Mid-Year 2013 Global Outlook

U.S. Overview

Economy

As we mentioned in our beginning of the year Global Outlook, the delay in resolution to the Fiscal Cliff had an adverse effect on the economy in the fourth quarter—GDP came in at a near stall speed of 0.4%; and, the automatic sequester cuts didn’t help the recovery from that slow growth—Q1 2013 GDP came in at 1.8%.  We believe the economy is showing gradual, incremental signs of improvement but we are not nearly as optimistic as the Federal Reserve appears to be.  Economic growth for the full year will struggle to get much above 2%; and, the unemployment rate will likely remain at the 7-7.5% level.  The story really hasn’t changed over the past four years:  fiscal policy is non-existent due to Washington’s political gridlock and monetary policy can only spur so much growth.

Inflation

Some Federal Reserve Governors have recently expressed concern about the trajectory and absolute level of inflation.  The Personal Consumption Expenditures Index, the Fed’s preferred measure of inflation, has been declining consistently over the past year and presently stands just above the 1% level (below 1% is considered to be dangerously deflationary)—the slowest rise in prices over the past 50 years.  Chairman Bernanke and the Federal Open Market Committee have outlined a data-dependent timeline for withdrawing quantitative easing.  Should the Fed’s optimistic projections pan out, the Fed would begin cutting back on its bond purchases toward the end of this year and stop them altogether by the middle of next year.  Unfortunately, the Fed has consistently been overly optimistic in its economic projections over the past four years.  We don’t believe quantitative easing will end until the Fed is certain deflationary pressures are off the table—which would equate to a Personal Consumption Expenditures Index closer to 2% than the current 1%.

Interest Rates

Short-term interest rates will remain low for some time.  Longer-term US Treasury yields, which have risen significantly over the past two months thanks to the Fed’s discussion about removing quantitative easing, are comprised of two component parts:  a real interest rate plus an inflation expectation.  The 1% rise in the 10-year US Treasury yield since the end of April was comprised of a 1.25% rise in real yields and a 0.25% decline in inflation expectations.  We would expect the real interest rate component to rise another 0.5% when the Fed does finally cease its quantitative easing—we don’t expect that to happen until inflation expectations increase.  As noted above, we have more deflationary than inflationary pressures at present.  As a result, we expect longer-term interest rates to stabilize and likely decline a bit from these levels over the balance of this year.  Longer term we expect the Fed will eventually succeed in engineering higher inflation rates and therefore higher long-term interest rates as both real interest rates and inflation expectations rise.

Domestic Equity Markets

Stock prices follow corporate earnings and we believe the corporate earnings environment remains positive even as the overall economic environment remains sluggish.  We also believe stocks will continue to benefit from an overall reallocation from bonds to stocks by investors.  Individual investors have been woefully underweighted in stocks since the financial crisis, and institutional pension plans will have a difficult time achieving 8% actuarial rates of return with any investments in investment grade bonds yielding 2.5%.  The stock market still offers comparable yields, far more upside, and only slightly more downside than the investment grade taxable bond market.  We remain bullish on the stock market over the balance of this year.

Domestic Bond Market

The domestic bond market experienced a major re-pricing over the past two months.  Investment grade bond indices were down 4% as bond yields rose nearly 1%–the biggest two month decline in bond indices and rise in rates since the height of the financial crisis in late 2008.   We think investors misinterpreted and overreacted to the Fed’s message, and we would expect bond yields to stabilize and likely decline modestly over the balance of this year.  Longer term we believe bonds are a poor investment as they still offer historically low yields, little upside and lots of downside risk as investors experienced these past two months.  Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics. 

International Overview

Economy

Europe is in a recession and many of the emerging market economies, particularly China, have definitely slowed down.  Central banks across the globe, with the exception of Japan, are looking for ways, like our own Federal Reserve Bank, to ease their respective economies off of the monetary stimulus drip they’ve been on for the past several years.  The monetary stimulus policies recently adopted in Japan are having an impact—the Japanese economy finally appears to be emerging from two decades of deflation.

Inflation

Slowing growth in the emerging markets coupled with most major central banks contemplating exit strategies for monetary stimulus should keep inflation in check.  We still believe that deflation may still be a greater risk than inflation to the overall global economy.

Interest Rates

As with the domestic market, we expect global short-term interest rates to remain low.  Longer-term interest rates in most major markets are still near historic low levels.  Any improvement in economic activity will drive those rates higher—we don’t expect that to happen over the balance of this year.

Currencies

The dollar has had quite a run ever since the Fed started talking about curbing its bond buying activities.  Just as we expect interest rates to stabilize at these levels, we would expect the dollar to do the same versus most major currencies with the exception of the Japanese yen—we expect the yen to continue weakening.

Natural Resources

The slowing of emerging market economies, particularly China, and the strength in the US dollar, has had a direct negative impact on commodity prices.  We don’t see that changing over the balance of this year, but longer-term we believe the emerging and frontier markets will resume their growth trajectories and natural resources will follow.

Global Equity Markets

While emerging market economies continue to show signs of slowing, we believe some of those markets’ stock valuations are becoming attractive.  At present we still have a bias toward domestic versus international stocks; frontier markets over emerging markets, and small cap stocks over large cap stocks in both domestic and developed international markets.

Global Bond Markets

Most of the weaker countries in the Eurozone (Greece, Italy, Spain) have seen their bond yields come down dramatically in recent months.  While we haven’t read or heard much about the European sovereign debt crisis lately, it doesn’t mean it’s been resolved.  We believe the risk is still there but the potential reward has been greatly reduced.  We would favor higher rated developed European countries at these levels.  We remain underweight emerging market debt as we don’t believe investors are being compensated for the reduced liquidity and lower credit quality in those markets.

 

2013 Global Outlook

U.S. Overview

Economy

The delay in resolution of the Fiscal Cliff certainly had a negative impact on consumer spending in the fourth quarter and will likely have an adverse effect on Q1 2013 GDP growth as many corporations postponed initiatives awaiting the outcome.  Even though the first leg of the Fiscal Cliff resolution preserved the Bush-era tax cuts for all but the wealthiest Americans, everyone will be paying higher taxes than a year ago as the temporary payroll tax holiday expired.  The next leg of the Fiscal Cliff debate could be even uglier and more dysfunctional than the first as spending cuts and an extension of the debt ceiling will be on the table.  While we are confident a compromise will eventually be reached between Republicans and Democrats, we suspect the bickering and haggling between now and then could further erode consumer and corporate confidence.  In short, we see a politician-induced difficult economic environment over the first half of 2013; but, once the politics are behind us we expect an improving economy over the second half of the year.

Inflation

At its last Federal Open Market Committee meeting of 2012 the Federal Reserve tied its accommodative monetary policy to the unemployment rate.  Specifically, the committee agreed to maintain its asset purchase programs and 0% Federal Funds rate policies until such time as the unemployment rate falls below 6.5%.  The Fed wants higher inflation.  For those of us who were raised in this business on the adage “don’t fight the Fed”, we believe the Fed will eventually get its way—lower unemployment but higher inflation.

Interest Rates

As noted above, short-term interest rates will remain low for some time.  Prior to this last FOMC meeting, the Federal Reserve had committed to keeping them low until at least 2015.  Longer term interest rates will benefit from the Fed’s asset purchase programs but will face more upward pressure from the aforementioned inflation outlook.  Moreover, bond investors are not comforted by fiscal irresponsibility—an extension of the Bush-era tax cuts for all but the wealthiest without an accompanying expense reduction plan will not be well received by bondholders.

Domestic Equity Markets

Ultimately stock prices track corporate earnings—we believe the corporate earnings environment remains positive even as the overall economic environment remains fragile.  That, coupled with an accommodative monetary policy, makes domestic equities attractive.  Dividend and long-term capital gains tax rates were bumped modestly for the wealthiest Americans, but not as much as many feared (back to the ordinary income tax rate).  On an after-tax basis, even for those paying the highest rates, the 2.2% dividend yield of the S&P 500 is much higher than the 1.75% yield on the investment grade corporate bond market or the 1.25% yield on the intermediate municipal bond market.

Domestic Bond Market

We expect short-term interest rates to remain low for some time; but, as we noted above, we do expect the Fed to ultimately win its fight to reduce the unemployment rate and increase the inflation rate—that isn’t a good scenario for longer-term bonds.  Corporate bond yield spreads relative to US Treasury debt remain attractive particularly when one considers the increasing supply of US Treasury debt relative to corporate debt.  In our tax-exempt portfolios we continue to emphasize higher quality issuers as declining property values and tax bases are having an adverse effect on many state and local municipalities.  Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics.

 

International Overview

Economy

Europe is in a recession, but there are signs of little green shoots popping up—we believe the worst may be behind the European Union.  Likewise, the newly elected Japanese Premier Shinzo Abe is putting pressure on the Bank of Japan to pursue the same accommodative policies as our own Federal Reserve Bank to stimulate growth in that country.  The emerging market economies are showing signs of renewed strength, as evidenced by the fact Macau saw gambling revenues balloon 20% this past December.  Longer term we still expect the emerging economies and the emerging middle classes within those economies to fuel significant growth over the coming decades.

Inflation

Since most of the world’s major central banks are pursuing inflationary policies similar to our own Federal Reserve Bank we would expect inflationary pressures to increase in most major economies.  Europe could be an exception to this as the austerity measures pursued there probably pose a greater risk for deflation than inflation.

Interest Rates

As with the domestic market, we expect global short-term interest rates to remain low; but, due to inflationary pressures we would expect some upward pressure on longer-term interest rates.  Again, the exception is probably the European rate environment where longer-term rates probably still have room to fall, particularly in some of the periphery states.

Currencies

The dollar remains the unquestioned global reserve currency but oddly enough, since last summer the Euro has been the world’s strongest currency.  This is largely due to Europe’s austerity measures as opposed to our inflationary monetary stimulus policies.  Japan is now also pursuing those same policies, which has led to a10% devaluation in the yen versus the US dollar.  We would expect the dollar/euro relationship to stabilize, but we expect further declines in the yen.

Natural Resources

Global central banks’ inflationary policies will be positive for natural resource prices.   Renewed economic growth in the emerging markets will be a huge positive for natural resource prices.  Longer-term, increased global demand without a comparable increase in supply will keep natural resource prices on their upward sloping trajectory.

Global Equity Markets

We’ve become much more constructive with regard to developed and emerging international markets.  At present we have a neutral weighting but the next move is likely to be an overweight.  Valuations in developed international markets remain attractive; and, emerging and frontier market valuations are attractive relative to their high growth rates.

Global Bond Markets

While we remain concerned about the seemingly never-ending sovereign debt crisis in Europe, we believe current yield levels offered by some of the periphery states compensate investors for those risks.  Longer term we believe developed foreign government bonds will outperform U.S. Treasury bonds due to their higher yields and less inflationary central bank policies.  We would underweight emerging market debt as we believe those yields no longer compensate investors for the inherent inflation and credit risks.

Jim Robinson

CIO

 

Disclaimer and Disclosures
This report is provided for informational purposes only, and does not constitute any offer or solicitation to buy or sell any security discussed herein. All opinions expressed and data provided herein are subject to change without notice. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Past performance does not guarantee future results.

 

2012 Mid-Year Global Outlook

U.S. Overview

Economy

At the beginning of this year we made the following statement with regard to the domestic economy: “We expect 2012 to be very similar to 2011. The economy might be able to ride the recent momentum for another quarter, but lacking a resolution to some of these headwinds we suspect the middle quarters will be sluggish. The fourth quarter should see an improvement in growth and employment as the November elections bring renewed hope for the economy.” We’re pretty comfortable standing by that statement.

The headwinds remain the European sovereign debt crisis, a mid-year lull (for the third year in a row) for the domestic economy, and a complete lack of fiscal cooperation out of Washington. The European sovereign debt crisis remains a drag on the global economy. While some of the recent European Union agreements, if implemented quickly, should prevent any contagion from reaching our shores, the low-to-negative growth the continent is mired in has had an adverse effect on the domestic and emerging market economies. The domestic economy is being choked by the legislative impasse in Washington. Corporate balance sheets are in great shape, but they are hesitant to make investments in an uncertain political environment.

Inflation

The Federal Reserve did not initiate another round of quantitative easing in the first half of the year as we anticipated, although it did announce a new round of Operation Twist. Energy prices have fallen 20% since the beginning of the year which should keep inflation in check for a while.

Interest Rates

Short-term interest rates will remain low for some time. The Federal Reserve has committed to keeping them low until at least mid-2013—we suspect it could be even longer than that. The Federal Reserve’s Operation Twist is designed to bring down longer term interest rates. Even though rates across the yield curve are at historic lows there is little to suggest they will be going up any time soon as inflation remains in check and growth remains sluggish.

Domestic Equity Markets

If a weak dollar is good for domestic equities then a strengthening dollar is likely to have the opposite effect. While the European sovereign debt contagion may not pose a direct threat to domestic banks and corporations, slowing economic growth in Europe and Asia will definitely impact revenue growth for domestic companies. Overall, corporate earnings have remained strong and should limit the market’s downside risk, but we don’t anticipate the outsized earnings growth that we saw the past couple years. A major positive for the domestic equity market is the amount of money on the sidelines—any significant declines in valuations will likely be met with renewed buying interest.

Domestic Bond Market

We expect interest rates to remain low for some time and if the Federal Reserve initiates another round of quantitative easing longer-term rates could even go lower—that’s a good environment for bonds. Unfortunately, bond yields are already very low and hard to get excited about. Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics. Corporate bond yield spreads relative to US Treasury debt remain attractive particularly when one considers the increasing supply of US Treasury debt relative to corporate debt. In our tax-exempt portfolios we continue to emphasize higher quality issuers as declining property values and tax bases are having an adverse effect on many state and local municipalities.

International Overview

Economy

Europe is a mess and it appears the Continent may already be in a recession. Regardless, the economic slowdown in Europe has had a direct impact on economic growth rates for the emerging market economies. Longer-term we expect the emerging markets and the emerging middle class within those markets to drive global growth but the next 6-12 months could be challenging.

Inflation

Given the Euro Zone’s austerity measures, we believe that deflation poses an even greater risk in the developed international markets than it does in the U.S. In the emerging markets, where the economic growth rates are higher, we would expect that growth to be accompanied by higher inflationary expectations.

Interest Rates

We expect the sovereign credit risk issue to remain an investor concern in the months (maybe years) ahead. As we speculated in our last several Global Outlooks, the bond vigilantes did in fact put upward pressure on bond yields in Italy, Portugal, Spain and even France. Until the European Union has a viable solution to this crisis we can expect to see continued upward pressure on longer-term rates, but we do expect that the austerity measures will eventually serve as an effective counterbalance to that pressure. Based on our outlook for higher inflation rates in the emerging markets, we would expect interest rates in those countries to trend higher. International bonds offer higher yields than comparably rated domestic debt but they are also fraught with greater risks, many of which are difficult to quantify.

Currencies

The dollar remains the unquestioned global reserve currency. This is particularly evident in times of global turmoil such as we’ve witnessed with each round of the sovereign debt crisis in Europe. Until the crisis is resolved we would expect the dollar to strengthen and the Euro to decline. However, if the European Union does finally arrive at a viable solution we would expect the dollar to resume its long-term devaluation trend versus both developed and emerging markets. The U.S. has actively pursued an inflationary monetary stimulus policy whereas the rest of the developed world is pursuing deflationary austerity measures.

Natural Resources

For the past two years, as the dollar goes, so go the prices of commodities—except in the opposite direction. Longer-term we believe limited supply and rising global demand will naturally drive prices higher, regardless of how the dollar performs.

Global Equity Markets

We would continue to underweight most developed international markets as the growth prospects in most of those economies remain stagnant. Emerging markets, which have underperformed domestic stocks for the past 18 months, are reaching historically attractive valuation levels; but, we wouldn’t be inclined to overweight those markets until we see greater stability out of Europe. Global Bond Markets While we remain concerned about the cascading sovereign credit risk crisis, we believe current yield levels offered by some of the non-Euro Zone issuers compensate investors for those risks. Longer term we believe foreign government bonds will outperform U.S. Treasury bonds due to their higher yields and less inflationary central bank policies.

Jim Robinson CEO & CIO—Telemus Capital Partners

Disclaimers
Telemus Investment Management, LLC, Telemus Wealth Advisors, LLC, and Beacon Investment Company, LLC, registered investment advisors, are wholly-owned affiliates of Telemus Capital Partners, LLC. Telemus Investment Brokers, LLC, member FINRA and SIPC, is a wholly-owned affiliate of Telemus Capital Partners, LLC