December 20, 2012
• Fiscal headwinds will prevail in the first half of 2013, but the U.S. economy will pick up in the second half.
• Lawmakers are likely to scale back the fiscal cliff and agree on a comprehensive budget plan in January.
• The private sector is poised for much stronger growth once clarity returns to federal policy.
We toyed with the idea of subtitling this section “Why bother?” It seems ridiculous to come out with an economic forecast ahead of a resolution of the fiscal cliff. Indeed, previous “Economic Outlook” reports have been a mind-numbing couple dozen pages. But keeping with tradition we are releasing our report at the turn of the calendar year, albeit in abbreviated form. We will add, modify, change, etc. as new information is discovered (i.e. new compromises are reached).
Due to the uncertainty over what will be agreed upon, a wide array of economic outcomes is possible, ranging from recession to robust growth. There are many ways the current tax and budget negotiations could play out regarding the fiscal cliff, but the most likely scenario has lawmakers agreeing on a comprehensive budge plan in early 2013. Our base case assumes a partial resolution of the fiscal cliff, including some spending cuts and tax increases, but no long-term credible agreement on entitlement spending. It will be enough to prevent a new recession, even if just barely. The resulting agreement will likely only lay out a broad framework and let congressional committees hash out the details next year.
With that in mind, we have been describing the economic outlook as a glass half-full. Models from the Survey of Professional Forecasters, Blue Chip, and the Federal Reserve’s FOMC show expectations of 2013 real GDP growth (“real” means “adjusted for inflation”, and that’s the number you typically see in the newspapers) at 2.0%, 2.3%, and 2.7%, respectively. Those numbers compare to the roughly 2.0% growth of 2012. These ranges make sense to us (we expect 2.6%). We think financial and credit conditions matter, and they will continue to support growth. We also assumed some headwinds from fiscal support. A rebound in nonresidential fixed investment along with steady growth in residential investment should offset the drag from the government sector. Trade and inventories will mostly offset each other.
But those are all weak assumptions until we have clarity on the fiscal cliff. If we go over the cliff and make no decisions until February 2013, the economy will go flat or perhaps contract slightly in the first quarter (Q1). We would then expect gradual, but modest, improvement. However, the economy is already growing at about a 2% rate. If the fiscal cliff uncertainties are removed, growth in the second half (2H) of 2013 could be quite robust, powered by a reviving private sector. An excess of leverage led to the Great Recession of 2009, but firms and households have rapidly pared down their debts since then, and balance sheets are now strong. With some additional clarity from Washington on taxes and budgets, businesses, banks and households should all become more aggressive in investing, hiring, lending, and spending.
No matter what happens on the fiscal cliff, we expect inflation, as measured by the Consumer Price Index (CPI) to remain contained next year. Higher inflation remains a longer-term risk as we believe the accommodative stance of monetary policy has created inflationary potential – but not a problem for 2013 (aggregate forecasts are at about 2.2%). If monetary accommodation is not withdrawn as the unemployment gap closes, higher inflation could result.
U.S. Stock Market Outlook
• The U.S. stock market has been in a secular bear market since 1999. 2013 could answer questions required to label future years as part of a new secular bull market.
• The gains and the longevity of the 2009-2011 cyclical bull and the 2011 cyclical bear were more consistent with past secular bulls than secular bears. If a cyclical bear is averted in 2013, then it is likely that the persistent cyclical bull will also gain secular bull characteristics.
• We calculate a Reward Zone of 1565-1630 on the S&P 500 for 2013 (The Risk Zone would be balanced in terms of magnitude, but less likely to occur).
Back in 2001, when Berkshire Money Management was founded, we also published a well-distributed line of financial newsletters called The Navigator series. In one of the first publications we headlined the lead article with the title “18-Years of Pain.” Prior to and since then we have used the information from that article to base investment decisions, relying on the historical existence of 12-18 yearlong super-cycles of bear markets and bull markets (aka “secular” markets) to correctly argue that starting in 1999 the stock markets would endure over a decade of pain.
In the year 2013, after fourteen years of pain (defined in different ways, to be sure), we could answer some additional questions that hold long-term implications. Will 2013 be the year when the fiscal debates are finally put to rest in the U.S. and Europe? Will it be the year when it can be said that the multi-year deleveraging process has finally run its course? Will it be the year when markets around the world break out to new record highs?
“No” answers to these questions would point to another year of economic worries weighing down stock market returns, a year suggesting that the major developed markets remain in their secular bear trends. But “yes” answers would confirm that equities have entered a new era for allocation, with bullish long-term prospects for absolute returns where there need not always be such a rush to raise cash to protect investment assets from crashes.
As a 12-18 year span defines a “secular” pattern, a trend that occurs within that span is referred to as “cyclical” (think 4-14 months, if it helps). During secular bulls, the cyclical bull gains tend to be relatively impressive and the cyclical bear declines tend to be relatively tame, with the opposite applying to secular bears. The gains and the longevity of the 2009-2011 cyclical bull and the 2011 cyclical bear were more consistent with past secular bulls than secular bears. If a cyclical bear is averted in 2013, then it is likely that the persistent cyclical bull will also gain secular bull characteristics.
Another double-digit rise in the S&P 500 would lift the index back to record highs in 2013 – currently less than 15% away. Using earnings projections and a 15% rise from the 2012 index highs, we can calculate a Reward Zone of 1565-1630 on the S&P 500, well into record territory.
As we always say, we do not make year-end projections; that’s a silly, arbitrary game. We merely try to define potential risk and potential reward. We would not be too quick to assume that 2013 will be the year of the global breakout, or even just the U.S. market, breakout. But the current weight of evidence and our current global and U.S. economic projections are consistent with a positive year for equities. Concerns have been discussed, and there is a Risk Zone for the S&P 500 of about 1,250-1,295 points.
Given the healthy tape, favorable December-January seasonality, and sentiment conditions that are no worse than neutral (we don’t want to the world being too optimistic), the current rally is likely to continue into early next year.
With that rally comes less favorable sentiment (i.e. too many people getting optimistic), combined with what will likely continue to be U.S. fiscal cliff concerns, and European recession evidence, there is very likely to be a stiff correction sometime in the first quarter of 2013. Then, with the accompanying renewed pessimism, stocks would be poised to rally again. In Europe, the prospects for a second-half economic recovery would be likely to revive interest in European stocks. In the U.S., equities would benefit on fading fears that the fiscal cliff impact would curb business and consumer spending. A stock market advance could last into the year’s second half.
For the Geeks: We do not forecast earnings, but if economic growth reaccelerates then Earnings Per Share (EPS) growth should be higher in in 2013 than in 2012. If nominal GDP growth is 4.8% (2.6% real plus 2.2% inflation), and if S&P 500 sales adhere to their average over the last 30 years, they will grow about 0.5 percentage points above GDP, or around 5.3%. Margin expansion will probably be about flat given that it is rare to see expansion three years into an economic recovery. And the potential dividend tax hike could entice companies to swap dividends for buybacks. Net purchases could rebound toward their 12-month moving average of 3.5% of market capitalization. The end result is 8.8% growth in S&P 500 companies’ operating profits in 2013, or about $108 per share.
An 8.8% growth rate would be higher than what appears to be about 3.4% for 2012, but below the consensus bottoms-up analyst expectation of 13.6%. The trailing S&P 500 operating P/E ratio is 14.5. Remember that talk about secular and cyclical bulls and bears? Well, at this assumed juncture the median P/E expansion has been 0.6 points. A 15.1 P/E on $108 of earnings would suggest 1,630 points on the S&P 500.
The biggest risk to this analysis is that economic growth-, and therefore sales growth, do not materialize. A secondary risk would be that corporate pessimism dampens repurchases.
Regional Performance Expectations
• Valuations are relatively attractive in Europe, and emerging Europe in particular.
• For growth-oriented investors, we are overweight U.S. equity. In the short-term we could allocate some of those assets to European exposure.
In considering the outlook for global relative strength, it should be recognized that valuations are relatively attractive in Europe, and emerging Europe in particular. Relatively favorable valuations also describe emerging markets in general. Emerging market stock investors should be encouraged by improving expectations for economic growth in China and other emerging economies.
Considering their economic sensitivity, emerging markets stand to benefit from the improved prospects for global economic growth in general. And considering their high-beta tendencies, they stand to benefit from the global market uptrend that’s likely to anticipate the economic pickup.
As for the Japanese market, the equity performance has yet to indicate a meaningful change in economic expectations, valuations are unattractive, and investors remain discouraged by weak earnings growth and profit margins. Entering 2013 we are maintaining our strong underweight allocation to Japan.
On the U.S., we remain overweight. On Europe, we remain underweight. But that could switch to market-weight to both (shifting some allocation from U.S. to Europe) in the short-term. Last year we said that a Eurozone breakup or even a Greek exit was a very, very remote possibility, as officials would do at least the minimum to keep from disintegrating. We continue to think that in 2013 official will continue to work in the right direction. The European Central Bank (ECB) has come to the rescue numerous times, which has bought the Eurozone time to address its underlying problems. The Eurozone has made progress, albeit slow, to closer integration since the crisis started over three years ago. Structural and fiscal reforms in the periphery are already starting to pay off, as evidenced by the World Bank’s index of Ease of Doing Business.
Global macroeconomic risks, however, remain very real. For the past few years the biggest risks to the global outlook have been political in nature. This year, the biggest threats came from Europe, but next year they’ll likely come from the U.S., especially if the fiscal cliff is not resolved by the end of the year, or very early 2013.
Bottom Line: For global equity markets, there are significant risks in the first half of the year. Fortunately, the largest risk, the fiscal cliff, is a very fixable problem. We expect some resolution to the fiscal cliff to occur in January 2013, but the first quarter will very likely experience a stiff stock market correction.
The U.S. economy is already growing at about a 2% rate. If the fiscal cliff uncertainties are removed, growth in the second half (2H) of 2013 could be quite robust, powered by a reviving private sector. While stock market risks are about equal in terms of magnitude, the potential for gains is greater in 2013.