August 26, 2013
Portfolio Manager Charles Shriver and Chief Economist Alan Levenson weigh in on global stock and bond markets, the economy, interest rates, and more—and offer an outlook for the remainder of 2013. Following is a transcript of the interview that took place.
Charles Shriver: U.S. equity markets were up over the quarter—it was a decent quarter; fixed income markets were generally negative as interest rates rose over the course of the quarter. In late May, Fed Chairman Ben Bernanke's comments about the potential to remove their highly accommodative monetary policy by slowing the pace of bond purchases concerned the markets. The markets reacted negatively as they interpreted the potential for higher interest rates for consumers; the potential for higher borrowing costs for companies; and, in terms of financial markets, the impact of higher yields pushing down bond prices, which was reflected in negative returns in fixed income markets in the second quarter.
U.S. equity markets were supported by several bright spots in terms of economic news. Healthy job growth as well as a move lower in the unemployment rate supported markets, and, importantly, recent trends in terms of home price appreciation helped to build consumer confidence.
Charles Shriver: When we look outside of the United States, weak economic growth in Europe and slowing economic growth in China weighed on equity market returns as both international stocks and bonds underperformed relative to U.S. markets. China has grown at double-digit rates for much of the last decade, and officials in China are seeking to transition to a lower but potentially more sustainable level of growth. This would entail a transition in their economy from more explorer infrastructure-driven growth, which can be very commodity intensive, to a more domestic-oriented or consumption-driven growth, which is generally less commodity dependent.
Emerging markets were particularly hard hit as they faced not only slowing growth, but the impact of higher interest rates and weaker currencies, as well as social unrest in countries such as Turkey and Brazil.
Charles Shriver: In an environment of lower global growth, investors tend to reward companies that are able to continue to grow earnings through more effective management, whether that's through development of innovative products; through more efficient management of expenses; or through effective use of capital, whether that's through investment through corporate growth projects or acquisitions or more shareholder-oriented avenues, such as dividends or share buybacks.
Charles Shriver: Our outlook for the equity markets is generally positive. We think that the valuations are reasonable and that, in an environment of a slowly improving economy, this should be supportive of corporate profits. Within our asset allocation portfolios, we remain overweight equities relative to bonds given the generally supportive environment for stocks. Our outlook for international and emerging market equities is generally favorable where we see them benefiting from slow improvements in global economic growth, but also we find them at attractive valuations presently. It's important to remember that there are still significant risks in global markets as we're in a low-growth environment and there's the potential for policy missteps as central banks try to remove highly accommodative monetary policy.
Charles Shriver: It's important to remember the role of bonds in a total portfolio where they often do well in environments when equity markets are under stress and investors seek safety in income. There are also benefits to diversification within bonds. There are segments of the bond market, such as high yield, that generally tend to do better in an improving economic environment where high yield bond issuers benefit from improving cash flows and an improving credit profile, and they're not as sensitive to increases in interest rates as perhaps U.S. Treasuries. Given the current interest rate environment, we are underweight bonds relative to equities within our asset allocation portfolios.
Alan Levenson: The economy in the second quarter this year is a split personality. If you look at the headlines that we're likely to see, it's less than 1% growth. But what we saw underneath is it continues solidity in the private sector; we produced about 200,000 jobs a month in private industries, and that combination of business investment, housing investment, and consumption grew at about a 2.50% or 2.75% annual rate so that underneath these volatile headlines, we're slowly getting better.
I guess the strength of the labor market was somewhat unexpected. I had thought that with the imposition of the government sequester and the general timing of fiscal policy that you'd see some ripple effects into other industries, but again the pace of job growth in the second quarter was the same as it was in the first quarter or slightly stronger. So that was a little bit of a surprise. I suppose the other surprise was, at least to the markets, the announcement by the Fed that it intends to cut back on its asset purchases, and they had told us they were going to slow things down probably in the second half of this year. The markets reacted fairly violently to that; things have settled down, but I think there's now a recognition that the Fed isn't going to keep the economy on a morphine drip forever.
Alan Levenson: Interest rates are also following two tracks that are given to us by the Federal Reserve. Short maturities is where the Fed typically operates with the federal funds rate, and what they said there is that it's currently 0% to 0.25%, and they're going to keep it there at least until the unemployment rate gets to 6.50% so long as inflation remains low. They don't expect to raise rates until sometime in 2015.
In terms of long-term rates, the Fed can't control them the way it can control the overnight rate. It can influence them by making asset purchases and was buying assets in order to give some near-term momentum to the economy. It started those asset purchases in September, and their thinking at the time was, "We can't do this forever. It's destabilizing to the financials sector, but we want to see if we can give a near-term push and get some additional improvement." Long-term interest rates did come down, and as the Fed has announced their intention to reduce the pace of those purchases, long-term interest rates are starting to come up again.
Alan Levenson: The sequester was, I guess, legislated in 2011 if Congress didn't reach a budget deal and make some big cuts about a half a percentage point of the GDP this year across the board—defense, non-defense—indiscriminately. The worst fear, I suppose, was that everything is implemented on March 1 at the start date, and we have this massive impact as a result. What we're seeing is that things are phasing in gradually, and so it's kind of a rolling, accumulating process. In terms of the impact overall on the economy, what's interesting is that the defense sector got started early and made some big cuts in the fourth quarter of last year, first quarter of this year, in anticipation of the sequester and brought spending levels lower. They're still cutting back, but much more mildly, and what we're starting to see come into place in the second quarter and the third quarter is the non-defense areas, whether it's fewer park rangers or less food inspection or Head Start staff or furloughs, at the Defense Department.
So we're going to see this accumulate over time, and there's no question that there's an impact on the economy. Because even if we don't see employment go down, because that civilian defense employee is still on the payroll, we know that they've been required to take a certain amount of time off and that they're not going to get paid for it. So there's going to be less income, but again, in terms of the effect quarter to quarter, we saw a lot of it over the turn of the year on the defense side. The non-defense side is at its most intense now in the second and third quarters and then should dissipate. But I think we're still moving through a phase where we need to be vigilant about not only monitoring the impact of the sequester as it comes into force, but also being alert for second-round effects, because that's where the debate is. Is it fairly well contained because the rest of the economy has such good underlying strength or is the rest of the economy vulnerable to some of those ripple effects? My view is that there is a lot of resilience in the private economy and that we're going to be able to push through in the sense that by the end of this year as the imposition of the sequester fades as a weight on growth, we're going to come back into the 2.50% growth rate and are on our way to 3.00% next year.
Alan Levenson: In terms of the outlook for the rest of the year, my cause for optimism is that the private sector continues to show signs of having healed from the excesses of the debt boom; the housing sector is the best example, with rising construction, now rising employment in the housing-related sectors. Consumers seem to be willing to step out a little bit as you see in vehicle sales how businesses have ample funding available to invest. The restraints on the economy, to some extent, are known, and in a way that's a relief itself. A year ago, we didn't know what the restraint to fiscal policy was going to be on the economy.
We knew there was going to be a restraint, but we feared the full dive off of the fiscal cliff. We've gotten all that out of the way—we may not like it, but we know what the path to the fiscal policy is, and it's helpful to have that certainty. Remaining uncertainty is mostly around the debt ceiling, which is still a law that we have to deal with; it's still more politically charged than it has been in earlier years. Sometime around the middle or end of October, we're going to be dealing with it again. I would like to think that the dead-enders who were willing to go off the precipice into a technical default are weaker now and less willing to do that than they were in 2011. But there's always room for miscalculation when both sides are expecting the other to blink first.
So my expectation is there will be some deal with some modest spending cuts in exchange for an increase in the debt ceiling, but I'm still concerned about not only this fall's version, but the fact that…if nothing changes a year or two out, we're going to be doing it again. The other area of risk that I'm concerned about is the global economy, which has not adjusted as quickly to the postcrisis world as the U.S. did. Policy response is rather belated or incomplete, and so there's still not only the risk that our exports are going to be weaker than I expected them to be, but that we have some sort of systemic financial risk that bubbles up. There we'll just have to wait and see; I think that China is trying to ratchet down to a slower rate of growth.
It's hard to do it smoothly, and in Europe they're moving along kind of piecemeal as crises come up. But they've not reduced the overall level of debt much compared to where it was five years ago when it was a bigger shared GDP than our debt was. On the bright side, you have Japan, which seems to be serious about implementing structural reforms to get more growth, and we'll see more about that after the elections in July, and then again that would be a cause for optimism.
The views are as of July 11, 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.