Investors often live in a state of denial. In the good times, we’ve seen investors reject the notion that the party will ever end. In the bad times, we’ve seen investors cling to the belief that things will never get better. I’ve seen recent surveys which suggest that, some three years after the official end of the Great Recession, three out of four Americans still believe that the economy is in a downturn1 with most Americans expecting the economy to be worse next year,2 irrespective of Congress’ last minute dealings to prevent income tax hikes on millions of middle class Americans. The fact that the economy continues to recover is indisputable even as the pace of growth continues to disappoint.
And there’s the rub. The lingering aftermath of a financial crisis has left us an unacceptable situation. Who among us is willing to tolerate high unemployment, anemic wage growth, growing income inequality, and to boot, a debt burden that is on track to equal the total output of the U.S. economy by the end of this decade?
Investing is a forward-looking exercise, however, not a backward- or even coincident-looking one. The market, having rallied sharply in three of the last four years, has accepted that our collective circumstances continue to get better, even as the utopian state remains maddeningly out of reach. As investors grasp for reasons not to put money to work, the economy improves and the markets continue to pass them by. With deference to the late Jerry Garcia, it’s when life looks like easy street that there is danger at your door. In other words, complacency is hazardous. With many investors still focusing on the bad guys in Washington or Wall Street, or remembering how cool it was when their home values appreciated every day, complacency now seems scarce—and that’s a good thing. Hard as it is to accept the plodding pace of economic improvement, that’s precisely what investors must do.
As we embark on this New Year, here is what I accept:
First and foremost, I accept that (spoiler alert) my generally optimistic outlook could be rendered obsolete in the wake of Washington’s inability to truly address our ongoing fiscal issues. Although it’s true that, as we expected, we managed to avoid the worst of the fiscal cliff on New Year’s Day, what we have now is a short-term compromise and not a grand bargain to reduce the $4 trillion over 10 years. As such, this compromise does little to allay concerns over future spending and tax decisions. The looming sequestration and the debate over the debt ceiling extend policy uncertainty and, at least for the early part of 2013, are likely to keep business leaders reluctant to deploy capital in a meaningful way.
While I’d really like to see the tax-preference barnacles scraped off the tax code, the larger debate continues to hinge on how much we’re willing to spend in the next decade on healthcare, pensions, and defense and how we will pay for it all. Every one of us—not just some other guy—will pay more or benefit less (or both!) from a tighter federal budget. That’s what makes compromise so difficult even though we’ll all benefit from a sustainable fiscal outcome.
I accept that breakout growth may once again be out of reach this year. Despite considerable progress, the drag from household deleveraging still has months and billions to go. But to the naysayers calling for a recession this year, I acknowledge that the business cycle is getting longer in the tooth, but ask: Where are the excesses in the system?
- Household debt-to-income ratios are declining and the burden of servicing the debt has fallen to its lowest level in 31 years (representing roughly $2,000 in annual savings to American households).3
- The inventory of existing homes for sale has been halved as housing has become more affordable than at any point in decades. Even the nation’s home builders are increasingly optimistic,4 a very positive sign for residential investment and construction-sector job creation.
- Consumers, feeling more confident, are making bigger ticket purchases including automobiles. Although we’re buying roughly 15 million vehicles per year,5 the average life of a car on the road remains quite high.
- Even the much-maligned states have seen their finances improve6 as each passing quarter of growth has brought new revenues into the coffers.
I accept that the future is more certain than it has been at any point over the past five years. The turning point can be summed up in three words: ”whatever it takes.” European Central Bank President Mario Draghi’s pledge to do enough (“And believe me, it will be enough”7) to preserve the euro had an immediate and unmistakable influence on the market. Peripheral European borrowing costs tumbled and risk appetites surged. I believe the emergence of a credible lender of last resort to increasingly illiquid countries like Spain and Italy, removed the threat of collapse for the European financial system. The European economy remains troubled even as structural reforms are making countries become more competitive (note the recent improvements in the current account balances of the countries of the periphery). Draghi’s commitment and the political support it received make the feared Grexit—a Greek exit from the Euro bloc—a much less interesting issue, and I continue to believe that recent moves towards tighter banking and fiscal unions are just the baby steps toward a more unified Continent.
Draghi may now have dibs on “Whatever It Takes” as the title of his future memoirs, although in truth many central bankers around the world could have claimed it as their own. In the U.S., it’s QE4ever, or at least until unemployment returns to 6.5%, an unlikely outcome in 2013 or even 2014—unless inflation spikes. In Japan, after two lost decades of growth, it’s full speed ahead on monetary and fiscal stimulus. Even the People’s Bank of China, which has been dead set against extending anywhere near the amount of stimulus it provided in 2008, has offered enough support for the world’s second-largest economy to start reaccelerating. As the world’s swing producer of growth, China’s reacceleration has many of the world’s emerging economies following in tow. We may not party like it’s 2005, but I believe world output will advance in 2013.
I accept that the world has no shortages of challenges in the year ahead. The globe is littered with festering hot spots ready to implode. Many conflicts—Syrian civil war, Israeli-Iranian nuclear standoff—are fraught with risk but when weren’t they? For all the talk about the shale energy revolution bringing jobs back to the U.S., perhaps the most important implication of “fracking” is that it stands to put a ceiling on energy prices, leaving the U.S. less vulnerable to the tensions of the Middle East. In the meantime, let’s remember that investors who decide to stay on the sidelines because of conflict in the region would have been standing there for much of the last many centuries.
Finally, I accept that the risks in 2013 are to the upside. U.S. businesses and households are flush with cash. The uncertainty of the past half-decade leaves businesses with lean work forces and aging capital and leaves households sitting on too much cash. Positive political surprises could be the impetus for idle cash to begin creating a virtuous cycle of more jobs and higher equity returns begetting consumption and even greater job creation. Treasury investors in denial beware.
1. ABC/Washington Post poll by Langer Research, 12/24/12.
2. Rasmussen Reports, 12/26/12.
3. Federal Reserve Flow of Funds Report dated 12/6/12.
4. National Association of Homebuilders, 12/18/12.
5. Ned Davis Research, 9/30/12
6. Bloomberg, 11/30/12.
7. From a speech by Mario Draghi, Global Investment Conference, London, 26 July 2012.