January 30, 2013
In a recent interview, T. Rowe Price Chief Economist Alan Levenson; Portfolio Manager David Giroux; and Stuart Ritter, CFP®, discuss the state of the U.S. economy and the financial markets.
For the U.S. economy, 2012 was another year of crosscurrents where the private sectors were continuing to heal from the wounds inflicted from the financial crisis and the recession, but we're struggling against headwinds external to that process so in the private sector the most notable, I guess, was the more visible pickup in the housing market—particularly in housing construction—added about a half a percentage point to GDP growth for the first full-year contributions since 2005. The headwinds were all in the external sphere. Again, the private sector was doing better, households were paying down debt, the housing sector was recovering, you had the fears of a hard landing in China and the euro-area crisis flaring up again in the spring and summer and fears about our fiscal cliff as well in the summer that caused some softening in the second half of the year.
And in terms of the employment picture, we continue to have modest job growth—about 1.8 million jobs created over the course of last year. The unemployment rate came down a little bit more than about half a percentage point, so we're gradually reabsorbing the big stock of employed people.
Yes, so first let's back up to before the end of the year when we got to the cliff. So this was tax increases that were scheduled by the law at the time to take effect, spending cuts to take effect. If nothing were done to address any of this, it was going to have a restraining impact on the economy equal to about 4.5 percentage points of GDP—something that would've thrown the economy into a recession if it were not addressed. So in the first week of January we took care of most of the tax elements—extended the Bush tax cuts for incomes below $400,000, allow them to rise for higher incomes, patch the alternative minimum tax, and took care of a bunch of other tax measures so that the impact on the tax side was little more than 1.5% of GDP, which is about what I'd expected and that's manageable. The spending side of the equation—we were going to have $100 billion of automatic across-the-board spending cuts—was a can to kick down the road for two months.
The general view was that there was a lot of acrimony and that it wasn't a good process—and the process was messy. One good thing about the outcome, again first of all, we didn't get hit with the full force of all these tax increases. The second thing was almost all of these elements that were changed, were made permanent. We've gotten out of this cycle of not knowing what the tax structure is going to be over time. That's helpful—reduction of uncertainty. For the remaining part, the spending cuts, we've still got to find some way to avoid this automatic across-the-board hit spending cuts to defense and non-defense, discretionary spending. It is now scheduled to take effect in the beginning in March, the same time that we're going to hit the debt ceiling, and so we're going to have to have the spending hawks—those that want to restrain spending—are going to demand spending cuts something to replace these sorts of mindless across-the-board cuts. We'll see where the President comes out in the State of the Union address. I think that's going to be an important marker. Hopefully what he's going to do is turn the conversation toward entitlement spending—particularly on the Medicare side—with a long-term time horizon, because that's where the cuts need to take place. And if he does that you can work with Congress, put in place a—several hundred billion or trillion plus dollar multiyear spending cut—it doesn't hit the economy right away.
I think what businesses are looking for is that the spending side to be put on a somewhat longer-term horizon and for our government to stop lurching from choke point to choke point every three, or six, or 12 months and to get out of the way. I think that there's the opportunity that if we can deal in a reasonable way with the spending side of the cliff with the debt ceiling that then we could have a more expansive year in terms of business hiring and investment decisions.
The confusing part for people, I think, is that a lot of that spending is for programs that we've made commitments for that are multiyear in nature, like Social Security, like Medicare and Medicaid. We know that for the foreseeable future we're going to be making these outlays and we know that we're going to be borrowing a third of the money to make those outlays, so why are we having to approve the program and then approve the ability to spend the program? That's the part that seems kind of silly and that people make the analogy too that it's sort of like in a household agreeing that you're going to buy a house on credit and have a mortgage but then you have to have another separate discussion of whether or not you should make the mortgage payment each month. It doesn't make any sense once you've agreed to take on the mortgage.
The debt ceiling—or the debt limit, as it was formally called—was established in 1917 in response to the government wanting to issue long-term debt, raise money as we prepared to enter World War I. And the Congress wanted to have some say in how fast the government was going to borrow money, and so since then that limit has been evolved so that it's now an overall limit where there's a current amount of maximum amount of debt that can be outstanding, and that's right now a little over $16 trillion. And as our debt rises toward that level typically then there's legislation and a process that takes place for raising that debt limit to accommodate the government's borrowing. You might ask, "Well why are we constantly accommodating government borrowing?" It's because we have a sort of political arrangement where the spending we have is not fully covered by the revenues that we bring in in taxes and in other fees. It's pretty inexpensive for the U.S. to borrow money—at least for now—the revenues cover about two-thirds of our spending. The rest of it is from borrowing. But this is where we are—and it was not a controversial decision typically, historically, to raise the debt level but now it's become very political and we saw this in the summer of 2011 where we came close to a technical default. Again, it doesn't mean that the U.S. is not going to make its interest payments on its debt. It does mean that if it comes to a point where it can't borrow because Congress doesn't make the authority to borrow, then 35% of our expenditures are going to have to be stopped, be suspended, because we're not bringing in enough money to cover them. So it's not interest payments on debt that get cut off, but it might be salaries for government employees. It might be Social Security payments get delayed. And that's called a technical or an internal default. Not a good thing in terms of market confidence or business confidence.
I think the debt ceiling will be resolved with a little bit less acrimony and a little bit less of that running up to the deadline than in 2011 for two reasons. First, in my view at least, the political cohort in Washington that was willing to risk running off that debt ceiling cliff and rear a technical default is weaker now after the elections, after the agreement to resolve the tax side of the fiscal cliff. And the second is that the public on the whole is better educated about this issue and less patient with their elected officials putting this fragile but improving economy at risk with this silliness.
Well let's assume that we get a decent resolution to the fiscal cliff—and by decent it'll be two things. First that the $100 billion in spending cuts that are going to take effect this year are going to be transferred away from defense and from nondiscretionary non-defense programs to entitlements over the long term so that there's not much hit to the economy. And let's further assume that we extend the debt ceiling sufficiently so that we get at least a year—hopefully two years—before we have to deal with it again; so all that's out of the way. What we're going to see underneath, again, is the housing recovery gathering a little bit of momentum, business confidence getting a little better so that planned equipment spending will be a little better—and again growth was 1.75% to 2% in 2012. We can look forward to something like 2.25% to 2.5%—maybe even a little better than that in 2013. With our domestic policy risks reduced now that we've got over the fiscal cliff—the main risk in the policy side is what goes on in Europe, which we've seen can have an impact on us by hitting our exports to that region, by weakening our stock markets. So that would be one thing to watch, on the downside. Let me also do something unusual and talk about what could happen on the upside. We're forecasting that the housing starts are going to grow by almost 30% this year and that the housing sector will add again about a half a percentage point, maybe a little more than that, to growth. The risk to that is, clearly to the upside, is that the rate of increase in housing construction—which still means that we're building more houses than we need given the growth in the population. We also have a very competitive manufacturing sector on global markets—where if the global economy stabilizes we could start to pick up a share of exports. And we've got an ongoing boom in our energy sector which could also add to growth. So there are things to watch for on the upside, not just the downside.
The domestic stock market in 2012 was pretty healthy. It had mid-teens kind of returns, multiples expanded. It was a relatively strong year for domestic equities last year.
One of the reasons why the market was strong in 2012 is because unemployment did come down pretty substantially. Oil prices did come down, and we came into 2012 with a relatively low earnings multiple with the market. There's basically two ways you get equity market appreciation: earnings growth, when the underlying companies in the S&P 500 grow their earnings, and also the multiple or the valuation that investors put on those earnings expands. So in 2012 the equity market multiple base expanded from let's say 12 times to let's say 13 times. So we were able to capitalize those earnings at a higher multiple than we did in the past—or over 2012. So we had modest earnings growth but multiple expansion—which really drove that mid-teens growth when combined with the dividend yield of the market.
I think that it's always very difficult to think about one year's equity market returns. I think the fact that we had a very strong 2012 probably would indicate to me—and the fact that we've also multiples expand—we'd probably be looking at an average to below-average year in 2013 for equity market returns. First of all, multiples have expanded. We had headwinds in the economy from the tax increases on the payroll tax, the tax increase on high-income earners—which will be a drag on GDP growth—which will probably mean, you know we had an economy that was growing at 2% to 2.5%—that could put the economy to grow in the low single digits, maybe 1% in 2013, which would not be great for corporate profit growth. And since we've had multiples expand a lot it's hard to see a stellar market 2013 after we had mid-teens kind of returns in 2012.
I would say for investors who are either near retirement or in retirement, we've had basically a 20-year period in the fixed income market where interest rates have come down pretty steadily. We're probably near the bottom of that. As a result of that it's very easy to lose money in fixed income as we revert to more normalized levels over the next year, two years, three years, the next five years. So I think that there's a tendency to believe that you can't lose money in fixed income. But given how low rates are, it's very, very possible to lose money in fixed income. And while the equity markets have more volatility, the equity markets also have generated better returns over time even on a risk-adjusted basis from where we are today relative to the fixed income market. So as you think, maybe balance the portion of your retirement that's in equities maybe a little more than you would've otherwise given how low interest rates are today.
As we've seen, politics in Washington are constantly changing. And this is just a continuing evolution of retirement responsibility moving from companies in the government to the individual. And that's why it's so important for people to save their own money for retirement. The more money you have in an account with your name on it, the more stability you'll feel. The more confident you'll feel that you're controlling the kinds of things that will matter to having a successful retirement that you want. That's why we emphasize so strongly to save 15% for retirement, and that can include an employer match if you get one, but the more money you have, the less vulnerable you are to these changes and whatever else might be coming down the road.
Before we even talk about your portfolio, let's make sure you're saving enough. That's the most important thing you need to be doing to achieve retirement success. For example, if you're saving 3% for retirement, that's like going to the gym for six minutes. It doesn't matter what you're doing with that time until there's more of it. So once you're saving 15% or you have a plan in place where you've signed up for an automatic increase program to get yourself there, then you want to make sure that your portfolio is properly positioned. And here's how to think about that. When you go on vacation, you check the weather for destination and pack for what the weather is there. If I'm going to San Diego, it's t-shirt and a bathing suit. Now I do that even if it's raining where I am right now, or maybe it's snowing over one of the cities where I'm going to fly. You pack your portfolio the same way. You look at your destination, how long will it be before you're using your money. Make sure that you have enough stocks for that time horizon so that if it's a very long time before you're retiring, most if not all of your money is in stocks. And even if you're on the cusp of retirement, recognize that you're going to be in retirement a long time and still need money 10, 15, 20, 30 years from now and you need enough in diversified stocks for that period. So even if there is some bad market weather a couple years ago or even if you anticipate some bad market weather in the next year or two, you're not packing for that. You're packing for your ultimate destination and you want to make sure your portfolio is packed right with enough stocks to make that happen.
Well with the payroll tax having gone up on pretty much everybody and some other taxes having gone up on some people, we're going to do what we always do when one of our expenses goes up. And that is to check our priorities. To make sure we figure out what's most important to us and what's less important. Make sure that we give up those less important things. What's great is that we have a lot of experience in doing this. Now we're not always happy when it happens, but we've done it before. The month the car broke down maybe you ate out a little bit less. When you had your first child you spent less money on yourself—and did the same thing when you had two. My wife and I have three. What you do is you sit down and figure out what it is you're going to give up to make sure you're still doing the things that are most important to you. So now the line labeled taxes has gone up a bit, so we figure out what we're going to spend less on, and that makes sure we can keep the things that are most important to us. And I would put saving 15% for retirement at the top of that keep list.