Edward F. Giltenan
Director of Public Relations
MR. GILTENAN: I'm Ed Giltenan. On behalf of all of my colleagues at T. Rowe Price, it's our pleasure to welcome you here today to our 2013 Investment and Economic Outlook, I have to say given all you've endured over the last several weeks in the New York/New Jersey area, a special thanks for being with us.
We know many of you have had difficult conditions to deal with, perhaps no power. I understand entire neighborhoods of Manhattan have been transformed. Jerry Morgan tells me that SoHo is now known as SoPo for south of the power. We have the usual great panel where we'll look forward to 2013 and beyond. As we were preparing for today's conference, we got to thinking about what a truly extraordinary five years we've lived through in this market.
We've had storms of both the natural and the man-made variety. We've had earthquakes, tsunamis, hurricanes, flash crashes, European debt crises, and now the fiscal cliff or slope. And then the ultimate affront, the ultimate calamity of all time, the apparent demise of the Twinkie is upon us. So I don't know how much we can take, but we'll try to bear up. We're five years from the peak of the market back in the fall of 2007 and about four years from the collapse of Lehman Brothers which brought on the financial meltdown.
So we got to thinking, how have equities and perhaps even a more diversified portfolio performed through this extraordinary period. This first chart that I'm going to show you here is basically the S&P 500 price index.
And as you can see over the last 5 years it's essentially made a round trip after having been cut in half, truly one of the historic bear market declines, only to recover by some 130%.
And then we got to thinking let's look at some other portfolios, and the solid dark blue line on the bottom is the total return on the S&P 500 over this period, dividends included, and you basically got just over 5% cumulative on the S&P, 1% annualized, so that's, certainly nothing to write home about, but it's far from the worst five-year period in the market.
In fact, we looked back to the Great Depression, not the Great Recession but the Great Depression, and there have been six five-year periods in which the S&P lost 10% or more, including one period where it lost just over 40%. So it hasn't been fun, but probably perhaps turned out a little bit better than it appeared it would back in the dark days of 2008, 2009.
The light blue line at the top is bonds which obviously performed the best. And the bar in the middle is a diversified portfolio, essentially a balanced fund. You've got about 4% out of that fund over the last five years. Again, it didn't protect you completely from the damage, but some evidence here that diversification at least helped you weather a truly significant storm.
So finally we got to thinking about people who were in really precarious positions going into this downturn, namely those approaching or actually in retirement, having accumulated a significant nest egg, only to then see it decimated by a market downturn. Let's take a look at what's happened to these people, and the example we looked at was our Retirement Date 2010 fund.
This is the performance of the fund in its 10 years of existence, so you can clearly see the run up to its peak, the peak in the middle there in the May of 2007. It peaked just several months before the market peaked and then it lost 37% of its value only to recover, so that over the full 10-year period of the lost decade you've gotten an 8.2% annualized return on that fund, which is essentially a balanced fund. So there is some evidence here that, again, diversification has acted as a buffer through these very significant turbulent times.
And then to look at even a worse case we thought well, what if we had a retiree who was retiring at the worst possible moment. That would be in the middle of the chart, again when the market peaked. So you can't think of a worse scenario, choosing to retire right at that point.
So we ran some numbers with someone retiring with $500,000 withdrawing at our recommended rate of 4% with an annual inflation adjustment. This person's portfolio dropped to as low as $300,000 at the bottom in March of 2009, so they had to be feeling pretty bad at that point. The market comes back, so that at the end of this September that portfolio is back up to $440,000, even after the retiree withdrew $120,000 in total income over the period. Now, I don't know about you, but I think many of us sitting around in March of 2009, having sustained significant damage to a portfolio like that, I think an outcome like this is something many of us would have accepted.
We don't want to underestimate the turmoil that people went through, but some evidence here that, you know, maintaining some perspective, maintaining a diversified portfolio seemed to serve people relatively well.
So with that I'm going to stop and we're going to get to the prospects for 2013 and beyond, so let's start with our chief economist, Alan Levenson.Back to top.
|U.S. Economy |
MR. LEVENSON: Thank you, Ed, and thank you all for being here. I want to start by relating a story that I heard about Levi Eshkol, who was one of the early prime ministers of Israel who was giving a press conference, and he was asked by a reporter, "Prime minister, tell us in one word how you would describe the condition of the state of Israel," and his answer was, "Good." "And in two words?" "Not good."
And that's the way that I'll describe the U.S. economy. The good things that are happening are in the private sector of the economy, where there's been a great deal of restructuring and adjustment in the wake of the financial crisis that internally self-regenerating part of the recovery gaining traction.
The not good is the uncertainty, and particularly in the policy and the external arena that continues to apply a brake on growth, and this has to do with uncertainty over the fiscal cliff, the fact that we're tightening fiscal policy at all levels of government, and uncertainties in the global environment, and so that I net this out to a not very inspiring outlook for next year.
After 2% GDP growth this year, we're looking for around 2 and a quarter next year and a gradual decline in the unemployment rate, and if there's good news, it's that I think that because of the work that's being done in the private sector, the chances of a relapse into a recession are quite low.
The Exhibit A for the private sector progress is rebalancing in household finances. The chart on the left shows you the debt levels of consumer credit and mortgage credit as a percent of disposable income. We got up to about 125% in 2007 at a peak. We're now back down toward 100%, so we've completed about half of the round trip from the 85% level where we started.
At the same time the saving rate, which was down to around 2% in 2007, too low a level, has now…has been mostly around 4% to 5%, a little lower than that right now, but a more acceptable, sustainable rate of saving. Asset prices have recovered so that net worth is again on the rise and above historical averages.
The more, to me, dramatic or significant deleveraging sign is the right-hand chart, which shows you the carrying cost of debt and periodic principal and interest payments, which has fallen by three percentage points of disposable income to historic lows of less than 11%.
And so that three percentage points means that compared to the peak at the end of 2007, we've now got 3% of disposable income that had been going to pay for stuff that was produced and purchased at an earlier time to buy things now that are currently produced, and so that supports growth in consumer spending.
The other place where a lot of work has been done to clean up the excesses of the housing bubble has been in the housing market. In the left-hand chart, the gray line shows you housing starts, which were running too strong during the recovery, got up to a 2 million unit annual rate, fell by 75% to 500,000 units, stayed there for two years while the overhang of vacancies, which you see in the right-hand chart, was eroded.
And as household formations have picked up, which is the blue line back on the left-hand chart, we're now starting to see some lift for housing starts. So housing had subtracted a full percentage point from growth in 2006, 2007, 2008, turned neutral in 2009, 2010 to a point now that this year it's adding about three-tenths of a percent to growth and will add about four-tenths of a percent to growth next year.
There had also been good work done in the corporate sector terming out debt, harvesting productivity gains—particularly during the depth of the recession there's unprecedented productivity gains, boosted profitability. What you see on the right side is the aggregate profit margin of the nonfinancial corporate sector growing more slowly but at a record level, which is why the left-hand chart only causes me limited concern.
This is durable goods orders, which hit an air pocket in July, in my view, related to uncertainty around Europe and around the fiscal cliff. If I couldn't see the…if I didn't know about the right-hand chart and just looked at the left-hand chart, I would have thought we were in a recession, but I think that what we saw is a pretty broad cancellation of orders and that we're likely to see a recovery in capital spending going forward.
This is a linchpin in the near-term outlook. We went from 5% to 10% growth to zip, but again Capex is doing nothing in the second half of this year. I think into early next year, assuming some resolution of the—or detour around the fiscal cliff that's not as steep—we'll see a pickup there.
When you net all these factors on the demand side, we've had a labor market recovery that on the whole has been okay, not relative to the depth of the recession, but if you look at the blue line, which most sectors of the economy were performing as well in terms of job growth as we did in the last two expansions. The weight on employment has been in the sectors that overdid it during the boom, construction and government, particularly state and local government.
Those are the gray lines, which have only recently turned neutral in terms of their contribution to job growth, so the last 12 months are around 160,000 jobs. We don't think the next 12 months are going to be a lot different. I guess we'll get up to 175,000 by the end of the year, excluding the effects of Hurricane Sandy in the near term, and that'll take the unemployment rate down three- to five-tenths of a percentage point over the course of next year.
And if the unemployment rate is going down, which you see in the right-hand chart, that means by definition that the output gap is closing. This is why inflation has stabilized. On the left is the deflation fears of the 2009/2010 period have been dispelled.
And this explains why, if you will, the Fed is concentrating on getting the unemployment rate down—because the unemployment rate at 7.9%, while a good distance below the 10.1% peak, is also still far above the estimate of the full employment rate from the Fed of around 5.5%, and that's why they're continuing to try to stoke the economy through additional asset purchases.
In September they rolled out a new open-ended program of purchases and mortgage-backed securities—as you know, $40 billion a month linked to the conditions in the labor market and specifically to the pace of job growth.
I think that they're going to supplement that with something around a $45 billion program to purchase Treasury securities when the current maturity extension program, Operation Twist, ends at the end of this year, so the overall pace of purchases at $85 billion a month will be sustained at least through the middle of next year.
By the time they're done, they could end up adding upward of a trillion dollars to their balance sheet from where it was at the end of September. Very quickly let me just go through a few key risk factors. First, the fiscal cliff, and we can talk about this later. You're probably familiar with at least some of these items.
Our assumption is that the current lame-duck session of Congress succeeds in deferring all but…or thinks that the part of the cliff that we fall off of is the expiration of the upper-income tax cuts so that those rates revert higher, the payroll tax holiday ends, and unemployment insurance benefit ends.
Those three items are worth a dollar amount equivalent to 1.4% of GDP. Most of that hit comes in the first quarter. Second is just to remind you that the global environment—even if we do everything right on the fiscal and monetary side, the global environment remains a drag.
As Ken will talk about later, growth in Europe is nonexistent. Europe may be slipping into a broad-based recession. The left-hand chart shows the weakness in the periphery—I show Italy and Spain here—led to weakness in France and Germany, so that recession is broadening, and growth is going to remain weak.
And on the right side you see a depiction of the slowdown in China. This just shows recent data, but the 10% growth rate that we had gotten used to for close to a decade has yielded to what's going to be closer to 7%, with most of that coming out of investments. So our export prospects are diminished by that.
To the upside, our—in terms of export competitiveness and the competitiveness of manufacturers in our home markets—I can talk about a healthier manufacturing sector. The chart here shows U.S. unit labor costs relative to some key trading partners, so there was an increase in relative unit labor costs.
That is a loss of competitiveness in the early part of the last decade, and then we recovered some of that. We could also see a stronger housing market, as I mentioned, and so there are upside risks. I think those are basically evenly balanced.
The last page shows you the outlook in numbers, and I'd leave that to your viewing, and I'll turn the dais over to John Linehan, our director of U.S. equities, to talk about the U.S. equity market.Back to top.
|U.S. Equities |
Director of U.S. Equities
Co-Portfolio Manager of the U.S. Large-Cap Value Strategy
MR. LINEHAN: Thank you very much, Alan. Good morning to everyone. What I'd like to do is talk about the U.S. equity markets.
Every time I read the paper, it's always another negative piece of news, and it really strikes me that there's this huge dichotomy between market performance and market sentiment. And, really, to steal Dickens' quote: "It was the best of times, it was the worst of times."
I actually put this in before the election, so this does not refer to the market preelection and then post-election, but I think that also would capture what's happened there as well.
So going to the worst of times, when we really think about it, a lot of headlines have been written. The U.S. growth is still tepid. Unemployment rate is still very high. There's a great deal of concern, and fears linger about the U.S. fiscal cliff that Alan has already talked about, a Chinese hard landing, European crisis. There's a lot of bad news in the marketplace, and I think it's been a very steep wall of worry that the markets had to climb over this year, and we believe actually that the market is well poised to climb again next year.
So when we think about market performance, global markets have done well. I think a lot of that has been as a function of really the extraordinarily accommodative stance by central banks all over the world, and also you're starting to see some green shoots of recovery.
Alan mentioned the housing market, and I think that's probably the place where the "Great Recession" really started, and in a lot of ways, the recovery has already begun, and just conceptually if we think about housing, housing is incredibly important to the U.S. market for a number of reasons.
It's a very good creator of jobs, but it's, importantly, if you think about the individual and the collateral on the individual's balance sheet, housing equity is probably the primary balance sheet consideration, and if the value of the collateral has increased, which it clearly has over the last year, it's going to make the consumer feel better.
So when we really think about the tug of war that exists right now, there are significant market headwinds and there are significant market tailwinds. On the tailwind side, we have very strong corporate fundamentals and very reasonable valuations. We have had decisive monetary action on behalf of the various central banks. We have improving housing and labor markets, and we have a deleveraged consumer and corporate balance sheets. Those are all positives, and we think these are all going to be present throughout 2013. The headwinds are also very obvious as well: the risk of the recession in Euroland, a hard landing in China, the U.S. fiscal cliff risk, policy uncertainty and regulatory burden, and a cautious outlook for U.S. economic growth.
So our outlook really is one where we continue to see this tug of war existing, but when we think about it, the reason we're optimistic is we believe that valuation remains the key for U.S. equity market performance, and valuation is reasonable. Corporate fundamentals are improving.
And then, lastly, we've seen a massive outflow of retail flows out of equity and into fixed income, and we believe over time that that will abate and, if anything, turn the other way. So when we think about…we have three reasons that we like the markets in here for 2013.
Let's start with valuation. So if we look at valuation, on the left panel you see price-to-trailing earnings, and right now the market's P/E on a price-to-trailing, not price-to-forward, earnings is trading below where it has in the last 60 years during the course of an economic expansion.
In the middle you see where we are right now with the S&P dividend yield compared to the 10-year Treasury, and for only the third time since 1962 is the S&P dividend yield above the 10-year Treasury, and this is also in the context where we're seeing some of the lowest dividend payout ratios in the last 50 years on behalf of companies as well.
So we're seeing high dividend yields relative to Treasuries, and, if anything, we believe that you're going to see that pace of dividend growth continue. And then on the right you see the comparison of the S&P earnings yield against the Treasury yield, and this is kind of the infamous Fed model.
And we're using it—not that it suggests that there is an equilibrium between the S&P earnings yield and 10-year Treasuries—but really to speak to the anomaly that exists right now between what's happening in the fixed income markets and the equity markets.
And I think it is very easy to make a very strong case that equities are a very favorable investment right now compared to fixed income, and in essence to invest in a 10-year Treasury right now, you have to have a very pessimistic view on what the U.S. economy will be over the next 10 years, and in essence you're getting more yield from the equity markets, even if we have no growth over the next 10 years, as we are compared to the fixed income U.S. Treasury.
Also kind of amplifying on this theme of valuation, what we've done here is we've regressed the starting point with the P/E-to-trailing earnings for the market over the last 50 years and then looked forward five years to what your actual returns have been, and one of the things it clearly shows is the lower the P/E at the time of investment, the higher the market returns.
And right now, with a P/E of about 13 times our regression, work would suggest that you should see a market return over the next five years of 13% per annum. That clearly feels high, especially in the context of a decade where we've actually seen flat or just slightly positive S&P growth, but if you look in the context of the last 62 years, the S&P 500's average annual returns of 11% a year, so in that context the regression analysis actually makes a lot more sense.
And one of the things I'll also say is, if we think about valuation, one of the reasons valuations are so low is that the markets are very effective in discounting a lot of bad news, and it's fairly clear to me right now that at current multiples we're discounting a great deal of bad news into the future, and if we don't get that bad news, I think it will be very positive then for equities.
So another reason to invest in equities right now is the strength of corporate balance sheets. On the left you see U.S. corporate net debt, and right now at negative 11% we're actually at some of our lowest levels in the last 40 years, and if we think of U.S. corporate cash right now, we're actually at some of our highest levels.
And going back to what Alan spoke to earlier, right now companies are at very strong balance sheets that they can deploy either into capex or into M&A activity, and we think that both of those will be a driver for positive fundamental improvement in the markets.
Then the last reason that we're positive on equities right now is that we believe at some point there will be a reversal of flows into fixed income and out of equities. Investors chase performance the same way dogs chase cars. They just cannot help themselves.
And if you really think about what's happened over the last five years in terms of flows into fixed income and out of equities, it's really a function of performance, and I think actually the stronger performance that we've seen in the last year, people are starting to feel a little bit better about equities.
It's very difficult to make a cogent argument for 1.5% Treasury yield. At some point, these flows will abate, and to put this in perspective, we've had almost $1.2 trillion going to bond inflows. That's three times the inflows that we saw in the late 1990s go into the TMT bubble.So there's been a significant flow of funds into fixed income and out of equities, and we believe if that just abates it's a positive for equities, and if we actually start to see flows into equities it's a very strong positive. So another way of saying it more pithily is there's a lot of money on the sidelines right now, and if that money comes in, it will be fairly positive for U.S. equities.
So what are some of the attractive areas of the market? In particular, we find the following investment themes attractive: companies with exposure to emerging market consumers. The aspiring emerging market consumer, I think, will be a dominant theme for equity markets, both U.S. and internationally, over the next 10 years.
We think there's some real opportunity on derivative plays on housing recovery. If you look at the home builders, they've had significant runs in 2012, but I think there's some very interesting ways of playing housing in 2013. As an example, some of the major regional banks look very attractive to us.
We also believe companies with growing dividend payments are very attractive—and note we're saying growing dividend payments and not companies with high yields. If anything, over the last year those defensive sectors, consumer staples and utilities, have seen very strong performance, and if you look at valuations they're somewhat unattractive, but companies that are steadily growing their dividends are very attractive in here.
Mark Bussard will talk a little bit later about providers of new treatments in health care. Edwards Lifesciences, Gilead Sciences are great examples of that. We think there's a lot of opportunity there. Companies with exposure to mobile and cloud computing. This will again be one of the dominant investment themes over the next 10 years and then compelling "sum-of-the-parts" valuations in the energy sector. There are a number of companies that are trading significantly below what their breakup value would be, and there are a number of companies I really think are very ripe for shareholder activism.
So in conclusion, valuations are attractive. We continue to think that you will have a tug of war between micro and macro. I think the real reason—another reason we're positive is we have more visibility into the market tailwinds than we do into the market headwinds, and some of the market headwinds could correct themselves over the next year.
Will Europe continue to be a contagion for the U.S. equity markets? If people don't know there's a problem in Europe by now, I'm really, really worried about their ability to steward a company, so I think what's happened is U.S. companies have been able to act and prepare themselves for a potential breakup of the euro, for a potential recession in Europe, so I think that risk is less today than it was a year or two ago.
How does the U.S. resolve its fiscal situation? The answer to this question…really I start with the old Churchill quote: "You can always count on America to do the right thing, after it has exhausted every other possibility." And I think right now we're still in the throws of exhausting every other possibility, but at some point we will see resolution in my mind on the fiscal cliff.
That will be a very strong proponent, a very strong tailwind for the U.S. markets. Which will win over time, macro or valuation? I think if you go back and look at that regression analysis, over time valuation tends to win. In the short term, macro concerns can win, and we really think in the absence of bad news or unexpected bad news over the next year there's a greater likelihood of the markets going up than they are going down.
And then the last is when will investor cash flows again favor equities? I don't want to look into my crystal ball and start predicting that in June of this year it will occur, but clearly the odds of it occurring are far higher today than they were two or three years ago, so that's where we are with U.S. equities.
What I'd like to do now is turn it over to my colleague Bob Smith to talk about international equities.Back to top.
|International Equities |
Portfolio Manager of the International Stock Fund and the International Growth Strategy
MR. SMITH: Thanks, John. I can see we're all a pretty formal bunch. I was looking around if anybody else had taken their coat off and I think we have one other person, so hopefully it'll be a little bit more relaxed when we get to the Q & A part of the presentation.
Over the years I've come up and spoke about the U.S. markets and sometimes when I was running our U.S. growth strategy. A few years ago I talked on the international equities. Scott Berg talked last year. What I'd like to do is first spend a few minutes talking about what we said last year to see whether we were right.
I kind of think we're trying to give forecasts and, if over time, we're bad forecasters then you probably shouldn't come to begin with. And then I'll talk a little bit about the current environment and then go on to what we think will happen in 2013. So Scott, last year—there are a few points I guess I'd highlight.
One is he thought that developed markets would underperform emerging markets, and I'll start with that one because that's the one that wasn't true. The view was that developed markets—and this is internationally, so Europe and Japan—would be challenged, and they were challenged economically, but those markets were better than emerging markets, particularly the big emerging markets would struggle because of a deceleration in their economies.
And so actually last year, and we're going to go through performance, Europe was the best market. He also thought that when you looked at this year that financials might do a little bit better and because they were particularly poor last year in 2011. And it's always interesting when people stop talking about stocks, that's usually a sign that they've about bottomed out.
And I kind of found toward the end of last year even the value people didn't want to talk about financial stocks, but in general financials have had a better year. We'll talk about that as well, so I think he got that one right. He said politics will matter, and I think this is worth talking about because, you know, we look at stocks.
We don't look at markets, we don't think about the bigger picture things as much as, maybe, Alan would particularly on the economic side, but policies by governments have really impacted stocks over the last several years, and I think Scott was right on that, and we'll again touch on that when we talk about what we think will be happening going forward.
He also mentioned that in EM that the non-BRIC countries would actually perform better, and he got that one right as well, so we were, I guess, three for four last year. Hopefully we can kind of continue along the same path. This slide here is – I put my conclusions different than John. I put the conclusions up front partly because I have a very short attention span and I figure maybe you all do, too, so we'll at least lay them out, and then what I'll do is I'll go through some slides to kind of support each of them. I'll start with a disclaimer up front, which is, again, I'm talking about international markets as a whole.
I am one portfolio manager. I will try to give our collective mind from our international group but it will be painted with Bob Smith's brush, so you'll have to deal with that, and when we talk about particular sectors you might find other PMs that have slightly different views.
In the last 12 months – I'll shoot forward –what's really driven stocks has been policy, and I find the interesting quote on this one is really when you look at Draghi's comment, "and believe me it will be enough," and really after that quote Europe did exceedingly well and it kind of separated itself in July of this year from other markets.
This is a market that really wants certainty, and it really dislikes the uncertainty in the market. I think part of the reason that you've seen EM do worse is because people really haven't felt comfortable with China policy. They haven't really felt comfortable with what's happening in Brazil.
They haven't felt comfortable with what's happening in Japan, but with this one statement it basically said we are going to support sovereigns and we are going to support markets, and that little bit of certainty seemed to have been quite dramatic in how it impacted equities.
Over the 12-month period, and this actually goes back 24 months, I would say markets have been surprisingly strong, and particularly Europe. I think Europe, if you had kind of painted a situation of what occurred from an economic point of view and what's occurred from a policy point of view, it would be surprising I think for people to have thought Europe would be the best market in international markets over the last 12 months.
And again, it's really separated itself more from this summer versus other markets, but it's been quite strong. And again, if you tie Europe's performance, but if you look at the uncertainty index every time uncertainty came down markets would go up, I think it would make sense.
And when uncertainty went up markets would go down, and we happened to on a year-over-year basis lapping against the highest level of uncertainty about a year ago when we were here, and that uncertainty has come down somewhat I think as people felt that policy and the risk of the euro ending as a currency is probably somewhat less, and that's been a big driver of the market.
When we sit and talk about where we think markets will go over the next 12 months, I always refer to Peter Lynch's comment, which was over time markets get driven by earnings, interest rates, and the expectations of earnings and interest rates, and if you really thought about the last year, earnings haven't been okay.
But what we're going to go through later is expectations of earnings have come down, but it's really been interest rates and the expectations of interest rates that I think have driven markets, and comments like we will keep interest rates low forever have been extremely supportive of equity prices.
If we look at the components of what drove the last year I think that it's again surprising. This goes back to John's comment where he said, it hasn't really felt that good this year even though the markets have been good, and I think part of it is what's really driven performance have been safe stocks.
If you look particularly at health care and consumer staples, usually when you have a good market they aren't the driver of good markets. They are the market – they are the stocks that help you in bad markets particularly, but this has been unusual. It's been – and we'll see this later as well, that it's been kind of a riskless rally in terms of what's driven stocks.
Health care is a great example. Pharma, which I was talking with Mark Bussard about this earlier, is that if you went back two or three years ago pharma did poorly because, well, in pharma you know the pipeline of a company, and so you know with certainty when things fall out of the pipeline or go into the pipeline.
And so two or three years ago people didn't want to own pharma because they felt with certainty that there really wasn't anything good moving into the pipelines, and there were few things moving out that were bad, so there was pretty high certainty that there wasn't much growth.
This year they've been great stocks because they are certain that things are going to be flat and they're not going to go down, and so it's interesting how pharma has been rewarded for this. Even though we've moved a little bit through the pipeline drop-off, it's that certainty of consistent dividend cash flow which the market now likes because it's uncertain about growth.
I guess the last point I would say, and this is another chart that kind of just talks about the riskless rally, is if you look at defensives versus cyclicals they've been exceedingly strong, and that's really where we enter this year.
And I think one of the issues we face, and particularly in Europe when you look at our conclusions, and if you go back to slide 34, which is where we're going to go off of in terms of what we think will happen in 2013, is developed markets, and I'm mainly talking about Europe here, have a tough 2013 ahead of them because earnings estimates have come down.
And you can see on this chart developed markets – it's a little bit confusing, but you can see expectations for growth in 2013 have come down somewhat. I think if we think about economic growth in Europe in 2013 we think it will be kind of flatlined. It could be a recession, it could be modest growth, but it won't be strong I think it's pretty safe to say.
And if you look at what the defensive stocks have done in Europe they've done exceedingly well, and so you have defensive stocks that have moved up to all-time premiums relative to the market, and the reason this matters is because if you are a company growing 8%, maybe 9% even though you're consistent if your stock is up 25% to 30% in a year, you've kind of discounted three years of earnings growth in one year, it is really hard to continue to compound at high rates if you have to then just rely on earnings.
And the multiples have moved up for most of these companies to a level that it might not be real rich, but it surely isn't as cheap as it was before, and so it'll be more difficult for the safe stocks to drive this market. I think they can sustain it, and we'll talk a little bit about why we think the expensive stocks will stay somewhat expensive.
And if you look at the risk stocks they'll be hurt by just the difficulty of earnings growth, and so Europe we think will be somewhat challenged, and it's priced—you know, really it's priced, so if I think about the European market it's a little bit like going to the race track and you go in and, the favorite's at the rate he's favored at, and then you have the longshots, and maybe the favorite's at even money and the longshot's at 20 to one.
And race by race it keeps going and the favorite keeps winning every race, and we're now kind of at about the 10th race and the favorite is now going off at 1:5 odds and the longshot is going off at 50:1, and so you really are paid in Europe to take risk but you haven't been rewarded for it, and so it's just a time where you probably do need to take some risk in Europe.
Moving on to emerging markets, the real disappointments in 2012 have been the bigger emerging markets. China has been difficult. Brazil has had a very difficult time, and India’s market has done better, but I think the economy in India has struggled more recently, and we do think that will get somewhat better this year.
So if you look at economic growth, particularly in China and Brazil, we think both of them are kind of somewhat bottoming out, so Brazil appears to be getting a little bit better. Our view is that China should have somewhat better economic growth and a little bit more clarity on policy as we work through the new administration in the Chinese government.
That'll be clearer I think sometime in 2013, but we think it's somewhat bottomed out and I think it will change sentiment somewhat. I think that sentiment on these bigger markets should improve, and so particularly we think that some of the discretionary spending stocks in those areas should begin to do better. I know we made this prediction last year, but we do then think that EM will do a little bit better than mature markets.
In terms of the safe stocks versus risky stocks, if I was going to take one slide or one thought out of my presentation that I think is really the crux of the issue in equity markets it's this one. Last year, or I guess moving into this year, people have felt comfortable moving from fixed income to safe equity, and that's sort of the first bucket to the second bucket, and maybe it's when high yield rates got below 6% or started to get to that level that a dividend of 3% to 4% for a pretty safe company seemed pretty attractive, and so we've been able to see safe equities go up in valuation.
What the market hasn't done yet is to be able to move money from safe equities to riskier equities, and I think when you think of this year I think slowly that will begin to happen. I think what it will take is for people to feel better about the intermediate term, so I think people have to feel a little bit better about the U.S. fiscal cliff and that the U.S. is in a better two- to three-year time horizon.
I think it will take people feeling better about Europe holding together on a sustained basis somehow as we move through this year, and I think it'll take people feeling better about China in the next five years as the new administration comes in, and Brazil and other markets where they feel better that governments aren't going to be so difficult on companies.
And I think that will slowly occur over the next 12 to 24 months, and I think during that period I think then you will see markets move into riskier assets, and so I think that's really where the opportunity will be, but it's going to be one I think that will slowly develop.
The last point is just in terms of broadly, and this is not that different than what John talked about, is valuations as a whole, if you look at developed markets, look reasonable. EM has come down to where I think that's being valued at a more reasonable level as well.
If you went back to when I took over running the international strategy in September of 2007 emerging markets probably had some of their higher valuations over recent time, but I think they've come back to being more attractive.
And then if you look at interest rates, interest rates are very low and we think interest rates probably remain low for a long time, and that should be supportive of equities as well. So moving from equities into fixed income, Mike Gitlin will present to you. Thank you.Back to top.
|Fixed Income |
Director of Fixed Income
MR. GITLIN: We've had, in my view, a few things that make the fixed income markets now more risky than they've been at any time in the last few years.
One is this unprecedented monetary experiment that we've had around the world, where the Fed's balance sheet is almost $3 trillion dollars and the ECB [European Central Bank] about €3 trillion. We've had two generational bear markets in equities in a decade, which have caused massive flows into fixed income and out of equities. That will reverse at some point.
When you add those things together, it's caused really stretched valuations in fixed income and the chances for cash flows to go out.
The policymakers have said we'll keep interest rates low forever. The dot, dot, dot after that is until we realize we have to battle inflation—and then rates are going to go up a lot.
Now, I’d like to talk about a couple of realities, a few risks, and opportunities. The reality is you've been paid for taking risk in fixed income, so the more risk you've taken since March 2009 through September 2012, the better the return. High yield and emerging markets did a lot better than mortgages and Treasuries, and CCC and B rated bonds did a lot better than AAs and AAAs, so you've been paid to take risk.
Another reality is that when you haven't had high-risk instruments like mortgages, UK 10-year sovereigns, U.S. 10-year sovereigns, you still have a lot of demand. So that $1.2 trillion of inflows have given you demand everywhere in the fixed income markets when money markets have paid zero.
Third, risks are rising. I want to talk about five risks today, all of which give us pause for concern in the fixed income markets.
Valuation risk: If you look at all-in yields of 10-year Treasuries, investment-grade corporates, emerging dollar sovereigns, and high yield, you'll see that they're at all-time lows across the spectrum, and this is against the backdrop of deteriorating credit quality.
So on both of these charts showing investment-grade corporates and high yield, a ratio of 1.0 means the same number of credits are being upgraded as the number of credits that are being downgraded. In 2008 and 2009, a lot more was being downgraded, and then in 2010 and 2011, we went through this big upgrade cycle, and that's starting to wane.
It's already waned in investment-grade corporates, and it's beginning to wane in high yield, so you're getting paid historically low all-in yields for potentially more credit risk.
When I speak to clients around the world, what we see is they've been involved in emerging equities for a long time, but not in emerging debt. And so they started getting involved in emerging market debt a few years back and they liked what they saw.
We’ve seen annualized returns of emerging market debt of 11% or 12% for the last decade, so in the next decade it's not going to be 11% or 12%. It might be mid- to high-single digits, but it's still quite attractive.
Everyone knows about the flows that have come into high yield. We had to close our U.S. high yield strategy to new investors in April last year because the flows were massive and it was harder and harder to find places to invest, and we wanted to make sure we could take care of our existing clients.
The other one is liquidity risk. Liquidity is really important. If you look at the primary dealers precrisis, they had—in their facilitation book, in their proprietary book—a lot of corporate securities on their balance sheet and close to $300 billion in aggregate across the primary dealers.
Now they're holding a lot less inventory, so that nearly $300 billion of inventory is now $50 billion. So that's fine until you have a risk-off event and someone needs to buy what everyone is trying to sell, and the broker-dealers who had been the backstop beforehand aren't there anymore to be able to buy what they had bought in the past.
And I think that's a risk right now that's being wholly disregarded because that requirement isn't there for people because people have been looking for paper and not trying to sell it. That's a risk that if we do have a risk-off environment, you'll see that come to fruition and people will say, "where did all the liquidity go?"
One thing we should have learned from the crisis is that the biggest risk of all is interest rate risk. So because policymakers have said rates are going to be effectively zero forever, people have gotten too comfortable with interest rate risk.
If you look at the left side, you can see investment-grade corporate bonds have a 7.2 year duration and a 2.7% all-in yield. A 100-basis-point hike in interest rates and you're down 5%, and that's just the start. That's coming from a very low base.
I really believe that the policymakers are saying that when we look at current conditions, we can't forecast a time when interest rates may go up. But as conditions improve, they'll say things have changed and now we can give you better insight to rates going up sooner than we had expected based on the fundamentals of the economy.
They leave in their policy statements that discretion, and I think that risk, like liquidity risk, is being totally underestimated by the marketplace. While your yield is more supportive for emerging market sovereigns when rates go higher, you still have a lot of duration risk in these bonds.
Credit risk: One thing that concerns us as well is the quality of new issues is going down, and we can see that in the bank loan market. We're seeing covenant-lite loans.
If you would have said coming out of the financial crisis that three years later you'd have this wave of covenant-lite deals coming to market, you'd all say no way. People will remember that, and they'll never let issuers get away with that again, and that's not true.
So if you look at the total value and volume of deals, covenant-lite loans are back. PIK toggles are back, where down the road the issuer decides that they're unable to make their payment to you and they decide to issue you more bonds instead.
That's not a great deal, but now you can get those deals done because people have too much cash to put to work. And having to put that cash to work, they're willing to take covenants that aren't as good as they had been in the past. So the average quality of deals is coming down.
In the loan market, we're seeing testing of those 1% LIBOR floors, nonstandard call provisions, narrower concessions. If you look at deals even in the investment-grade corporate market, you have deals now that are six times oversubscribed with zero concession to the secondary bond that's already trading.
What the debt capital markets desks on the street will tell you is, we price them where the demand is, and the demand is coming because of the technicals of the inflows. And what that leads to is lower credit quality—weaker new deals in terms of what we like to see.
Our participation rate is going down as the quality of deal flow is going down. So this all presents to me a pretty big risk in the market—that when you start seeing things like you did in 2006 and 2007, you should start being concerned.Fixed Income Opportunities
But there are some opportunities still out there. I picked three of them. They all yield in the 5% to 6% range, and it's across the duration spectrum from zero to nine years: bank loans, emerging market local debt, and BBB rated munis.
Emerging market local sovereigns: Emerging dollar sovereign issuance is going down, and emerging countries are issuing more bonds in their own currency. The average credit quality of emerging local bonds is investment grade. I think people have a ’90s mindset of, if it's emerging it must be subinvestment grade, but we've had this massive upgrade cycle and it is now investment grade. And the yield is higher than the duration.
While you still have duration risk of 4.7 years, your yield is pretty supportive of that. Over the last year, we’ve seen strong return in this sector, but we haven't had that drive from the local currency, and I think we'll get that in the future. I believe the U.S. dollar is in secular decline.
From an all-in yield perspective, yield to maturity, we're at historic lows like we are across all of fixed income. But if you look at the spread relative to five-year Treasuries, we're at the average over the last five years.Bank loans: We had heard that we were all highly worried about this wall of maturities, and that wall has been pushed out. It's been refinanced with all of the flows that have come into the market, so that's a good thing. Default rates over a long period of time relative to high yield are very similar, but bank loans are supported by being very often first-lien leverage loans.
So they have higher recovery rates in the event of a default, close to 70%. So the maturity wall has been pushed out, the default rates are low, and the recovery rates in the event of default are high. Another thing I'd say about bank loans is that quality matters, so right now the market is rewarding CCCs.
We are a core conservative manager. We focus on Bs and BBs. Why? Because if you look over the last 16 years, BBs have generated two-and-a-half times the return of CCCs for half the volatility or less than half the volatility. There will be periods of the cycle like now, where the worse the quality the better the performance. But over cycles, BBs and Bs are the place to be in the bank loan market, and you take less risk.
Municipal bonds: A lot of the cumulative budget gaps have been addressed through spending cuts and tax increases. The states, in general, have done a pretty good job of facing the fiscal issues in addition to having an improving economy.
If you look at the tax-equivalent yield of BBB munis, again you're up in that 5% to 6% range. So bank loans, emerging market local currency debt, and munis all have these 5% to 6% yields with some technicals and fundamentals that we think are supportive.
At the same time, you have to have an incredibly pessimistic view of the world to buy a 10-year U.S. Treasury at 1.68%. That being said, a BBB muni, where you're able to get a taxable-equivalent of 5%, looks a little bit more attractive. We're not trying to make headlines and call this a bond bubble. But we are trying to say that while equity valuations are compelling, interest rates are at all-time lows; we have real interesting monetary experiments going on in Japan in addition to Europe and the U.S.; and that we are concerned with some of the things that we're seeing in the fixed income market.Back to top.
|European Financial Crisis |
Portfolio Manager/Analyst, Fixed Income
MR. ORCHARD: Thanks, Mike. So I'm going to give you a very high-level overview of what we think about the eurozone crisis, and contrary to what Mike said, I'm not going to be entirely negative. I'm not going to tell you that the eurozone is going to fall apart, and I'm not going to tell you that it's all fine either.
We have, I think, a rather nuanced, balanced view of looking at the crisis. Now first of all, I think it's instructive to think about what exactly is driving the crisis in Europe, what are the underlying structural causes of the crisis. A lot of people call this a sovereign debt crisis, but I think it's really so much more than that.
I know we think of it as a triple crisis. The first area is the competitiveness and balances that arose following the formation of the eurozone in 2000, and you can see that on the top left-hand chart. This is nominal unit labor costs in the various countries, and the line down at the very bottom is Germany, and all those lines at the top are in various other countries in the periphery and France.
And you can see how they diverge quite significantly over the period, and that has led to big differences in current account balances. Germany and some of the other core countries in the north are running very large current account surpluses and then the periphery countries running very large deficits, and of course those deficits have to be financed.
And so they were financed by capital flows that were going from the northern countries to the southern countries usually through the private sector banks. Now, the other part of the crisis is the fiscal deficits, and I would emphasize here it's not high debt, high sovereign debt per se, that we think is the problem.
But it's really these unsustainable fiscal deficits, that when you combine these levels of deficits with rather low GDP [gross domestic product] growth for the foreseeable future that means the debt ratios are really unsustainable, and they're projected to be rising in most countries for at least a few more years.
And down at the bottom it shows high debt levels, and you can see that it's not just sovereign debt that's the problem in Europe, but it's also household debt, corporate debt, bank debt in general is very high. Particularly in the period from 2000–2006, 2007 private-sector debt increased significantly in the eurozone.
And you can see in general Europe has very high debt levels, compared to the U.S., which is on the far right-hand side, really the only major country with debt levels lower than the U.S. is Germany. Now the economic background, as Alan mentioned, is still very challenging.
The chart at the top shows our eurozone financial stress index, and you can see that over the past few months we've seen quite a big decline in financial stress in the eurozone, and in a normal situation you would expect that to lead to some rebound in economic activity but, in fact, we haven't seen that.
The purchasing managers’ indices have not really rebounded. These aren't a perfect predictor of GDP growth or not a perfect correlation with GDP growth, but I think they give a pretty good indication. And you can see that we've seen very little rebound and, in fact, no rebound in some countries in the past couple of months despite the improvement in the financial markets, and unemployment rates continue to rise, of most concern.
In Greece and Spain we're now at 25%. This is probably somewhat elevated for reasons of the way that the labor market is structured. In reality they're probably lower than that, maybe 17%–18%, but still they're incredibly high, and this makes it very challenging for the governments to balance their books when you have such a large number of people that just aren't working.
So how do we solve this crisis? Now, if this was an emerging market, well, then the recipe would be pretty simple. Usually you have devaluations, you have debt restructurings, both sovereign and the private sector, and then you also have large-scale bank recapitalizations, but of course the eurozone is not an emerging market.
And because of the fact that it's sort of an institutional political construct, this typical recipe is really not possible in the eurozone, and so there's been a lot of focus on what are often called bazookas over the past few years, and these are really liquidity infusions.
Now, these have been the EFSF [European Financial Stability Facility], the ESM [European Stability Mechanism], the LTRO [Long Term Refinancing Operation, the Eurobonds and now most recently we have the ECB's [European Central Bank] announcement that it will do OMT. These are the outright monetary transactions, and we think they fall into the same category, and they can buy a fair amount of time, but on their own liquidity does not solve the underlying structural drivers of the crisis that I talked about at the beginning.
They can reduce economic and financial stress that allows for some of the adjustments to take place, but liquidity on its own does not solve the crisis. So we think about it as the critical question: Can the countries—and Spain I think is key, but this applies to all of them—can the periphery countries undertake this competitiveness and fiscal adjustment and reduce debt while staying in the eurozone?
Now, we think the answer is: Probably. The problems are not insurmountable if the correct policies are followed, and here I don't just mean domestic policies. I think the broader eurozone policies are important as well. There’re definitely going to need greater integration and mutualization of risks in order for the eurozone to succeed over the long term.
But I think we can't kid ourselves also that this adjustment within the confines of the eurozone—with the eurozone—is going to be very difficult and it's going to take a long time, and this crisis is going to be with us still for at least a few more years.
And finally we have to recognize that this is an economic, social, and political experiment. There are no instances in the past that we can point to that we can say, "Look, here was a similar situation or a similar country that went through this sort of adjustment and did it successfully."
Other large sovereigns that have gone through similar adjustments have usually done so in a very different environment, so if you look at countries like Canada or Sweden in the 1990s that went through big fiscal and competitiveness adjustments, they were able to reduce their exchange rate and they also had a very buoyant global economy that really helped them along.
And we don't have that happening right now, and so the question is: How much can we expect the populations in a large, modern democracy to accept? And these politics of austerity that we have going on in places like Spain right now are very difficult, and I think it's an open question: How high can unemployment rise before people start to say, "We are no longer willing to do anything more. We like the euro. It's very important to us, and yet we've reached our limit."
So, this is sort of like the limits of the analysis of where we can get to and say there certainly are some very uncertain… We're in a very gray area. Looking at the adjustment so far in the eurozone, we figured that the competitive adjustment is about 50% complete.
The chart on the left shows current account balances in the periphery countries, in France, and you can see there's been a fairly significant shift over the past 12–18 months, where most of the countries’ current account deficits have declined. Ireland is now running a current account surplus.
Now, we figure that most of these countries need to be running current account surpluses. Because they've got so much external debt they need to shift to a current account surplus in order for them to be able to start repaying that debt. And so when we look at current account balances we also look at some other things, such as unit labor costs relative to Germany, and we estimate that the adjustment is about 50% complete, so I think that's the good news.
The fiscal adjustment, slightly less good news. We estimate that it's about 40% complete, and this chart shows the comparison of how much countries have done so far in the fiscal adjustment versus how much they still need to do, so the gray bar shows what they actually have done so far from 2010 to the middle of this year, the blue bar shows what they still need to do in order to get to their 2015—2016 targets.
And you can see that for Spain and Ireland in particular there's still a lot of ground to be covered. Other countries are in slightly better shape, but still it's a long way to go. Countries like Greece and Portugal, where on this measure have done more than half, are still looking at adjustments in the range of sort of 5%–6% of GDP which is very large.
Now, in terms of deleveraging we've seen very few signs of it happening in both the private sector and the public sector. On the left chart it shows the private sector and, other than Ireland, which is the line on the top, you can see coming down, there's been very little deleveraging.
I know Ireland has restructured its banking sector and shifted a lot of loans off the bank's books to an outside management agency, so that's the reason you see that. And in the public sector we still have debt-to-GDP rising for all countries, Greece being the line at the top. You can see even with the debt restructuring that it went through in March, debt is again on a rising path.
Now, how do we see this all ending? We think there are three possible outcomes. The first one we call Grande Italia, greater Italy, and this is the path that we think the eurozone is on right now.
We call it greater Italy because the eurozone turns out looking a little bit like Italy does now, where you have a relatively wealthy prosperous competitive north and you have a poorer, much less competitive south, and you're going to have to have transfers from the northern countries to the southern countries in order to make it all sustainable and to make it work.
The northern countries are not going to be happy about this, but at the same time they're not going to be willing to blow up the eurozone and the European project, and so they basically are just forced to accept it.
Now, the middle scenario is Foderales Europa, or federal Europe, and this is where Germany would like things to go, and Germany has been pushing quite hard in order to get the eurozone down this path for the last couple of years, and this is where the eurozone ends up looking a little bit more like the United States, where you have quite strict limits on how much the individual states can borrow.
And so debt ratios are able to come down at the individual country level, but you have more borrowing taking place on the eurozone level, and you also have countries pushing through very tough fiscal and structural reforms in order to make the periphery countries more competitive.
Now, the problem with this scenario is that it is going to be very difficult for the periphery countries to do this. It could be bumpy and we wouldn't be surprised if some countries don't make it, particularly thinking about countries like Greece, which we think there is a moderately high probability that they could be leaving the eurozone in the next couple of years, or Cyprus as well.
And the final scenario is the eurozone breakup, which we see as the least likely out of the three scenarios, but still has a material probability attached to it. Now, this is not a tail risk, and this is where the eurozone dissolves into either 17 new currencies, or there could be the remnants of a block in the north, and then individual currencies again in the periphery countries.
And it is, in fact, driven by just the social and political exhaustion with this adjustment process, and the people and the politicians at some point just feel that they're no longer able to push this austerity and adjustment onto their populations. It could be preceded by sovereign and bank defaults, and it also could be initiated by both weak countries or strong countries.
Now, we've seen in countries like Finland and the Netherlands, that there is a fairly material Eurosceptic factions in the population and in politics, and it is possible that at some point in time if you had Finland, for example, saying that, "We don't want to pay into the eurozone anymore, we don't think that this is important enough for us, it's not worth it," well, then that could start to undermine the eurozone from the strong end of it rather than the weak end of the bloc.
Now, finally a road map of how things might develop over the next couple of years. I won't go through all of these, but one thing to highlight in terms of the items to watch are German elections in September, and these are important because the closer that we get to the German elections we think that it's going to make action more and more difficult.
The German government's hands are going to become increasingly tied because they don't want to do anything that could jeopardize their reelection chances, and so they're going to become increasingly reluctant to commit large sums of money or enter into big new long-term commitments for countries the closer they get to the elections.
In terms of the known unknowns, the Spanish rescue program, frankly we don't know when this is going to happen, but we're fairly certain that the Spanish rescue program is going to need to get bigger and broader. Spain does have the bank rescue program now, and we think that it needs to shift to a sovereign rescue program. That is probably going to happen sometime next year. It may take some market stress to push them to do that.
A Greek eurozone exit, as I mentioned, we think is a material risk next year. The recent package of fiscal and structural reforms that the Greek government pushed through is going to be incredibly tough, and we have concerns as that starts to be implemented in next spring that you could see people on the streets in Greece again, and the government, which is not very cohesive and not very strong, could be unable to stand against those sort of protests.
And finally the amount of social stress I mentioned at the beginning, Spanish unemployment is now at 25.8% as estimated by Eurostat. It's been going up by a few points of a percentage point every month, and you're seeing protests on the streets of Madrid more frequently. Exactly where is the limit to austerity in Spain before people say no more? So I'll stop there and hand it over to Mark.Back to top.
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