October 29, 2012
|In a recent interview, T. Rowe Price Chief Economist Alan Levenson and T. Rowe Price Retirement Funds Manager Jerome Clark discuss the state of the U.S. economy and the financial markets.|
Alan Levenson: I guess the best way to do it is perhaps with a story about Levi Eshkol, who was an early prime minister in the state of Israel. He was asked to summarize the state of the country, of the state of Israel, in one word. He said, "Good." And then he was asked by another reporter at this press conference, "Well, could you summarize the condition of our country in two words?" And he said, "Not good." I'm Alan Levenson. I'm the Chief Economist at T. Rowe Price. This is what I mean by the tailwinds that are good and the headwinds that are not good.
If we just look at the U.S. economy, we see some nice things happening. The housing sector's starting to recover. We had very sharp cutbacks in housing starts, home prices—those are starting to rise and contribute to growth, contribute to household wealth. That's good, and that's a tailwind for growth. Household balance sheets and finances are in much better shape, but debt service, which was taking up 14% of income in 2007, is now taking up only about 10.5% of income. That's more money we can spend on current purchases instead of paying off previous purchases. So these are good things—we're making the corrections and adjustments that we need to in our domestic economy.
But when we first look outside of the things we have direct control in within our country, we see again this fiscal cliff—a lot of uncertainty about what's going to happen to taxes and government spending at the end of the year. And that's holding up the recovery, particularly in hiring and business investment. And then even more problematic, because there's some evidence that at least on the Senate side politicians understand they need to address the fiscal cliff, we look at what's going on in Europe. This is going to be years of economic weakness, political fragility, financial uncertainty, as they try to strengthen their monetary union and recognize a lot of bad debts.
And in China as well—this country had been an engine of growth in the 2000s. It's now in the process of downshifting from what had been 10% growth to 6% or 7% growth, and that process can always have unintended consequences, or overshoot to the downside. And so even as we're doing these good things domestically, it's like shoring up the structure of your boat on a rockier sea.
Levenson: So if we're talking about a pretty sluggish growth environment—real GDP is at best 2%, 2.5% over the next year or so—that means that the demand for labor to produce 2.5% growth is pretty muted.
And it's been about 150,000 jobs a month over the last 12 months, which brings the unemployment rate down by about a half a percentage point a year. So the last three months have been a little slower, and I think that some of that is businesses not knowing what the state of the economy's going to be at the end of the year, what their tax costs are going to be, what demand they're going to get from government contractors. So they're holding back on employment to some extent. Manufacturing has lost jobs the last two months, after adding jobs for several months. That reflects weaker export demand with the slowing broadening in Europe and deepening in Asia as well.
So unfortunately—well, again, it's kind of a good news/bad news story. The good news is we're generating jobs—1 million, 2 million a year. The bad news is that we're going to have to live with this slow pace of recovery in employment after a very sharp and very deep decline, so we won't get back to what we think of as full employment until sometime in 2015 or 2016.
Levenson: I'd love to be able to make a case for rapid growth. Typically, if you looked at the 10 recessions after World War II before the most recent, there's a record that the deeper the decline, the bigger the bounce. And with a 4% or 5% decline in GDP like we had in 2008-2009, we should've had 5% or 6% growth the first couple of years.
We had less than half of that, and this is just life after a financial crisis and housing boom. We're not having a sharp housing recovery because we still have a lot of vacant houses. We're not having a new credit cycle because we're still paying off debts from the last cycle. And so is there going to be stronger growth out there in the future as these headwinds turn to tailwinds, as we go from reducing the housing stock to having to rebuild it? Sure, but at that point the government's going to be cutting back, and so we could get a period of 3% to 4% growth, but we're just not going to have 5% or 6%. I don't think it's fair to represent that as a likely outcome.
And again, no matter how well we get our act together in the U.S., we're going to be doing it in an environment where the structural adjustments that we made have not been mirrored promptly by the related structural adjustments that have to happen in Europe and that have to happen in China and other countries that were geared toward lending into our debt bubble. And so even if we're healthy, we're going to be in a room with sick people, if you will, and so that also restrains growth.
The rosy picture is one where we get everything right that we can possibly get right, and that our politicians do the right thing in terms of putting a long-term budget package in place that doesn't squeeze the economy too much now but raises revenue over time, controls entitlement spending over time. So nobody worries about whether we're going to build up too much debt over the long term and so that nobody has any, again, uncertainties about where the tax code's going to be. It'll be nice just to rewrite the tax code and not have things that are expiring in five years or 10 years, but this is the way it is.
Levenson: Let me describe the main elements of the fiscal cliff. This refers to laws that are set to take effect at the end of this year that, in total, bring about four and a half percentage points of GDP worth of fiscal restraint to the economy if nothing is done to avert them. So on the spending side of the ledger, the most prominent of these is the $1.2 trillion over 10 years of spending cuts that were written into law a year ago when the socalled super-committee failed to come up with a long-term budget deal and said, "If we don't, you have automatic across-the-board spending cuts, half in defense and half in non-defense." So that's the law that's currently on the books.
The other main elements are the Bush-era tax cuts, which were set to expire—that were temporary, not permanent, set to expire at the end of this year. And that's $210 billion in the aggregate; the sequestration super-committee spending cuts were around $90 billion. You also have a payroll tax holiday that was put into place first at the beginning of 2010. That's set to expire. And extended federal unemployment benefits set to expire. Now, there are other things like the alternative minimum tax, which gets patched every couple of years for inflation. That's up for this year. I'm sort of assuming that the things that generally get rolled over are going to get rolled over, and the ones that I mentioned are the ones that are most in play.
And so, this is where Congress has to come up with some way to prevent, particularly, the Bush tax cuts from expiring and the across-the-board spending cuts from taking effect. There seems to be pretty broad consensus on not renewing the payroll tax credit and on not renewing or phasing out gradually the extended unemployment benefits. So when we talk about a detour around the fiscal cliff, it's, for example, the president suggesting on the tax side, let the top two tax rates expire and go higher, but hold tax rates for people making less than $250,000.
That's what me mean by the fiscal cliff, and so it's a situation where if something bad happens, if Congress does nothing—and probably a lot of people would agree the Congress is pretty good at doing nothing—so it's a concern. There are efforts going on now in Congress, particularly in the Senate, to work toward putting together some kind of so-called grand bargain, which again would be multiyear, which would deal with the fiscal cliff in some way. Say pushing off two-thirds of that four and a half percentage point of GDP blow and would also lock in some longer-term deficit reduction with tax reform and entitlement reform.
So I'm a little more hopeful, just because Congress isn't waiting until the presidential election to start talking about possible—I don't want to say resolution of the fiscal cliff, but possible detours around the fiscal cliff. And then that would be step one—that's to screw it up. You ask, "Could they screw it up?" They would screw it up if they just drove us off the fiscal cliff, because not only would we suffer the hit to the economy from all that tightening of fiscal policy, but we also won't get high marks from rating agencies or financial markets for our policymaking acumen. But that's step one.
Step two would be to put in place some kind of a process that next year continues to work on, again, the broader package of reforms. But if Congress were to deliver an A+ answer in terms of simplifying the tax code but raising revenue over the long term that reduces business uncertainty and improves pricing signals in markets. That catalyzes economic activity, and if we also put in place, again, long-term reforms on the spending side, so the budget's going to be balanced over the long-term, that also boosts confidence. That could be very helpful to sort of the ability of the private economy to grow.
Levenson: The fiscal cliff isn't one of these all-or-nothing events where if it happens, it's terrible, and if it doesn't happen, it's great. But it's not something where we can monitor the progress the way we can, say, with the recovery in the housing market, where we get data on a daily, weekly, monthly basis. But I say this: In general, the U.S. economy is doing OK. It's going to keep growing, maybe even gain momentum. We also know in terms of investing, if we want to think about the links to, particularly, equities, the way I'm willing to talk about it is if you have a growing economy, you tend to have growing corporate profits.
That growth is slowing, because profit margins have been starting to stabilize rather than to continue to expand. But profits should continue to grow. That's assuming that policymakers don't hurt us with their response or lack of response to the fiscal cliff. So if you think that they're going to screw it up at the end of this year, then you can reflect that in a greater caution in investing in the near-term, and see what happens.
If you think that we're going to, say, muddle through and get, again, some kind of detour that softens the fiscal cliff, keeps the expansion intact, and then get at least a down payment—let's say $2 trillion of deficit reduction over 10 years, not the $4 trillion of Simpson Bowles—and that's sort of the camp I'm in—then you can focus more on the fundamentals of what's going on in the private sectors of the economy and invest based on that.
Jerome Clark: So the third quarter was very interesting because we've had slow growth within the U.S., and we've had businesses that are spending less on infrastructure. Then outside the U.S., we have a recession in Europe, and then emerging markets have been slowing down, particularly China, and that's hurt our exports in the U.S. Despite that, we've had returns in the U.S., highs in the U.S. equity markets that we haven't seen since 2007.
Within the U.S. markets we've seen returns for the quarter above 6%, and that's been led by energy stocks because of rising oil prices. Outside the U.S. and non-U.S. developed countries, we've seen returns that have been quite good; actually, approximately 7%. And that's being driven by the European Central Bank making a pledge to help countries that are in trouble if they do fiscal reforms within their country to address their problems. Emerging markets have done very well because there's been a greater appetite for risk because of these pledges by both the Fed during the QE3 and the European Central Bank announcement.
For the U.S. bond market, the returns have been positive also, but not quite as well, with a little over 1% return, and that's because the efforts on the Fed have kept interest rates near historic lows. And then outside the U.S., we've had pretty good returns also, and that's been driven, again, by the European Central Bank's announcement, pledge, to help troubled countries. And so we've seen returns there closer to 4%. What's most interesting is that actually the best returns outside the U.S. have come from those troubled countries in Europe: Italy and Spain.
Clark: For this quarter what we anticipate is pretty much more of the same—a fair amount of uncertainty. We have a lot of challenges that are going to take a long time to take care of in Europe, even though we've had this pledge by the European Central Bank, that's going to take years, probably, to take care of—and the same thing with getting our economy going. We've had over the last two years, quarters of risk off and risk on. We don't know which one we're going to get. We're kind of tilted at T. Rowe Price toward a risk-off quarter. But what we do know is that we're going to take care of the political uncertainty coming up here in November. But immediately after that there's going to be a shift to fiscal uncertainty, with a looming fiscal cliff that we have coming up.
And then in Europe, I would say that theme of risk off, risk on is going to continue, because what we see is economies that continue to deteriorate, particularly in China. But then we see the central banks and policymakers making efforts to take care of that.
Clark: I'd say, for investors worried about their retirement savings, these risk-off, risk-on quarters that we've had have resulted in pretty dramatic differences, changes up and down. And I think the story is that old adage of "stay the course," and kind of pick a strategy that makes sense long term, and resist that urge that we all have to chase returns.
I'm a member of the Asset Allocation Committee here at T. Rowe Price, and I can tell you that we have positioned our portfolios here for a little bit tilt towards a risk-on environment. We think long term that markets are going to continue to do well as we go through these volatile periods. They just are going to tend to trend up and do quite well.
With the exception of fixed income, which, based upon the yields that we're experiencing, sooner or later, the Fed is going to take off the policies that have forced interest rates low, and that's going to be a very challenging environment for fixed income.
With that being said, with this heightened uncertainty around both political uncertainty and fiscal uncertainty, it's more important than ever to stay the course and stick to that long-term strategy. So with that being said, with all the current fiscal and political uncertainty that we have now, it's probably more important than ever to stay the course and stick to that long-term strategy.
The views are as of October 10, 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.
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