November 19, 2013

In a recent interview, Andy Brooks, head of U.S. Equity Trading, and T. Rowe Price Chief Economist Alan Levenson discussed the state of the U.S. economy and the financial markets.

The Markets: Third Quarter Review

Brooks:
So generally, the stock market hates the drama that is in Washington, D.C., and it was…the stock market reacted accordingly, but we seem to have now gotten used to some of this drama, and so the reaction almost throughout the entire government shutdown and related jumping jacks that we're doing, the markets did better. Now, let's differentiate. The bond market has struggled a little bit this year, but the equity market has really been strong, and either we're getting used to the drama from Washington and know how to deal with it better or the underlying strength in the economy is just allowing us to push right through. But make no mistake, everybody is tired of the drama from Washington, so we'd all like to see it end; we'd like to see responsible decisions being made, tough decisions being made. But we seem to be getting used to this high wire act and getting pushed right to the edge by Washington, and we respond accordingly.

The Markets: Impact of the Congressional High Wire Act

Brooks:
I don't really know if anyone truly understands what was drama and what could have been cataclysmic if the government shutdown didn't stop and if perhaps we defaulted on our debt. There were lots of discussions and analysis being put forth about how much debt was truly owed and when; so what the scheduling was of the repayments and interests payments, and what checks needed to go out from the government to retirees, and other beneficiaries. So there were lots of people that were trying to understand, and how much cash the government really had, and how long they could go before they ran out of money in their checking account, if you will. Or before the process of sending out millions of checks was going to be so challenged that it would cause real harm and extended harm, if you will, to both the economy and to the populous. So one of the things about these conditions often is we've never been there before, so who knows; so who do you want to listen to? Do you want to listen to the people that say we're going to be fine, or do you want to listen to the people who say it's the end of the world as we know it? It's probably somewhere in the middle, as was often with these issues. But the point is, it's really not a good exercise to try to get there. Why? What do we gain from that other than political grandstanding, and so I think most Americans ought to be writing their Congressmen and Senators right now and say please get engaged and try and figure out [a] compromise. Because we're tired of the drama, and the markets are even though the markets responded, the stock market responded very well during this period and then it's higher. Bond markets are nervous about this, and foreign buyers, sovereign debt buyers and others that buy a lot of our debt, whether it's in China, Europe, or other countries, I think it makes them nervous, and it sets us up as being foolish, if you will, and reckless, and who wants to be known as foolish and reckless. That's generally not a good…those are not good attributes for investors to warm up to. I think it would have been highly improbable that we actually would ever default, technically or really there are a number of different levers, there are always ways it seems to me the government can figure out how to extend things, and there's always genies you can pull out of the bottle or rabbits out of the hat. The damage, though, comes from just getting close and having others have the perception that we can't manage our own affairs. It's inconsistent, at least in my view, that we can be a world leader and show so much caring about world issues and problems, and yet be so…act so ridiculously on the home front and not take care of our own affairs. Drama gets old after a while and you…at the markets, we plow through this. At some point, it might really do sustainable damage, and that's not good for investors.

The Markets: Thoughts on Stock Market Performance

Brooks:
This year, in particular, has highlighted, I think, the importance to have exposure to both small companies and probably some sectors like health care. Health care has been on fire; it's been in…the stocks have done very well, biotech stocks have done well. Small company stocks, in general, have really done well, and they go through these periods, and that's why you want to own those stocks and those funds and have that exposure over time. So it's been pretty extraordinary. The Dow has been laggard and the Dow's done very well, but relative to both the broader market and the S&P and the small-cap sector, it has lagged. I think when you have a sense of an improving economy, and employment is getting better, and the consumer is doing well, often, the small-company sector is the one that leads there, and I think we've seen some of that this year. So balanced portfolios are great, but you always want to have some exposure to some of the sectors of the economy that can really get cranked up and small companies have been one of the sectors. So there's certainly some sectors of the market that have not done as well. Some of the big oil stocks, perhaps, or some retailers and some other consumer names; some of those stocks have not participated as fully in this rally, but overall, a balanced portfolio has done very well. You can't have everything up, and that's why diversification is important. Often when you get a rising market and an improved economy, people go for the sizzle; they want to go where there's really some action. So that's often small companies, biotech, stocks that might have a higher P/E, but higher growth potential, and you see that push out often in an up leg of the market, and we've probably seen that this year.

The Markets: Health Care Debate and Sector Performance

Brooks:
How health care is delivered and how people access it is different than the benefits that the health care sector can provide the population of the world. So there have been huge strides in the biotechnology field, and there's an amazing thing happening with the pharmaceutical companies and the products that they are coming out with and the innovation and the incredible creativity and how that's being really provided to people and making them better and extending life expectancy and helping sick people. When we talk about the health care sector being great, that's what I'm talking about. How health care gets delivered and Obamacare I…pretty complicated for all of us. But underlying health care is the product and how people are being helped and lives being saved. I think that's a very fertile area for investors, it's a very dynamic area, and it's complex, and there are lots of different things going on. But with broad exposure there, it can be a very good place for investors to have some assets, and it's been a good sector this year.

The Markets: Thoughts on International and Emerging Markets Performance

Brooks:
The markets outside the U.S., O.U.S., have been strong as well. Last year, I think Japan was just on fire, that the NIKKEI's not been as robust this year as some of the other global markets. But double-digit returns broadly, clearly the European continent has improved a lot, and there's been some action there, better markets. Emerging markets, I think, continue to present probably pretty extraordinary return opportunities from investors over a long period. So they've got a lot of upside. If the developed countries are…their game is pretty predictable and it's 2, 3, 4% a year GDP and kind of stuff, and just steady as they go, which can generate nice returns, the emerging markets have…there's a lot of action there. There's a lot of growth, there's a lot of things still to happen, but it's not without its trials and tribulations. So there's a little bit more risk there, and that's why I think it's important to be…really have a long-term orientation and to balance that and watch it a little bit more, if you will. But those prospects are pretty strong, I think. But I think the story so far this year is just to be invested in stocks, and if you've done that globally, you've been pretty well rewarded. I think it always reminds me if the average returns over time are whatever they are: 10, 11, 12% in stocks over the last 100 years; whatever that number might be. In order to get that, you've got to be there for these big years like we're having today, because there are going to be times when the market's return is below the average. But broadly speaking, O.U.S. markets have been very strong.

The Markets: How Investors Should React to Washington

Brooks:
So when it comes to Washington, I would like to just close my ears sometimes and just shut my eyes and not give it any consideration because it's so frustrating for us to see them struggle to find compromise or to engage in what would seem to be a reasonable way. But I'm optimistic, in general, on life and so I'm certain that we will find a way forward, and it won't be perfect, and it'll be ugly, and it'll be lots of challenges and our own dilemmas to face. But I'm confident that the government will find a way to get organized and to address some of these long-term issues. But it will be painful to watch. Now, painful as an investor, yeah. Probably, because there are going to be some times when people are going to get scared and they're going to sell stocks, and the market's going to go down, and we'll have to respond to that. But I do think that also creates opportunities, so we'll again be careful and try to be thoughtful and seize those opportunities that the market gives you. It is important at some point, and we keep the prospect of kicking the can down the road. At some point, you have to stop. Now you can always keep kicking it, but at some point, you have to stop because we do have to address these issues of the structural deficit and entitlement programs and taxes and spending and all that stuff. Would it be nice to see a compromise committee come together and actually produce something we could all get behind? You know there's a definition of a successful negotiation and it is that everybody's mutually dissatisfied. Nobody gets what they want; everybody has to give up a little bit. I don't know why that's so hard in Washington. I kid with people. Sometimes, we say we just need nine minutes, nine minutes to run the world. We need nine minutes to say we're going to reach an agreement on what we need to do. I think Congress probably lives for overcomplicating things and bringing in this drama that we've talked about. So it would be wonderful if we could have less drama the next few months and actually try and frame this in a way that gets compromise, gets it done. We all are frustrated by Congress sometimes, but I'm not sure what…what is their job? Their job is to get things done; so maybe they shouldn't get paid until they get things done. Don't not pay everybody else; don't pay yourselves. So probably more political than we should be, but it would be nice if the markets could get a respite from some of the drama that Washington presents. They do need to do the people's business and we…every time we go through one of these exercises I guess we set ourselves up for a little more risk, and a little more impatience with either other investors outside the U.S. or people in general. So at some point you're going to lose people, and I think it's been really unfortunate that it appears that so many people have been on the sidelines during a very good market that we've had. We'd like to…I think, we all would like to see more people invested and to appreciate the benefits of a successful investing program. It's not without its challenges, as you know, but over time, being invested has produced good returns for the people that are there. If Washington is systematically pushing people to the sidelines because of what people view as the inability to address long-term structural issues, that's bad for those people because anybody that's out of the market today, they've missed an enormous opportunity and I'm sad about that. Frankly, it's unfortunate. So we ought to work together and try to figure out how to make the water a little bit more inviting for everybody to come in if we can, and if Washington can help with that, it would be wonderful, but it's a struggle.

Investing During Turbulent Times

Brooks:
So I think our job every day on behalf our investors is to pay attention to risk and to pay attention to opportunity, and try to find that balance, and that's what we do. The individual investors, they need to look at their own exposure, broadly speaking, and figure out a way to stay the course, and figure out a way to stay in balance through all of this noise that goes on. So that means when if the market just soars for a number of years and then all of a sudden you've got a little more risk than you…a little more exposure than you normally do, it's time to rebalance. But it's important not to be overly dramatic or to respond too aggressively; so you can't sell everything and then hope to get back in. Or where you can't get entirely out of fixed income because it looks like rates are rising. You've got to leave a little bit there; so good investors, I think, as individuals periodically assess where they are and where they should be. Where they should be is in balance, in general, and there's a time to take a little more risk, and there's probably a time to take a little less risk: age requirements, needs of family, all those kind of things. Our job is to always be looking at that relationship between risk and return and trying to fine-tune that, and that's what we hope to do for our investors. So many times, it's tempting to just…to say I can declare a victory. I should sell, and if you did that last year, you missed this year. So you can't sell all; maybe you can sell a little bit and you redeploy. But don't be all in or all out; that seems to me to be a really…that's a really tough call. But understanding that markets ebb and flow, and over time, they do better, I think, is an important consideration. You have to figure out how to fit in that as an individual. We have to figure out how to do it professionally on behalf of our clients and shareholders. But individuals have to figure out how to stay the course and not get overly nervous or the world's going to end. Maybe we've talked about this before, but we had a wonderful investor here who has retired and he used to say [that] today is the hardest day to invest. So there's always some reason you can find "I can't do it today, tomorrow will be better," then you never get in. On the other side, you've always got to be looking at where you are and maybe are you risk adjusted; are you in reasonable shape considering again your needs as a family and for whatever your plans might be? I think really good investors personally and professionally figure out how to find that balance.

The Economy: An Uncertain October

Levenson:
If we rewind the tape and go back to the late spring, early summer, the talk that was somewhat surprising was how strong in quotes the U.S. economy was. It was clear that it wasn't going to do any better than 2% or 2.5% in the near term, but it was showing a steadiness that other economies around the world weren't showing; it was showing signs of gathering some forward momentum because the private sector was healthier. Housing activity had been cut to a low level, home prices were starting to grow and grow pretty fast, and I think that was behind a lot of the optimism. So there was this feeling that the U.S. economy was gaining strength. How much difference a short summer makes that as we came to the end of the third quarter, which is also the end of the government's fiscal year, the fighting in Washington started again, and I guess we've just forgotten that it was an issue and assumed that everybody had a chance to grow up. But the fountain of youth must be in Washington because they're still acting like children, and then the extent to which uncertainty started to rise and started to reverse the forward progress in financial markets, too, put a damper on the economic outlook, so sentiment has changed a lot, and now, as we've talked about it, the government became the overwhelming focus. It now shifts to the background a little bit since we've kicked the can another three months down the road.

The Economy: In the Wake of the Shutdown

Levenson:
So looking at the scant economic data that we have of how the economy has done in the wake of the shutdown, business sentiment seems to have held up reasonably well, but claims for unemployment insurance are up a little bit, and beneath the noise in those data, it does again give us a sense that we're going to see slower job growth in October, but it will bounce back in November and December. So, again, that's going to feed the story that if we don't have another government shutdown, we're going to gain momentum going into next year. The "if," though, is a big one because in January…on January 15, the continuing resolution to fund the government expires and we're going to have another fiscal food fight over to the turn of the year that begins on December 13, in a sense, when the bipartisan committee that's trying to put a proper budget together is supposed to present some kind of conclusion to Congress. I don't expect much because there were no carrots, and more important, no sticks involved in this process. So we're going to be at another crunch point in the middle of January with the budget, and with the debt ceiling February or March. So we'll see some choppiness in the economy; it means the Fed is going to go very slowly. But the thing for investors, I think, to think about is that the underlying economy is in a good place, getting slowly better, and it seems to me that the temperature is cooling a little bit now in the sense that I think the Republicans saw they didn't get anything out of shutting down the government, and they're going to tick a lot of people off if they do it again. Everybody wants to turn toward the election; so my wish/forecast is that when we get to January 15, the kick of the can will be past the election or at least to the end of the fiscal year, at the end of September so that we would then buy a six-month window in which we can again start to see the rest of the economy is doing the positive things that it's been doing.

The Economy: Origins of the Debt Ceiling

Levenson:
The confusion about the debit limit is very well founded because it's very confusing about why we would have it. So suppose I have a certain income coming in from my job every year, but I also have a credit card with a credit limit on it, and I've been borrowing on that to the tune of 25% of my income. So my expenditures are 125% of my income. Then I hit the credit card limit just like the debt limit, and I call the credit card company, "Can you increase my credit card limit?," and in fact, to increase it by 25% of my income every year so I can keep borrowing. If they say no, then you've hit your limit; that's it. Then I've got to cut my expenditures. So then I would sit down with my family and we'd look and say "What can we cut back on?" We wouldn't cut the mortgage payment, and we would make it…that would be the first thing that we would say we need to keep doing that, and if you want to think of that like the Treasury continue to service its debt, making that the very highest priority, then we'd start to look through other things and cut things we don't need as much. But we would certainly make sure that we keep a roof over our head, and that's the sense in which I'm saying that it's astonishingly unlikely to me that the Treasury would default on the debt, because there's absolutely no reason for it to do so. It's bringing in plenty of money.

So let's go back to the decisions that were made to end the government shutdown. One was, again, to adopt the continuing resolution to fund the government at the level of spending that prevailed in fiscal year that ended September 30, which I believe it was $986 billion. So that's what Congress has said to the executive who runs the agencies that spend the money; this is what we want you to spend over the next three months, is at a rate that if you did it for a full year it would be $986 billion. So the Treasury says we got it; we're going to spend $986 billion, and then Congress says we've also passed some legislation in terms of tax rates that's going to bring in something less than $986 billion. We know that we tend to run budget deficits, but these are the laws that we passed. This much spending, this much tax, which is going to result in a deficit. You would think that by having set those two things into law it's implied, and it clearly is implied if the Treasury says where are we supposed to get the rest of this. Obviously, you're going to have to borrow it, and the Treasury says, "Okay," and the Congress says, "Not so fast. We have to give you permission, and we want you to give us something in return for us giving you that permission." So hopefully you can see it that way, "I've given you permission to spend this much, I've given you permission to bring in this much. There's a deficit, but I'm not going to give you permission to fund that deficit in the way that we all know you need to fund the deficit. But instead I have to pass a third law to raise the debt limit; it's one law too many, or it's one prominent and well respected, by me at least, analyst said it's like the human appendix with no discernible or discoverable purpose. So…but it is a leverage point that traditionally, in past debt ceiling crises in the '90s or the '80s, pitted Congress against the executive, and that's a good old-fashioned balance-of-powers battle. That keeps the economy or the government and the policy healthy. What's dangerous about this is [that] it's pitting parties against each other, and it's being used as a point of leverage.

The Economy: Chances of Technical Default

Levenson:
There's one other thing to keep in mind, because depending on what side of the debate somebody was on, they might sound very hysterical about the government is going to default on its debt if we don't raise the debt limit. The one thing we're not going to do is miss interest payments to service the debt, and so again I just want to explain what happens if the debt limit is not raised. When first we get to the October 17 date, you may remember that's when the Treasury secretary said we will have hit the borrowing limit because they would have had to issue some debt say on the 16th, we've not hit $16.999 trillion, which was the debt limit at the time. We have $30 billion in the bank that we're now going to start to use to pay bills until we run out of money. What happens when you run out of money? Again, we've got spending up here, income…revenues down here, if you can't borrow and you run out of spare cash sitting around, you've got to cut spending down to the level of where income is. That's simple arithmetic; we can all understand that. But the Treasury has some capacity to choose which bills to continue to pay because it's still bringing in a lot of revenue; they have to cut spending by, I think, about 25%, which would hurt a lot of things, but the strong presumption is that the highest priority would be given to maintaining interest payments so that we don't technically default on the Treasury debt. So that's something investors should not worry about...nobody should worry that the Treasury is going to pay its debt; that if you bought a Treasury bill or bond that you need to sell that now because it's just not a safe asset. If we get to a debt ceiling squeeze again and you're still receiving a regular benefit, whether it's a check or a service from the government on a regular schedule that's going to be a little more uncertain, but nobody should worry about the government defaulting on the debt itself.

The Economy: Global Reputation at Risk

Levenson:
Even if we don't default on our debt, our risk of incurring cost to ourselves, and because of our position in the global economy, to the world economy, and so outsiders, whether it's the International Monetary Fund or the State Administration of Foreign Exchange in China looking at us and are saying one of the things we've liked about you, the United States, is that you take care of your business, and do you think about a household. It's not just that I make my mortgage payment and that I keep up with my credit card payments, but I develop a good reputation in my community because I always pay my bills on time, I don't try to negotiate people down when they've told me in advance what they wanted to charge me, and if I get into a situation where every couple of months I'm calling up the dry cleaners and saying I'm going to have to wait a month to pay you while I sort out this thing with the credit card company, they're going to get a little irritated with me. They don't want to hear about my problems with the credit card company. So it's one thing not to default on the debt, it's another thing to default on our obligations; that is not to have Social Security checks go out on time, not to pay vendors on time; some of whom are foreign merchants and providers of goods and services, who, while they still need to own U.S. dollars as a reserve currency, might make us pay them more for the privilege of having that reserve currency status. I think it's a mistake to look at the 2011 experience where Standard and Poor's downgraded us after that fiasco in the middle of the year, but during that period of time, U.S. interest rates were going down. So you could say I'm not worried about default; interest rates are going to go down as if there's some causal relationship between defaulting and being able to borrow more cheaply, which is absurd. People forget that there was a high degree of risk mounting in Europe in the middle of 2011 as well, which was causing this flight to quality in the Treasury securities. It, again, also shows that at the end of the day, people didn't doubt that we were going to make our interest payments, but we shouldn't think that the reaction wouldn't be the same if we do it again. The biggest point is that if this is going to be the way that we run our government without a proper budget, and at three-month intervals where we're agreeing to fund the government, I wouldn't blame the rest of the world for getting sick of us because our own citizens are getting sick of the government that behaves that way.

The Economy: Outlook for the Fourth Quarter

Levenson:
So my underlying outlook for the rest of the year, which only has three months to run, and into next year, again, as I said, we start to see the economy stabilize after the speed bump or pothole of the latest fiscal policy shenanigans and gain momentum next year as the impact of easy Fed policy gains momentum, the housing construction starts to pick up again, and a big thing is, we're having less tightening from fiscal policy next year than last year. You have to remember this year we had the expiration of the payroll tax cut, expiration of some of the Bush tax cuts, the imposition of the sequester, and we don't have any tax hikes coming in 2014. The increment of sequesters is going to be about one quarter of what it was in 2013; so a lot of that weight is getting lifted off of the economy, and I also think that there's a reasonable expectation that the silliness in Washington is going to be at a lower temperature next year after we get through January, in particular, because attention is then going to turn to the election. Nobody wants to…I don't think our elected officials want to be having these fights all year; I think they want to be running for office.

The views are as of October 24, 2013, and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.