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  • April 27, 2012

    In a recent conversation with T. Rowe Price's Todd Cleary, Chief Economist Alan Levenson and fixed income Portfolio Manager Dan Shackelford discuss the state of the U.S. economy and the financial markets.

    The Economy: A Look Back

    Todd Cleary: Hi, I'm Todd Cleary with T. Rowe Price and this is Market Update. I'm joined today by Alan Levenson, our chief economist, and Dan Shackelford, portfolio manager for our Inflation Protected Bond Fund and the New Income Fund. Let's talk about the economy. Alan, where do we currently stand?

    Alan Levenson: Well, the economy is growing steadily, if not too fast, at around 2½%. We're still not getting much contribution from housing, but housing is not a drag anymore. There's much less of a downside risk for the economy. Part of the good news—or part of the best news—has been more progress in the labor market. We're producing about 200,000 or 250,000 jobs every month. The unemployment rate is coming down, and there's evidence that this trend is better maintained and will be better maintained than it was last year.

    It's important to remember that last year we had not just an oil price increase but a broad commodity price increase; it took a lot of money out of consumers' pockets. This year, gas prices are up, but electricity costs are down, natural gas costs are down, and food prices are flat. So there's much less of a bite on consumer purchasing power from the inflation side of things.

    And, of course, we have not, thank goodness, experienced another earthquake or big natural disaster disruption to the manufacturing supply chain. So I think that the growth outlook is firmer. There's a little bit more risk that we could see better growth than about that 2½% rate that we're expecting.

    Cleary: So between construction and some other factors, there are some good signs there but still some challenges.

    Levenson: Yeah, I mean again, the good signs are there are two ways to look at it: [one] is that the worst parts of the financial crisis seem to have healed substantially—not just that housing construction is finally starting to rise gradually; state and local cutbacks are in their later stages; [and] the financials sector, in terms of employment, has stabilized. And so those drags are easing. And then in the meantime, consumers are making progress leveraging, and they're starting to spend a little bit more freely, and business capital spending on new plants and new equipment has also been growing.

    Cleary: Right, some good signs of hope there.

    Levenson: Absolutely.

    Cleary: Yeah. Alan, do you think we can sustain the decrease in the unemployment rate going forward?

    Levenson: I do. I think the unemployment rate is on a steady downward path. It won't be as fast as we've seen in the last several months, where in October we were at around 9.0%, we fell to 8.3% in January [and] held there in February. So that's .7 of a percent over three months (would be two percentage points or three percentage points every year); we're not gonna see that. I do think we'll be below 8.0% by the end of this year, from 8.3% now, but part of what happens is the labor market improves—is that you have people who aren't in the labor force looking for work, deciding that the time is right to go find a job. When they enter the labor force, generally, they're unemployed at least for a short period of time first and that can back the unemployment rate up a little bit. But the general trajectory will be lower.

    The Price of Oil

    Cleary: The conversation around the price of gas seems to have really picked up in the first quarter. What are your thoughts on oil prices?

    Levenson: Well, you know, just to back up a second, the reason that there's always so much conversation about the price of gas is that everybody knows what the price of gas is. We drive by gas stations every day. And oil prices rose earlier this year in response to heightened tensions in regard to Iran's nuclear program. And so gas prices are gonna continue to see that pass through as we move into the spring. There is a seasonal changeover to the higher oxygenation levels and the like. But the fact is that, unlike the year-ago increase in gas prices, this was really isolated in its cause to that geopolitical stress. While gas prices were rising, natural gas prices and electricity prices were falling, and they're also a significant part of the consumer energy basket. And where last year we also had a rise in commodity, food commodity prices that was pushing on inflation, we're not seeing pressure there as well. So in terms of the overall impact on consumer pocketbooks, it's going to be much less than what we saw a year ago.

    Cleary: And seems to be really driven by the geopolitical factors as opposed to the other categories.

    Levenson: Yeah. And the fact is that from mid-February, the price of oil has been pretty much stable at $120.00 to $125.00 a barrel, and so once we fully pass through the increase that we saw over the winter, we're looking at a much calmer environment.

    Progress in an Election Year

    Cleary: In an election year, progress seems to be stalled in terms of passing a federal budget. How do businesses and the economy continue to grow in an environment like this?

    Levenson: Well, you know, it's an interesting question, and there are two parts to it. I think that we've gotten used to carrying on with our private sector business even as budgets get put together on the fly. It's been a long time since Congress actually enacted a budget by the end of the fiscal year—that is in September for the next October-to-September period. They tend to finance the government with shorter-term resolutions. The bigger issue in the election year is that at the end of this year, all the Bush tax cuts expire, we have got this super committee from last fall instituting spending cuts that start in January, and if there's no action to offset any of that before the beginning of the year, that could be a hit to growth of two-and-a-half or three percentage points of GDP [gross domestic product]—it would be a big threat to the expansion. And, you know, you'd think that that might be causing some hesitation on the part of private decision makers in businesses or individuals, and I think the broadly held assumption is that after the election, the lame-duck Congress and whoever the president is will kick that can down the road to soften or mitigate completely the impact of those policies.

    Cleary: Dan, a lot of what we're hearing and seeing on the news now is all about the election. How connected is the election in terms of the economy now and all the factors that we face in the markets?

    Dan Shackelford: Well, that's a very good question because, as you recall, last summer it was certainly the inability of the Democrats and Republicans to come to some sort of compromise on the budget, in addition to the downgrade of the U.S. Treasury market, which, I think, just took a real swipe at confidence, and we saw a tremendous rally in bonds. So what I would like to see coming out of this election would be more balance, perhaps, between the Congress and the president and some hopeful or more optimistic ideas about how to solve some of the longer-term problems. The real overhang in the bond market, I think, is longer term. It's the structural issues in the U.S. budget, and it seems like we've had lots of talk about it but very little action. And I would like to think that with the election behind us, that Congress and the president, whoever that is, will be willing to sit down and start negotiating and get serious about the longer-term structural problems.

    The Markets: A Look Back

    Cleary: Dan, the markets seemed to be fairly optimistic about economic recovery in the first quarter. What are your thoughts?

    Shackelford: Well, there are some good things that happened in the fourth quarter of last year and into the first quarter of this year. So let's start with Europe, which was a problem in the fourth quarter and quite a concern over the summer, and we've had some intervention by the European Central Bank, which I think has calmed the nerves of a lot of investors and has also, I think, taken a lot of the risk out of the financial system in Europe. So that was a real positive. Plus, we've had job growth in the U.S. and some better economic data in the U.S. So I would say that the growth prospects look stable to improving. Certainly not that exciting for the bond market to do anything material, but nevertheless, I would say there's optimism in the marketplace. But we have some issues on the horizon, late next year, that have to be resolved, and I think the global growth situation is also in the back of investors' minds. China has been slowing down, and the eurozone, despite some improvement and taking some of the risk out of the financial system, has a long way to go, I think, to gain traction on the economic front since budgets are getting cut, and there are austerity measures that need to take place over the next several years.

    Cleary: Dan, do those global issues—fears about weakness in China, the ongoing adjustments and weak growth in Europe-does that mean that even as our economy recovers that interest rates aren't gonna reflect that by rising? Because if we're seeing growth expected to be 2½%, 3% this year and next year, and—in real terms, but real interest rates are still 0% or negative.

    Shackelford: Yeah, well, I think that in order for that environment to change dramatically, we would need, I think, the eurozone to come back online, and I would like to see some additional upward momentum on the emerging market growth story. That was a big part of what we had seen in the past and I think, whereas there are growth issues in the developed nations, in the UK and the eurozone and the U.S., there are inflation issues in the emerging markets. So I think once we get global growth back in sync, I think we can think more seriously about a major adjustment in the Fed's policy, right now, which is quite accommodative.

    Thoughts on Interest Rates

    Cleary: Dan, the first quarter saw some movement in terms of interest rates. Can you tell us what we should expect?

    Shackelford: Sure. We had a modest backup in interest rates in the first quarter, and I think that [was] related to a couple of things. One, we've had some better economic momentum, not stellar, but strong enough, I think, to give some pause to the rally that we've seen in rates over the last year. Second, I think we saw in the fourth quarter into the first quarter a lot of momentum in the stock market as well, very nice returns, and stocks, I think, that probably gave the bond market a little pause, as well as, I think, investors rediscovered maybe stocks as a value. So I anticipate that as the economy continues to grow modestly that we might see a backup in rates, but I don't see a big material change in the Fed's policy any time soon.

    Cleary: How about from you, Alan? Where is the Fed on all of this, and what do you see going on there?

    Levenson: Well, I would agree with Dan's sentiment that they're not gonna change policy any time soon—that means in either direction. So they've cut interest rates to 0% by December 2008; tripled the size of their balance sheet; and, in January, reinforced their expectation and their communication of that expectation that they would keep interest rates where they are until the end of 2014. That's about as stimulative as they're gonna get, in my view. And, in fact, it seems to me that that late-2014 rate guidance is somewhat at risk. But they're now at the stage where having cut interest rates, expanded their balance sheet—that's a policy of extreme stimulus to the economy. Doing nothing doesn't reduce that stimulus, it keeps that stimulus in place, and that stimulus will gain traction in the economy as the underlying healing continues. But I don't see them raising interest rates, at the soonest, until early in the second half of next year.

    A Bond Strategy for Preretirees

    Cleary: Dan, as investors approach retirement, they start thinking more abut generating income from their portfolio. Could you put some perspective on the table here for those investors who are approaching retirement around their bond portfolios?

    Shackelford: Yeah. So this is a very difficult environment, I would think, to think about income, mainly because of the Fed's policy and how extraordinary it is with 0% interest rates and 10-year Treasuries, for example, yielding around 220. There is a meager amount of income at the very high-quality scale. I think the way I would think about it is maybe branch out and think beyond just Treasuries and move into lower-quality bond markets. We still think there's value, for example, in some of the lower-quality corporate sectors. In addition, I think dividend-yielding stocks still look appealing, maybe not as much as they did in the fourth quarter. So there are ways of getting income into a portfolio, and the Fed is actually encouraging investors, I think, to take risks. So for the time being, and I think for a while, you're gonna have the Fed at your back in terms of an accommodative policy.

    Cleary: Right. So as an investor, they might be thinking about hearing lower-quality bonds. Does that mean more risk and how do you manage that?

    Shackelford: That will be more risk, but let's divide risk into two buckets. One is interest rate risk, which I think is very high; the other risk is credit risk, which I think is fairly priced. So the way we would approach this is, right now interest rate risk, which would mainly be expressed in Treasuries (with 10 years at 2¼% and the Fed targeting 2% inflation), to me, has no long-term appeal, and it's more of an insurance in the short run if things go wrong in the global economy or the U.S. economy. But I think that's a lot to pay for the type of risk that we see there. But in terms of the corporate market, though, you can still find yields at 3%, 4%, 5%, and if you move a little bit further out the risk spectrum, maybe higher. That, to me, is a reasonable amount of income generation over the near term.

    Levenson: Dan, let me just follow up because when you say lower quality, I understand that to mean compared to Treasuries, where we're guaranteed they're gonna pay them back.

    Shackelford: Right.

    Levenson: They've got the printing press or the tax authority in the basement-they can do it. But looking at, say, investment-grade corporates or, I don't know, some emerging market corporates, do you characterize those as low quality, where investors should be significantly concerned about getting paid back?

    Shackelford: Yeah. I think that's a really good point. Low quality relative to the U.S. Treasury, and maybe we have a debate about that as well. But if any sector of the economy has done its homework and really performed well over the last five, 10 years, it's corporate America. Cash on the balance sheet is, in some cases, at historic highs. The leverage or the amount of debt that corporate America has taken on is very manageable and low, and, as we've seen in the stock market, that they have been able to perform in very difficult environments. So I would have a lot of confidence right now in investment-grade and lower-quality—in terms of credit rating—corporate bonds, mainly because we've seen corporate America deliver on what they're trying to do. They seem to have mastered this environment as much as anyone.

    Cleary: So if I go from owning a 10-year Treasury at 2%, and I can get a pretty high-quality corporate at 4%, that gives me a lot of cushion to sort of withstand that interest rate increase when it comes.

    Shackelford: It's producing income immediately, but it also, as you say, I think, provides a little cushion should we have an upward surprise in terms of growth.

    Why Bonds Now?

    Cleary: Dan, how about you help those investors who are asking the following couple of questions. With interest rates so low, why should I invest in bonds? When interest rates go up, don't I lose money?

    Shackelford: Right. So, it's a very good question because interest rates are at historic lows, as you point out, but we could have said that two or three years ago, and I think investors are very happy over the last five years to have bonds in a portfolio, and in a broadly diversified portfolio (Balanced Fund, for example), bonds have come through. I would still believe that bonds come through by producing positive returns if our general outlook here is completely wrong, and the U.S. economy is going back into recession and the global economy starts to look weak again, I think bonds will come through for an investor.

    But if you think about bonds in general, again, we would want to emphasize that, within the bond world, there are lots of choices, there are Treasuries at one spectrum [and] there are investments that you can make in emerging markets and in high yield and others that produce more income.

    I think you still want some higher quality, though—some high-quality element in your bond portfolio—just in case things continue on as they have for the last several years, and that's a very low-growth environment, a very low-inflation environment. I think bonds will do just fine.

    So the one reference, I think, that investors need to think about is this isn't the '80s and the '90s where bond yields went through a period of a huge decline. I think we are in a world where bond yields are in the 2%, 3%, 4%, 5% environment. I don't foresee going back into an 8% or 9% environment. So the point here is that if yields go up, I see yields being capped mainly by the changes that are taking place globally in terms of growth expectations and generally a benign outlook that I have on the inflation front, despite all of the money printing that we've had by central banks in the developed world.

    Cleary: So it feels like, in this environment, diversification is key—stay on the shorter end for some safety, but it's OK to go out a little bit longer to get some yield.

    Shackelford: I think that's right. I think if you divide bonds into that interest rate risk and the credit risk, it's the interest rate risk that you might think about bringing the maturities of your bonds closer to home, closer to the three to five year as opposed to longer. But also, have confidence that you can manage the risk, I think, in a diversified portfolio if you take a little more and earn a little more income in the corporate and higher high yield bond market. The other thing, I think, to think about here as you put a bond portfolio together, as you near retirement, one of the things, too, that you want to think about is preserving the real value of your investment. So a little inflation protection, I think, as you approach retirement becomes maybe a little more important. And as you retire and as you move through retirement, again, having some equity exposure is important, but having inflation protection is also important.

    Cleary: Right, that becomes really important to protect that income stream on a fixed income.

    Shackelford: That's exactly right.

    Cleary: Right. Remember, it's your money and your future—stay in control of it. I'm Todd Cleary and this has been Market Update with T. Rowe Price. See you next time.

    Yield and share price will vary with interest rate changes. Investors should note that if interest rates rise significantly from current levels, bond returns will decline and may even turn negative in the short term. There is also a chance that some bonds will have their credit ratings downgraded or will default.

    T. Rowe Price Investment Services, Inc., Distributor

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.