple years. A lot of growth abroad — and growth in the emerging markets — had come from U.S. exports.

Finally, government spending. Here, things don't look really quite so attractive. There's a widespread perception that government spending is bloated and rising. Bloated perhaps, rising no. The stimulus has worn off, and government spending, if you include state and local spending, actually has been retrenching. In addition, because of the payroll tax that's coming on board, we're going to get some fiscal trending this year.

How does it all add up? Well, we're going to see some sectors picking up and others exhibiting moderate growth, and government spending actually exerting a bit of a drag on the economy. What we think this adds up to is something close to the consensus forecast of a gradually rising GDP growth rate.

The market implications of this? We still recommend a substantial allocation to equities. In many ways, this year may well pan out exactly the way last year did, which wound up being a surprisingly good year for equities despite its being an election year and despite there being the fiscal cliff to worry about. Now we have the spending cliff and, coming up ahead, the debt ceiling cliff. I think we're all tired of hearing the “cliff” metaphor.


Despite that, depending on the index you look at, equities managed to turn anywhere from 11% to 16% in the past 12 months. That's pretty remarkable. Valuations are inexpensive. The forward [price-earnings ratio] for the S&P 500 is only 12. Now, if you believe Jeremy Siegel from The Wharton School, the earnings yield, which now is over 8%, is an unbiased forecast of the future real return on stocks.

Well, 8% real — and add to that a 2% to 2.5% inflation rate — brings us up to 10.5% to 11%, which sounds almost too good to be true. But we just had a year where we got that kind of performance.

There is also a perception that stock markets can't do well in periods of slow growth, and it turns out that really isn't true. Historically, stocks haven't done as well in periods of 2% to 5% growth as they have in 3% to 3.5% growth. But they do turn in, on average, about an 8% growth. We did even better than that last year, and so we're hoping for the same.

We're a little worried about bonds. The expected inflation has ticked up. Just in the last few weeks, Treasury yields have gone up. They briefly went above 1.9% on 10-year Treasuries. The [Treasury inflation-protected securities] yields didn't go up, so it almost all reflects long-term expected inflation, which is now running at about a little under 2.6%. Now, a year ago, it was about 2%.

So what we've seen is a slight rise, only about 60 basis points, in long-term expected inflation that doesn't seem to have been caused by a rise in oil prices. So it seems the bond market already is starting to worry about the eventual inflation implications of quantitative easing.

We don't think that a rise in interest rates is imminent, but we think spread products such as corporate bonds — anything that provides a spread over Treasuries — will cushion any rise in rates this year.

We don't think commodities are going to pop this year, given the moderate growth we see not only in the United States but worldwide. We continue to recommend a substantial allocation to alternatives, just because we think this is still a pretty good market for active management and for fund managers to add value by going long or short.


InvestmentNews: I don't want to use the word “cliff,” because it'll get Brian upset, but now that we're beyond it, or beyond the first phase of it, I would like to know what the panelists have to say about the next couple of months. Are there some strategies that might make sense leading into the end of February?

Mr. Colas: I would make two points on that. The first is that Round One of the fiscal cliff seems to have trained capital markets to believe that at every deadline, Washington will come to an agreement at the last moment, and that it ultimately will be a compromise reasonable enough to avoid affecting the economy. I think that is very much embedded in market psychology right now. It's why you're seeing the [Chicago Board Options Exchange Market Volatility Index] so terribly low in an environment which obviously has risks, both earnings risks and headline risk from political change.

So what's very odd to me is that the markets already have incorporated that and have a lackadaisical point of view about what the next round of negotiations could bring. They've seen the movie already, and they know what the ending is. If we start to see that the movie doesn't end the way we expect, obviously, volatility will pick up. But as of right now, the market really thinks they have this entire thing figured out.

If you look at the current state of the market, you would think that the next 90 days will be the most predictable of the year; that everything is locked and loaded. It does not feel like the market is afraid of anything at the moment, rightly or wrongly.

InvestmentNews: Jim, what is your take on that?

Mr. Russell: How do you handle the next couple of months? Clearly, the uncertainty is going to grow here. I think the line is in the sand regarding the Republicans' and Democrats' positions — that is, the Democrats are going to look for additional tax revenue, and the Republicans are going to look for meaningful spending cuts, probably in the area of entitlements.

What scares us is that we've got this budgetary debate, which is spending cuts and its orientation, which to us anyway is a much more difficult thing to pull off than tax increases. Spending cuts deal with congressional districts. Which industries are likely to get cut? Which federal funds are not likely to flow into programs? Which geographies in the United States are likely to take it on the chin? There is a lot of political angst that certain districts and geographies will take the brunt of the cuts.

I think there's also an ideological debate around the Democrats and the Republicans around entitlement spending. It's the third rail for Democrats. But if you add up Social Security, Medicare-Medicaid and the interest on the federal debt, that's 50% of the federal budget every year. You have to attack entitlements if you're going to meaningfully cut spending in any way. So from an investment standpoint, we are nervous about the debate's scaring the public. I think that tying spending cuts to the raising of the debt ceiling is potentially dynamite. I would hope that the politicians view those as two separate issues. I'm concerned that they won't and they will be tied together politically.

Although it seems as though the market thinks everything will be resolved on a timely basis and there won't be any delay, I do think that investors are probably ramping up a little bit and will expect a very noisy, acrimonious type of debate around these issues.

But what I think lies beyond that is, No. 1, a macro economy that's performing reasonably well, not as well as we'd like but reasonably well, and a global economy that seems to be improving and also responding to global monetary stimulus.

If the debate is resolved — let's just dream for a minute — it might put this country on a glide path of lower, long-term deficit reduction. Now that may be asking for too much, but I do think the markets are seeking growth and some degree of guidance out of Washington that would indicate that our debt is manageable and that there is a plan to bring it down a notch or two.

InvestmentNews: Jim, what did you mean by “investors are ramping up”?

Mr. Russell: I think investors are used to the 11th-hour type of negotiating tactics. Unfortunately, Congress used them first in August 2011, regarding the first raising of the debt ceiling, and of course, we just saw it on the fiscal cliff. I think we will wait until the Treasury secretary is screaming at the top of his lungs that we cannot have any more extraordinary measures, and the government will start shutting down before the negotiations get serious.

But it will get serious because of both the linkage between the deficit-reducing spending cuts, which will almost by definition slow the economy, and the possibility that we may get downgraded yet again. Or we may start to close down the government in phases, which has a precedent. We've been there before.

The world would not end if we did. I do think that investors are maybe less panicked about that this time than they were last time. It certainly won't be favorable, but I don't know that it will be seen as a crisis like it was in August 2011.


InvestmentNews: Brian, what's your take on the next couple of months?

Mr. Gendreau: With re-gard to complacency, one big surprise of the last two months to me was that the VIX reading never went all that high. It got up a little over 20, which is pretty close to its historical average, but nothing like the level of close to 40 that it reached in August 2011 when we had the discussion about the debt ceiling. So what was going on there? Was it complacency? Usually a low VIX is a sign of complacency. It may have also been just fatigue on the part of investors or a lot of institutional investors on the sidelines saying, “I'm just going to keep my powder dry until this is all resolved.”

These negotiations are going to be very difficult because they're three-party negotiations. Not only does the congressional leadership and the White House have to agree, they have to sell any agreement they come up with to their constituents — and that's been the hard part.

I think there will be some shocks and some vulnerability. Recently, when there seemed to be good news or good rumors coming out about a potential agreement, the market would go up. When it was bad news, the market would go down. I expect to see more of that.

These problems really aren't necessarily as insurmountable as they're often portrayed. For instance, it has been noted that if spending increases were limited to just 1% below the previous year's inflation — not all the time but just whenever spending becomes higher than its 30-year average, 18% of GDP — fiscal ratios would return to 2008 levels without any tax increases.

Another way of looking at it is that for your debt-to-GDP ratio to stabilize, the government first has to run a primary surplus, meaning that the interest owed is taken out of the equation and the government spends less than it takes in. Then have the nominal GDP growth be a little higher than the interest rate. Well, we're already there on nominal GDP growth — it's much higher than the interest rate. All we need to do is run the fiscal surplus.

Now, these sound like they're easy goals to achieve. Of course, there are many constituents out there who very much want their funding to increase above the inflation rate, and that certainly includes people who get entitlements. But it is, at least as a matter of arithmetic, achievable.

Do I think we're going to achieve that? Not really, no. I don't think these negotiations will result in anything like that envisioned by the Simpson-Bowles deficit-reduction commission. I expected it to be more in the nature of patches. What will the market's reaction to that be? It'll probably be tepid, probably not very excited, but not enough to lead to a big tanking in the market.


InvestmentNews: If history is any guide — I mean recent history — it seems like the equity markets is the place to be. None of you is superpsyched about fixed income right now. But there has to be someplace to be in fixed income.

Mr. Gendreau: First of all, we would never recommend that clients not hold any fixed income, however much we may like equities more than fixed income. But we do like equities somewhat more than fixed income, just because of diversification. I can remember a couple of years ago when I thought that 10-year Treasuries yielding 3% were a terrible bargain. Taking a 10-year risk for only a 3% return? Could Treasury yields fall below 3%? Well, they could, and they did. Could they go down as low as 1%? Well, certainly, they could.

One point I would make is that if there is complacency in the stock market, there's certainly complacency in the bond market. If you actually looked at the projections of what the budget deficits and debt levels for the United States will be, given the explosion that's forecast in spending on entitlements, there is no way you would hold a 10-year government obligation that has a negative yield. That doesn't make any sense whatsoever. It just seems the market is somehow saying, well, when the time comes, policymakers will do that right thing. If that's not complacency, I don't know what is.

Within the fixed-income market sector, I think what makes the most sense is high-grade corporate bonds, because, despite spreads' narrowing, they do provide a fairly attractive margin over Treasuries.

InvestmentNews: Jim, your take on fixed income?

Mr. Russell: We're leaning toward municipal bonds. In a higher-tax-rate environment, municipal bonds have natural advantages. Certainly, we avoid some states on a risk basis. But for the taxable client, we think that not only are tax rates headed higher immediately, we think over time, they may go even higher.

We would agree that there's no huge inflation problem. But we do think that the best you could see in terms of Treasury returns this year would be the coupon. There might even be some price erosion.

We also like selected corporate bonds, as well. They do offer safety. There's probably additional spread contraction to occur, and the coupons are pretty attractive. The higher-grade corporate type of security makes a lot of sense. High yield is very expensive and perhaps prohibitively so.

InvestmentNews: Jim, municipal bonds are potentially on the chopping block in the next round of Washington negotiations. And when you talk about municipal bonds, are you talking about individual bonds? Is that the best way to hold them, or would it be bond funds?

Mr. Russell: The question has been knocked around about whether we should water down or means-test or somehow eliminate the tax-advantaged portion of municipal bonds. We don't have any kind of indication that that is likely. Yet as we all know, that camel's nose is now underneath the tent.

In terms of individual bonds or bond funds, we like the individual muni bond more in terms of the format. When interest rates begin to rise, a bond fund never matures. You will, of course, eventually start to see price erosion pretty quickly in a bond fund — at least in individual municipal bond issues.

InvestmentNews: Nick, what do you think about emerging-markets debt in the fixed-income side?

Mr. Colas: First, I do think that it is a good idea, particularly the higher-quality emerging-markets sovereign debt. It provides a very good level of diversification. Let's face it — one of the biggest challenges we all face is just finding things that aren't 100% correlated with everything else in a portfolio. An emerging-markets sove- reign-debt investment has shown some ability to provide the benefits of diversification.

For anyone who advises high-net-worth clients or higher-income clients, the government's target is your client base. And there is no doubt that further tax increases will have to be part of the fiscal solution that's being politically wrangled about in Washington. So we haven't seen the end of tax increases. I'm convinced that anything that can happen that will tax higher-income individuals will probably happen.


InvestmentNews: A question from a listener: For clients who are approaching retirement and looking for income, but there is risk in the bond market, would you suggest any kind of an asset allocation shift to manage that? Are there ways that people can help their clients manage that in this environment?

Mr. Russell: Increasingly, the income component of our clients' portfolios has been eroded by the reinvestment rates available on fixed-income securities, whether it's in the municipal market, Treasury market or some other market. We have found dividend growth equities to be, in some cases, a suitable partial solution. I'm not saying dump all fixed income and buy all dividend growth stocks. But perhaps substitute in some dividend growth that you get in selected stocks, call it 5%, 6%, 7%, 8% per year, which is beating the pants off of inflation right now. Of course, you do not get that in a fixed- coupon, fixed-income instrument.

One other solution we have used is preferred stocks, which offer a little bit higher initial yield than fixed income, but we don't want to overuse that because of the interest rate sensitivity of preferred stocks overall. So again, what we do is, we try to cobble together a variety of solutions to provide a solution to the very-low-interest-rate environment. By doing so, perhaps we can offset some degree of what we see as zero return, perhaps even a negative return, in the fixed-income markets.

InvestmentNews: Another question from an audience member: Can you address the issue of active management? This is an environment where the active management can actually be more valuable than normal. Nick, would you agree with that sentiment? Can active management play a stronger role in terms of stock selection and fund selection?

Mr. Colas: We've always thought about active management as just generating alpha. But I think just as important is generating an acceptable return while minimizing volatility and meeting clients' needs. So I am a big fan of involved strategies. All of those require some level of active management, even if they're passive strategies, to analyze what drives volatility in a portfolio and minimize it.

What I would hate to see is an active manager who just goes for the fences, and during a market pullback has a big drawdown, scaring a client out of equities. Active management definitely has a role, but it's as much managing volatility and client expectations of volatility as just old-school alpha generation.


InvestmentNews: You mentioned housing in your opening remarks, and there are a couple of questions from some of our audience members regarding the real estate market and the outlook for real estate this year. One of our audience members is asking specifically about [real estate investment trusts]. What are your thoughts with regard to the recovery in housing and real estate generally — how that might translate into investment strategy.

Mr. Gendreau: I can think of a number of ways to profit from the recovery in housing. The most obvious one is just to buy homebuilder stocks. They've already gone up. When housing construction picks up, so do purchases of home furnishings. If people buy a used house, they want to make modifications to it and they go to the home improvement stores.

In addition to that, another way to do it would be timber companies. Of course, you have to watch valuations and the like.

Finally, REITs as an asset class performed very well last year, and I don't know if the fundamentals have changed for those at all. So I'd recommend a diversified approach across all those subasset classes.


InvestmentNews: Did anything in the fiscal cliff deal, most of which involved hiking various taxes, affect your outlook for either the near term or long term?

Mr. Russell: We had to scale back our 2013 GDP forecast a bit. We had thought that the all-end U.S. GDP growth rate would be in the 3% range. Now we think 1%-ish in the first half of 2013, ramping to 3%, so call it all-end 2%. So I do think that our forecast has been scaled back for domestic GDP growth. With that, we were a little bit more optimistic that unemployment would fall in 2013. We've had to back off of that optimism, as well.

InvestmentNews: Can you anticipate any additional alterations to your outlook, considering that this next round might focus on spending?

Mr. Russell: Yes, it is a tough question because we think that the nature of the spending cuts will impact the economy. If the spending cuts are defense-oriented or if they cost a lot of jobs, either from the private sector or from the public sector, we would have to take another look at our forecast, as well. We're hopeful that the nature of the spending cuts won't worsen an already weak labor picture for 2013. So I think that matters. If it's just spending cuts that are entitlement-oriented or service-oriented, we might be comfortable with our current forecast.

InvestmentNews: Nick, what is your take on that?

Mr. Colas: It's something definitely to watch, and we'll know in the next couple of weeks what the response from the consumer is and how that progresses through the first quarter. As far as the current debate, I would only say the following: I'm worried that the political process is more broken than I think even we realize. I'm not altogether convinced that we're not going to see a much more dramatic political showdown with changes in political structure this time around than we did in 2011. So I'm in much more of a wait-and-see mode to see how this all shapes up.

InvestmentNews: Brian, did your outlook alter as a result of the cliff?

Mr. Gendreau: Our baseline outlook didn't alter at all, not in the slightest. What I think it did alter was our perception of downside risk. There has been a growing perception on the part of even some academics that fiscal policy doesn't matter. The idea is that no government stimulus will work, because it leads to higher taxes later on, and then money is taken out of the income stream later on. People realize that now, so they cut back on their private spending to offset their government spending, and so nothing works, nothing matters.

But austerity can hurt. I think there's a little more downside risk, not just because of the payroll tax cut but also because of spending cuts. We don't think it's really going to change our outlook for growth, which would be basically about 2.2% for the year; faster later in the year. There is the chance that we could get even slower growth than that going forward. We think that won't happen, because momentum is building in the private sector, but it is a possibility.

InvestmentNews: One more question about the ultimate defensive position. What do you think about precious metals?

Mr. Gendreau: I'm a bit of a gold bug. I've always liked gold, mainly because I think that the structural argument for a substantial allocation to gold, meaning anywhere from 5% to 10% of a portfolio, really makes a lot of sense. The reason is that the easy-to-get-to ore is now gone. People have to go miles down to get gold in many places because of environmental restrictions and other kinds of restrictions. It takes longer and longer to bring a gold mine into production. Meanwhile, demand is unabated. Not only has private-sector demand from China and India held up well despite the slowdown of global growth, but increasingly, gold is becoming a monetary asset again. Now, we don't know how much they're actually buying in gold, but that's something we haven't seen from central banks in almost two decades.

Gold is tricky on a short-term basis. I think the argument for an upward trend in gold is still intact. The reason gold is tricky is that different factors drive the gold market at different times. Sometimes there's geopolitical risk, sometimes it's supply and demand at the consumer level, and sometimes it's fear of inflation. So we certainly wouldn't recommend that clients leverage up and buy gold at one time or short gold at another time. But we do think it makes sense as a core holding; a small core holding.

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