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August 2, 2012

Todd Cleary Alan Levenson Bob Smith T. Rowe Price's Todd Cleary, Chief Economist Alan Levenson and T. Rowe Price International Stock Fund Manager Bob Smith

In a recent conversation with T. Rowe Price's Todd Cleary, Chief Economist Alan Levenson and T. Rowe Price International Stock Fund Manager Bob Smith discuss the state of the U.S. economy and the financial markets.

Economy in brief

Todd Cleary: Alan, let's start with the economy first. How about you put it in perspective where we are now, and I think a little bit of history would help us understand how we got to where we are and why we're here.

Alan Levenson: A little perspective and a little history are both important because, with the new cycle being what it is and with the ebbs and flows of the data being what they are, it's easy to get whipsawed.

We're still in the aftermath of a financial crisis, we had a big debt bubble in the 2000s which burst when housing prices started to fall, and then the financial crisis in 2007, 2008 threw us into a deep recession. When you come out of that, we still need to deleverage—reduce the leverage in the banking system, reduce our mortgage debt, and we still have to work off an excess supply of homes. And those kinds of factors are weighing on growth.

So we're seeing 2 percent GDP growth on a trend basis. That's about all we're going to get over the next year or so is 2 or 2.5 percent. The underlying economy is getting a little better, but again, it's not flying with all its engines. It's missing the housing engine, missing state and local government engine. Consumer credit is really not contributing too much.

The good news is that, because of all the corrections that have taken place underneath, it's sturdy, and the chances of relapsing into another recession are pretty low. So one thing I try to suggest to people is first of all to remember that growth is supposed to be weak. It's disappointing compared to the 1990s, but it shouldn't be surprising. And the second is that it can be choppier.

And just as one example, in the first quarter of this year, we had an average of 225,000 jobs created each month. In the second quarter of the year, 75,000 jobs. The economy wasn't as strong as the 225,000 a month suggested, wasn't as weak as the 75,000 a month suggested. That 150,000 average over the six months is about right, and that's what we'll see going forward, which again isn't what we have come to expect in recoveries from deep recessions. But with the overlay of the financial crisis, you don't expect that normal recovery.

And the second thing to remember is we're going to sustain this modest but continued job growth and GDP growth even as Europe goes through its financial sector adjustments, and as emerging economies adjust to the fact that they've lost their big export customers in the U.S. and Europe.

Maybe we thought that after falling so hard we were going to bounce more strongly.

Slow recovery

Cleary: It just feels like we have to get used to more gradual recoveries than we've been used to in the past.

Levenson: Well, and again, look back at the last 35 years. The recovery from the deep recession of the early 1980s was a very vigorous recovery. A rapid decline in the unemployment rate, 4 and 5 and 6 percent GDP growth rates. Then we had these two shallow recessions which each had many versions of financial excesses—the saving and loan and commercial real estate investment in the late 1980s, coming into the 1990 recession, and then the tech bubble coming into the 2000 recession. Each of those we had a fairly shallow recession but a sluggish recovery. The term "jobless recovery" that's now so popular was first introduced in the early 1990s to describe the recovery from the '90/'91 recession.

So we sort of have gotten attuned to shallow recoveries. Maybe we just forget. The weight of all the debt that still needs to be worked off, and again, the state and local government pension obligations and debts and the excess housing inventory is just dampening that response.

But, you know, if the first rule of medicine is do no harm, it's the same thing in policy.

Fiscal cliff explained

Cleary: Alan, we're hearing a growing concern from our investors about this concept called the fiscal cliff. Could you shed some light on what that is and why it's important?

Levenson: It's a significant element of uncertainty hanging over the economic environment. Uncertainty is bad for business planning, hiring, and investing. And it is a series of tax and spending measures that are written into current law that are going to hit the economy at the end of the year. And people call it a cliff because you can think of it as, imagine let's build up from the ground level here and recognize that the Bush tax cuts are scheduled to expire, so that's $200 billion. Then you've got the payroll tax cuts expiring, that's another $100 billion. Then we've got unemployment insurance benefits extensions expiring, that's another $50 billion. Super Committee's spending cuts that were put in place last year, that's another $75 billion. You've got close to $450 billion dollars. That's about three percentage points of GDP.

So imagine here the Road Runner is going along at about $15 trillion a year, Wile E. Coyote is following him, that's businesses who are thinking that "we're going to keep going at $15 trillion a year." Then we come to the end of this year with nothing done about any of these measures that are due to hit, and Road Runner keeps going. But the level of the ground, the level of GDP falls by three percentage points, by $450 billion. Wile E. Coyote, when the dust clears, looks down and we know how that movie ends. In this story I don't know if a little chunk of rock falls off the edge of the cliff and adds insult to injury, but what people are worried about is a sudden drop in spending power when all those taxes are increased and all that spending gets cut.

It's a problem of too much entitlement spending over the long term, not enough revenue generation over the long term.

Fiscal cliff likely outcome

Cleary: So the policymakers aren't doing much to decrease our uncertainty. The partisan nature of what's happening in Washington is making this situation even tougher. So what's the expected or what's a likely outcome of all this?

Levenson: Well, unfortunately, there were efforts last year to put together what was called a grand bargain. The grand bargain was going to say, let's bend the cost curve on entitlements, let's harvest more tax revenue, maybe by closing loopholes, and put the budget on a long-term narrower trajectory.

That didn't happen. It takes a lot of compromise. It's again structural on both sides of big comprehensive reforms. And we're not going to see that this year, I don't think, because that's what the election is going to be about to a significant extent.

I think the consensus view is that everybody in Congress is aware that this is going to happen, everybody in Congress is aware that it'll be a bad thing for them to allow it to happen. Any action before the election is unlikely. And what probably happens after the election, it seems most likely to me, is in that lame duck session of Congress where President Obama is finishing his term, whether he's reelected for a second term or not we don't know now, but he'll be finishing his term. The Congress that's going to turn over, but it's still in place for six weeks, will vote to extend all of this stuff for another six months with the understanding, or certainly the expectation, that when the new presidential administration begins, whether it's Romney or Obama, and when the new Congress takes office, that they make at least a down payment on a more permanent solution to these issues.

We can't keep running policy with six-month extensions of programs, because nobody can plan that way.

Cleary: Right. Yeah. And it just creates a lot of uncertainty in the markets. So you think some sort of stopgap measure will take place and then they'll look later at a more permanent solution?

Levenson: Yeah, again, nobody likes our tax code. Everybody loves to say this is a 5,000-page book, it's unwieldy, it's insane that it's that hard to prepare your taxes. And I think that many people are coming to understand that we're not going to be able to afford the entitlement programs that we put in place. There are just going to be too many elderly people and not enough working people to support it. But again, it's going to take time to address that.

And so the stopgap is, let's at least wait until the new government takes form. But if that's going to be the solution, I'd just as soon see that voted on today. So the cliff at least gets moved out for another six months.

Europe: What's happening

Bob Smith: If you think about the German situation and Europe as a whole, they have the ability to steer through this. So it's sort of like a family, that if the combined assets and the combined balance sheet is fine, but you have some members in the family that don't have good balance sheets, that don't have good fiscal discipline, that the family has the ability, assuming that they can make the right decisions.

And I think the one thing that is good is the market is forcing people to make the right decisions. And so it's painful at those moments, you know, like when we had the Greek election, when we've had the Spanish situation in terms of the banking problems—the market punishes, it takes interest rates higher, it hits equity markets. But those market movements are affecting policy.

So if you think of Germany all of a sudden has gone from a very rigid, I guess, position to one where they are leaning and bending and understanding, if you take French elections, the market is moving policy. So on the intermediate term, I think we get through. The hard part is if you have a very short-term horizon, it's very difficult, because markets can go up and down. But I think if you take the two- or three-year time horizon, we have the ability, Europe has the ability, I think China in terms of moving itself toward a consumer-led economy has the ability to get there. So I think you just have to stay diversified and kind of work your way through and understand that it's going to be choppy.

Levenson: In a way you're making a very good point, because both sides of these conflicts in Europe use market stress as a bargaining chip. And so the stronger, richer countries force the weaker countries to undergo stress, face higher interest rates, see the writing on the wall that their economies are going to buckle under the weight of this debt service if they don't take the reforms that they need to take to get their houses in order to stimulate more growth and close budget gaps.

At the same time, the weak countries are saying, if you don't help us, strong countries, these market stresses are going to pick up, we're not going to be able to raise our debts. Who knows? The next election, we may have a government that wants to pull out of the euro, and then all bets are off.

So it's not that you want to, again, be a tactical investor, investing in every episode of stress, but to recognize that after stress comes responses getting Europe closer to something more sustainable.

And China in a way is feeling itself through the same sort of thing, testing how far can it go in the reforms it wants without unacceptably weak growth, and then bringing back just enough to keep things from getting too weak but not going back to the old way of doing business.

Smith: Over time, economic growth drives revenue growth, and it drives earnings growth, which drives stock prices.

Why earnings matter

Cleary: What's happening in terms of corporate earnings? Talk to us about that and why they're so important.

Smith: Most of the economies are showing some degree of slowing. If you look at emerging markets, which are the faster-growing markets over time, you know, Brazil has slowed probably more than we would have thought, China's been slowing, India's had issues in terms of policy which have caused it to slow. Europe is slow to begin with. It's more troubled at the moment. Japan is not a vibrant market to begin with and so it's relatively slow. And so that slowdown—and even the U.S., which kind of seemed to be accelerating, seems to be plateauing a little bit—is when the economy is slow, it tends to make revenues slow for companies, and therefore earnings slow.

And the reason that matters, that over time, earnings and cash flow drive stock prices, that coupled with interest rates. And so that will weigh probably near term; I mean, when we look at second-quarter earnings, they're going to be announced, I think it's more likely that earnings are at least somewhat disappointing. Companies are probably not going to be, in terms of their comments on the second half, are not going to be super optimistic. One is because we do have economic growth slowing, and then also Alan's comments about policy by most governments is very uncertain, and uncertainty makes companies want to sit on their cash and not hire and not invest. And so I think we'll still be going through a period like that.

I think, on the positive side, valuations have come back a great deal. So if you're again a longer-term holder, particularly in international markets, the ability to buy stocks in a lot of these countries is lower prices, which is good if you're a longer-term holder. So I think you're going to have to work your way through slowing earnings, which will weigh a little bit on stock prices. But I think if we work our way forward 12 or 18 months, we'll begin to see emerging markets start to resume better growth because they've taken interest rates lower and are easing putting policies in place that should accommodate better growth, and I think that should be good down the road for emerging markets.

And I think Europe and Japan are going to be subdued for a while, but I think if we can feel a little bit better about the intermediate policy, I think the valuations there, which are very low, can rise even though the earnings for those countries, the earnings that come out of those countries, will still be a challenge.

And we don't own Europe. We own European companies.

Why invest in Europe

Cleary: So why do we invest in Europe?

Smith: There are great companies in Europe that have very little exposure to Europe, or they have exposure and are gaining share and still growing in a tough environment. I mean, we've over time owned companies in Spain and Portugal which have great growth, and it's just not coming from Spain and Portugal, it's coming from their exposure in other places. And I think that is important as an equity holder to know that our companies can be exposed to very great growth opportunities even if they're located in countries that might seem troubled.

Levenson: I wanted to ask you a question. You said growth drives revenues, revenues drive earnings, earnings drive stock prices. I believe that, and I understand that. But if I'm making buggy whips, it doesn't matter how fast the economy is growing, I'm not going to sell 'em. And if I'm rolling out iPhones over the last few years, even in Japan where there's no growth, I would guess that there are a lot more iPhones being carried around than there were three years ago.

And you mentioned market share. There are companies that are developing new products and growing their companies that are going to gain market share—the global economy is slower and maybe less dynamic than it was five years ago. Do you find more difficulty identifying those kinds of companies now than you did five years ago?

Smith: Yeah, I mean, I think the pool is not growing as fast and it's harder to find growth. So the average company is probably going to grow less in the next three to five years than it might have in a normal part of an economic cycle, because of what's happening with the deleveraging of countries. Companies I think are mainly delevered, but as the countries delever, it kind of puts a drag on economic growth.

So I think in general the pool will grow less, but as you said, the pool is huge. So if you can find companies that are taking share, then it's not that important. We over time have owned companies that have been able to have great growth in markets and in sectors that really don't grow that much.

Europe in general hasn't had a lot of growth at the consumer level for a while. Maybe if you're kind of outside of Spain, which probably had its big jump, but there have been some great luxury goods companies that have come out of Europe that have great growth because they're taking share and they're investing in markets where luxury is just beginning to be bought.

So we look at companies, and I think it is important to know we really think a lot about what's happening from a country point of view so we're not ignorant of it. We don't own them in a vacuum that way. But you can find great exposure, either because they have a better format if you're a retailer, they have a better product if you're a technology company, that allows you to create great shareholder value in a no-growth world.

Levenson: It's really come home to me over the years at T. Rowe Price, because Bob's not the only person who says "I pick companies." Why would I want Bob to look in just one country for companies? There are good companies all over the world. And growth is becoming more diffused all over the world. The U.S. has a smaller share of the global economic pie, so I'd rather have people who are evaluating individual companies and securities cast the net widely on my behalf.

Smith: So we hope that you all know that we're worried about it, and we will try to do what's right over the long term.

Retiring during recession

Cleary: Every day about 10,000 [people] turn age 65 in the United States. They're approaching or in retirement, so that's an important time for them to reassess the portfolios and look at risk differently. Bob, when you look at risk in portfolios and managing asset allocation and retirees desire to become more conservative, how do you look at the concept of risk and conservatism in portfolios as people approach that phase?

Smith: I think right now is a very difficult time for retirees, more so than normal. In general, what you tell them is that you take less risk as you get older because you need the capital and you want to make sure that you don't have capital at risk because it's important for you to use for your retirement.

The problem now is that we have very low interest rates, so if you are in a fixed income versus equities, unless you take risk in fixed income, are getting really, really low rates, which make it more difficult for you to live on. In addition, I think those assets which have very low rates aren't as riskless as you might seem. So if you think of U.S. safe Treasuries, they're not as safe as they might have been over time because of the balance sheet of our government, I think. And at the same time, the dividend yields of equities tend to be relatively high. As equity prices have moved down, yields have moved up. And so the trade-off between what you thought was risky and what you thought was riskless might be less of a difference than you thought before. And what you get paid to take risk is much higher.

And so I think that if you are a retiree at the moment, you probably would have somewhat more equities than you might normally have, or what your asset allocation, or what asset allocation models in general might tell you, I think because of the fact that prices are low, yields are high in those particular securities. So that's one aspect.

And I think the other aspect is that just like companies in the U.S. are investing outside—so if you look at most U.S. companies realizing where the great growth opportunities are for the next 15 or 20 years, have more of their assets and more of their earnings coming from outside the U.S.—I think that retirees should have more of their assets outside the U.S. So I think having more of an international flavor—one is it gives you more diversification, but at the same time we think over time that they should give you pretty good returns both on the equity and fixed income side.

So I think having that part of your portfolio be a little bit bigger probably makes sense. And in general, being diversified I think is important, particularly as we're going to probably stay volatile for a little while until we get some of these intermediate bigger-picture issues dealt with.

Levenson: We talk about, what is it, 10,000 people turning 65 every day? It is not and should not be the case that up until the day before, they were 100 percent equity, 0 fixed income, and the next day they think they're supposed to flip it the other way. It's a gradual process that should be ongoing as you approach retirement and plan for it. So the day after you retire, your portfolio is where it should be. And also recognizing that the process has a long tail.

Smith: You hope that when, as you always say, from an investment point of view, that you never change how you swing the bat when you go to the plate.

Recession's impact on managers

Cleary: Has your approach to investing changed since 2008 in terms of the risks you see, or is it the long-term nature of your thinking and what you do, has that changed much?

Smith: That's a good question. So we hope we look at it the same. But I do think we're in a world where growth is going to be a little bit less, and it's going to be more difficult. So in terms of the premium you might put on companies that have very strong business models and companies that have very good cross controls and companies and managements that are really good users of capital, that those assets might be more valuable during this period. So I think you might tilt a little bit that way.

And then we try to take advantage of that when risk is—when people are afraid, you want to be a buyer, and when people are not afraid, then maybe you sell risk. And I think, at the moment tactically, I think we're in a very nervous market where people are really holding on to certainty. So I do think tactically we're trying to take a little bit more risk, because I think that you're paid to take it at the moment.

Again we do things incrementally and with a long-term approach and buying companies that we want to own over the next three to five years, but I think tactically that's an opportunity that is in front of us.

Cleary: Yeah. Thank you very much, Alan, and thank you, Bob.

Cleary: To review the specific performance and economic data, please download the Market Report. And 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.

The views are as of August 1, 2012 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.

Stocks and sectors may not perform in line with the managers' expectations. All funds are subject to market risk, including possible loss of principal. Funds that invest overseas generally carry more risk than funds that invest strictly in U.S. assets, due to factors such as currency risk, geographic risk and emerging markets risk. Because of the concentration in rapidly developing economies, investing in emerging markets involves a high degree of risk. Bonds are subject to credit risk and interest rate risk. Investors should note that if interest rates rise significantly from current levels, bond fund total returns are likely to decline. Diversification cannot assure a profit or protect against loss in a declining market.

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