Anyone who watched the national debate unfold during this election year could be forgiven for viewing the United States as a place any shrewd investor would avoid at all costs. The dysfunctional behavior of politicians, coupled with the paralysis of business leaders, hardly paints a picture of an environment possessing real economic potential.
Yet a growing chorus of professional investors is increasingly convinced that the U.S. economy may be about to break out of a decade-long malaise, punctuated by five years of recession and anemic growth, and resume a faster expansion. “If you permitted me to lock up money for five or 10 years, I’d overweight the U.S. and emerging markets,” says Bob Doll, chief equity strategist at Nuveen Asset Management.
America is coming out of the worst recession and financial crisis in 80 years in “far better shape than anyone else,” economist Ed Yardeni told attendees at the second annual Fiduciary Gatekeepers Investment Research Manager conference in October. That sentiment was echoed last summer by Ray Dalio, the founder of Bridgewater Associates, the nation’s largest hedge fund. In an interview in Barron’s, Dalio remarked that the United States has executed a masterful job of deleveraging since the financial meltdown.
If all this sounds a little strange to you, it should. In the five years since the financial crisis began, the U.S. government has added more than $1 trillion in debt each year. But watching government debt too closely without looking at corporate and consumer borrowing could be a big mistake when trying to read tea leaves.
Former Merrill Lynch chief investment strategist Richard Bernstein, who today runs his own eponymous advisory firm, remarked in October that total U.S. debt—meaning government, corporate and consumer debt—has declined from its peak of 350% of GDP to 320%. Bernstein admitted he was stunned to discover this. While the decline may be small, the change in trajectory is significant. By his reckoning, total U.S. debt has never fallen at as fast a rate before. Look around the world and the U.S. is, in Bernstein’s words, “the smartest kid in summer school.”
The Big Game-Changer
Still, the biggest game-changer working in America’s economic favor is its declining dependence on foreign energy. For the first time in more than half a century, the U.S. is poised to become a petrostate, and this has far-reaching ramifications. The Vienna-based International Energy Agency predicted in November that by 2020 U.S. oil production would climb to more than 11 million barrels a day, exceeding that of Saudi Arabia, and bringing a decline in U.S. imports to 4 million barrels a day from the current 10 million.
At the same time, the IEA predicts that the U.S. is expected to emerge as a major exporter of natural gas in the next five years and that it could become energy independent by 2035. This is a far cry from the looming peak-oil theory that dominated the conversation among global thought leaders only five years ago. And the U.S. isn’t alone; much of the rest of North and South America suddenly is using new technology to replace energy reserves at the fastest rate in decades.
It remains to be seen precisely how the energy boom plays out. Oil, with a price determined by global markets, is much easier to export than natural gas, with a price determined locally. That is prompting some German manufacturers to change plans and build facilities in the United States, primarily because the price of natural gas here is one-third of what it is in Germany.
At the same time, countries like Japan might be willing to pay a premium for natural gas to reduce that insular nation’s reliance on nuclear energy, particularly in the wake of the 2011 Fukushima disaster. If the U.S. discovers technology to increase the efficiency of transporting natural gas, would its price then be determined by global markets? Would Americans object?
Undoubtedly, environmental politics and national economic interests are bound to clash. Recall former House Speaker Nancy Pelosi’s 2008 observation that natural gas was “a cheap, clean alternative to fossil fuels” shortly after her husband invested in several gas projects with T. Boone Pickens. Protectionists might also point to national security requirements as a reason to leave the resources within the U.S. If cheaper domestic energy sources keep proliferating, it’s not hard to imagine environmentalists demanding that projects like the Keystone pipeline be approved only if the dirty Canadian shale oil gets exported to some faraway place like Africa or Asia.
Still, the oil and gas boom is for real. Amid all the uncertainties, one consequence that is crystal clear is the implication for most of the major components of the trade deficit. The implications “are humongous,” says Loomis Sayles Vice Chairman Dan Fuss. The dollar should be a beneficiary as well.
As German manufacturers’ decision to relocate factories to the U.S. reveals, America may start to benefit from some of the rest of the world’s problems, Bernstein says. It’s no coincidence that the sectors that suffered most in the Great Recession—autos and housing—are now taking the baton from the technology and manufacturing industries, which performed best early in the recovery, and are propelling the second leg of economic activity. A rise in home prices for the first time since 2006 already appears to be producing a surge in consumer confidence.
What About The Others?
All this, unfortunately, ignores the sorry state of the rest of the world, or much of it. “People have grossly underestimated the risks outside the U.S.,” Bernstein told a conference in mid-October. Two months later, French and German equity markets were touching their highs for the year. Could investors in France be in denial? After all, their economy was re-entering recession after the government raised the top marginal tax rates to 75% while the U.S. government was twisting itself into a pretzel over whether the highest tax rate should be 35% or 39.6%.
Could an unsatisfactory resolution to the so-called fiscal cliff throw the U.S. into a recession in 2013? Easily. Even if the Beltway dispute is resolved, the outlook for 2013 is mediocre, at best. But as Schwab’s chief investment strategist Liz Ann Sonders observed at the firm’s annual Impact conference, there are very few excesses in the American private sector presently, so any recession likely would be mild.
The rest of the world is in weak shape, and though third-quarter U.S. productivity figures and exports surprised markets by rising, it’s hard to see how that would continue in the fourth quarter or in early 2013, which should not be a strong year for global growth. The only question about Europe’s economy is whether its current recession will be soft or serious. And with 15 nations in the euro zone facing parliamentary elections in the next 18 months, the entire continent’s future is fuzzy at best.
As Bernstein noted, debt and delinquency ratios in Brazil have climbed rapidly in recent years. And anyone who knows anything is suspicious of any information coming out of China. “The U.S. is the only country that can lead the world out of this slowdown,” KKR co-CEO George Roberts remarked at the Schwab conference in November.
Another factor likely to be working in America’s favor over the next decade is a rebound in manufacturing. Recall that outsourcing became a fad in the late 1990s when U.S. unemployment stood at 4.0% and workers of all skill levels were in short supply.
What a difference a decade makes. Since 2000, wages in China have climbed fivefold and labor unrest has increased. As Yardeni noted this fall, a 15-year-old Chinese worker who grew up in that nation’s rural west may eventually demand more than a higher salary by the time he turns 30.
Meanwhile, American workers who were unenthused about manufacturing jobs paying $15 an hour have changed their attitudes following 10 years of falling median incomes. Faced with chronic membership attrition in private sector unions, some unions are even embracing two-tier wage structures in which new workers accept jobs at pay levels 30% to 50% below those of existing employees.
The journey to a manufacturing renaissance is by no means certain. When employment begins to recover, will unions maintain their docile posture? That remains to be seen. Even with abnormally high levels of unemployment, manufacturers in many industries have found it difficult to attract workers with the requisite skill sets. As baby boomers keep turning 65 at the rate of 300,000 a month for the next decade, the dynamics of the labor markets are likely to turn less advantageous for employers.
One Giant Nursing Home?
Growth prospects around the world aren’t what they used to be. Much of the problem can be traced to rapidly slowing population growth. Indeed, it sometimes seems as if the planet gradually is turning into one giant nursing home orbiting the sun.
Take Japan, for starters. If current trends continue, that nation could lose 20% of its population by 2040 and half its population by the end of the century. China’s one-child policy has convinced many people that the world’s biggest country will grow old before it becomes rich.
Even in population, the U.S. is operating at a relative advantage. The country’s population is likely to reach 400 million by 2050, while Europe probably will see a decline, albeit at a slower rate than Japan.
Economic growth, after all, can be divided into two components—productivity growth and population growth. “Real gross domestic product has been growing at a subpar pace of about 2-2.5% on an annual basis for the past three years,” Yardeni recently wrote in The Financial Times. “However, excluding government spending, it has actually been growing about 3-3.5%. In other words, the non-farm business sector’s performance doesn’t jibe with the so-called ‘new normal’ scenario of a structural decline in the economy’s potential growth rate.”
If a strong U.S. recovery materializes in 2014 or 2015, it would be good news for American businesses and workers, but it might not necessarily translate into strong returns for equity investors. One could easily argue that markets are already discounting exactly that event, given that the Standard & Poor’s 500 index has already advanced by more than 100% from its lows of March 2009. Numerous studies have shown that markets historically perform better in the early stages of a rebound, anticipating more robust growth to come later in the cycle.
Yardeni believes the current stock market rally has earned less respect than Rodney Dangerfield. Among retail investors, he is certainly right.
At Schwab’s conference, Sonders cited a Franklin Templeton survey of its mutual fund investors. Many are living in their own gloomy bubbles and tuning out the markets. Asked what they thought the stock market did in 2009, fully 66% said it went down. Those figures were 46% for 2010 and 53% for 2011.
If retail investors are living in a world even more comatose than Pimco’s new normal, characterized by 4% equity and 2% fixed-income returns, others are not. Bernstein believes the U.S. equity market is in the early stages of what could become the most powerful bull market of his lifetime. From someone who got his start in the investment business in the early 1980s, it’s a significant statement.
“Bull markets often begin in periods of fear,” he remarked in October. Many of the same issues paralyzing investors today were gripping the markets from 1982 to 1987. Corporate profit margins shrank from lofty rates throughout the decade, while trade and budget deficits dominated the headlines. The strong-willed Federal Reserve Board Chairman, Paul Volcker, acted almost like a law unto himself, and embraced drastic measures to stifle inflation. Though the economy enjoyed a strong recovery in 1983 and 1984, the term “growth recession” was coined in 1985 as expansion moderated.
Bernstein’s optimism makes him a lonely voice. “People today are asking is [the 2009–2012 stock market rebound] over?” he noted in October. A bear market has never been preceded by mutual fund outflows like those experienced in recent years, and none of three key bear-market signals—an inverted yield curve, extreme overenthusiastic sentiment and lofty valuations—are present today.
At least on the valuation point, many would challenge Bernstein. In a paper on November 12, AQR Capital Management managing principal Cliff Asness examined several variations of the Shiller price/earnings ratio and reached the opposite conclusion. By his calculations, the S&P 500 Shiller P/E ratio, designed to weight earnings over a 10-year period so as to smooth year-to-year distortions, is higher than it has been for 80% of the time since 1926, even if it isn’t at its 1999-2000 peak.
Critics of the 10-year Shiller P/E point to the collapse of earnings in 2008 as an aberration. But others counter that today’s record levels of corporate profits at roughly 11% of GDP as unsustainable. Finally, he points to the “big gun” critics aim at the Shiller P/E—that the last 10 years “are just too disastrous” to be meaningful. One might think so in light of terrorist attacks, tsunamis, wars, the Great Recession and a series of political standoffs scaling ever-new heights of gridlock.
Statistically, the last decade “has been mildly above average,” Asness writes. That certainly would be news to the investors in Franklin Templeton’s survey.
Where you stand depends on where you sit. “All of our problems are political,” Yardeni remarked in October. But financial advisors spend a lot more time with the mass-affluent investors polled in surveys like Franklin Templeton’s, dealing more with the details of their personal finances than those who are in the world of Bernstein and Asness. Whatever their political persuasion, clients are more likely to see headlines like the prospect of going over the so-called fiscal cliff as a reason for either adopting a defensive posture or total paralysis. That can make it harder to see the forest through the trees.
Many of the sharpest advisors—people like J. Michael Martin of Financial Advantage in Columbia, Md., and Bill Bengen of Bengen Financial in Chula Vista, Calif.—also buy into Asness’ conviction that Shiller P/E ratios reveal an overvalued U.S. equity market. They have no problem waiting for a correction that they believe is inevitable before they establish positions in investments they believe to be promising.
There are a variety of ways how the U.S. and the rest of the world could ultimately emerge from the anemic post-crisis economy. In an increasingly interconnected global economy, prosperity hinges on more than a few large nations enjoying robust recoveries. Bernstein admits individual nations are less decoupled than ever, and while various regions’ problems may play to America’s advantage in the short term, they won’t in the long term. For his scenario to come to fruition, an entire host of factors would have to fall into place at the same time. Even then, a bull market rivaling the 1982–1999 move to the stratosphere looks improbable. Ultimately, being the smartest kid in summer school might not be enough. But that doesn’t mean things won’t be a lot better later in this decade.