Note: this summary for 2013 is provided by Guest Blogger Buck Klemkosky. Because it is long, you will see below his introduction and summary with 12 topics in the middle. Any of these topical areas can be read in full by scrolling down to the appropriate footnote number.
Americans, especially investors, have a lot to be
thankful for in 2013. Remember, the year started with everyone worrying about
falling off the fiscal cliff. Due to the budget impasse, automatic federal
spending was cut through the sequester, and taxes were raised for the wealthy. Economic
forecasters and other pundits were predicting that the sequestration would
hamper economic growth or possibly cause a recession.
The Economy –
The U.S. economy has performed better than expected with annual real GDP growth
expected to be 2.4 percent for the year. The economy was bolstered by auto
sales, housing and the consumer. It is difficult for the economy to have any
meaningful growth without consumers being part of it, and they were in 2013,
overcoming the supposed “fiscal drag” of the sequester and the austerity
measures of state and federal governments. Economic prognosticators had
forecast 2013 economic growth of less than 2 percent, so the economy performed
better than forecast and the third and fourth quarter numbers suggest a
stronger trajectory for the economy and consumer spending going into 2014.
Inflation[i]
Industrial
Production[ii]
The Fed[iii]
Deficits and
Defaults[iv]
The Volker Rule[v]
The Financial
System[vi]
The Corporate
Sector[vii]
Employment[viii]
Household Debt[ix]
Household Wealth[x]
Energy[xi]
Investable Assets
[xii]
2013 – Recessions
caused by financial crises take longer to recover from than normal cyclical
recessions because debt has to be taken out of the system. This appears to have
been completed in the U.S. for the household and financial sectors in 2013. Hopefully,
this has set the foundation for continued economic growth in 2014 and beyond.
The corporate, household and financial sectors in the U.S. are all in better
shape than any time in the last decade or longer. The European economies and
financial systems appear to have stabilized, and Abenomics in Japan has
produced positive economic growth and stock returns in excess of 60 percent in
2013. China’s economic growth has come down over the last five years but still
a solid 7.5 percent. Global and U.S. economic growth should be higher in 2014,
with U.S. economic growth expected to be around 2.5-3.0 percent. Don’t expect
2014 stock market returns to replicate 2013; in 2013, markets anticipated and
reflect economic momentum and other positive developments expected to occur in
2014.
The one big unknown is what if any problems have been
created by the Fed’s zero interest policy and QE. It has created stock and bond
market wealth and now housing again. Hopefully it has not created any
significant bubbles or misallocations in the economy. So Fed actions and other
macroeconomic events will continue to make headline news in 2014 and influence
financial markets. Financial markets have performed much better than the real
economy for several years, including 2013.
[i] The
views on inflation have been all over the map. Many are worried about the
enormous amounts of liquidity pumped into a global financial system by central
banks and the potential for hyperinflation. Others worry that deflation may be
the problem going forward. The inflation rate in 2013 was 1.1 percent, less
than the 2 percent the Fed is targeting, as are the European Central Bank and
the Bank of Japan. The most obvious danger of too-low inflation is the risk of
falling into outright deflation of persistently falling prices. As Japan’s
experience shows, deflation is damaging economically and hard to rectify. So
central banks are more concerned about deflationary pressures than inflation.
[ii] U.S.
industrial production, which measures the output of manufacturers, utilities
and mines, hit a milestone in November 2013 when the index surpassed the pre-recession
peak of December 2007. While manufacturing is still below its 2007 peak,
overall production is up 21 percent since the end of the recession in June 2009
and up in 2013 relative to 2012.
[iii] The
U.S. Federal Reserve celebrated its 100th anniversary in 2013 and
perhaps never in its history has it faced the complexity and risk it now does.
At the end of 2013, three rounds of quantitative easing (QE) have inflated the
Fed balance sheet to $4 trillion, up from $800 billion before QE started in
2008. QE3 started in September 2012 and entailed purchasing $85 billion monthly
of U.S. Treasury bonds and mortgage-backed securities. Annualize that and it
comes to more than $1 trillion a year of bond purchases that end up in the
Fed’s balance sheet. QE3 is not sustainable and the Fed just announced that it
will start tapering in 2014 by reducing monthly bond purchases by $10 billion. Chairman
Bernanke announced in May 2013 the possibility of reducing or tapering the
amount of bond purchases but delayed any final decision until December 2013,
his last major decision as his second four-year term ends in January 2014. From
May to December, tapering or lack thereof was the most talked-about and
analyzed event in 2013 and it will continue to be as long as QE3 exists.
The Fed also will continue its accommodative monetary
policy by keeping short-term interest rates close to zero even after unemployment
rates fall below 6.5 percent unless inflation exceeds 2.5 percent. Janet Yellen
takes over as Fed chair in February 2014 and is expected to continue Bernanke’s
monetary policies.
[iv] Congress
passed a 21-month budget resolution in December 2013, the first since 2010.
While many applaud the ability of a dysfunctional Congress to even pass a
budget, few seem to be happy about it. As a percentage of GDP, the federal
deficit has fallen from more than 10 percent in 2011 to 4 percent in 2013 and
less than 4 percent projected in 2014. Prerecession, a deficit of 4 percent of
GDP used to be considered reckless; now some consider it austerity and a fiscal
drag on the economy.
While a flawed budget deal may be better than no budget
deal, one of the flaws in the U.S. fiscal policy is that congressional voting
on spending is separated from voting on borrowing via the debt ceiling. The
debt ceiling law has been in effect since 1917 but was not a political issue
until the 1970s. Since the Carter administration, Congress has voted 45 times
to increase the debt ceiling. Linking the vote to borrow to the vote to spend
would seem logical, but don’t count on congressional rationality in this day of
partisan politics. This will become headline news again in February 2014, when
the federal debt is again expected to approach the debt ceiling of $16.7
trillion.
[v] The
Federal Reserve Act, passed in 1913, was 31 pages long. The Dodd-Frank law,
passed in 2010, was 2,391 pages long. It entails 398 rules, of which 161 have
been finalized, and the Volker Rule is the latest. From its conception to
finalization by five government regulatory agencies, the rule has grown to 963
pages, containing 2,826 footnotes and posing 1,347 questions. All this verbiage
is to basically prevent proprietary trading by banks. They can still trade for
clients, but most banks had already eliminated proprietary trading in
anticipation of the rule. Full compliance is not required until July 2015.
Monitoring and compliance will be complicated, and there may be unanticipated
consequences such as less liquidity and more cost to trade less actively traded
issues such as corporate bonds.
[vi] In
2013, the U.S. financial system was much stronger and transparent than before
the financial crisis. Dodd-Frank, Basel III and other regulatory changes have
taken debt and leverage out of the system, increased capital and monitoring not
only of banks but also non-bank financial institutions. Hopefully regulators now
understand how complex and interconnected the financial system is. One thing
that has not been fully resolved is the too-big-to-fail issue. The 10 largest
financial institutions in the U.S. in 2013 had more than $11 trillion of
assets, compared with $7.8 trillion at the end of 2006. The market share of the
10 largest has increased, and thus their potential for systemic risk.
[vii] Corporate
profits relative to GDP remain at historically high levels in 2013: 10 percent
versus an average of 6 percent. While revenue growth was subpar, corporations
were able to grow earnings through cost controls and share buybacks.
Corporations today spend 60 percent more on share buybacks than on dividends,
even though dividend growth has been positive. Because of economic and
political uncertainty, corporate investment has not kept pace with
profitability. Another reason is that the capacity utilization rate is slightly
below 80 percent at the end of 2013, so there is no urgent need for capital
expenditures until utilization picks up another 5 or 6 percent. Corporate
balance sheets are in great shape and corporate cash as a percent of assets is
at historical high levels. Even so, U.S. corporations set records in 2013 for
issuing bonds, both investment grade and high yield, taking advantage of
historically low interest rates. Two of the largest bond issues of all time
occurred in 2013; Verizon issued $49 billion to finance an acquisition, and
Apple $17 billion, even though the company had $70 billion in the bank, half of
that overseas for tax reasons.
[viii]
Job growth averaged about 190,000 monthly in 2013. The unemployment rate fell
to 7.0 percent at the end of 2013 but not all of the improvement in the rate
was due to job growth. The labor participation rate fell to a 30-year low of 63
percent, meaning millions of people have left the labor force for whatever
reason. Still, at the end of 2013 there are 1.2 million fewer people working in
the U.S. than at the end of 2007.
[ix] Financially,
households have put their houses in order, so to speak. They have paid down
more than $1 trillion of debt since the financial crisis, mostly mortgage debt
which comprises about 70 percent of household debt. The debt service ratio,
debt payment as a percent of disposable income, also fell to a 30-year low in
2013 as it approached 10 percent. With household balance sheets in better shape
and consumers more confident, U.S. household debt increased in 2013, the first
annual increase since 2008. One area of debt that is of concern is student
loans; the amounts outstanding surpassed $1 trillion in 2013 and they had the
highest delinquency rates at 12 percent.
[x] U.S.
households lost $19 trillion in the financial crisis: $9 trillion in stocks, $7
trillion in housing and $3 trillion in other assets. This didn’t all happen
simultaneously as stock prices started to increase in March 2009 and housing
prices continued to drop through 2011. The peak loss was approximately $15.0
trillion. Household net worth, the value of assets minus debt, set a record of
$77.5 trillion in 2013. However, adjusted for inflation, this amount is in real
terms about the same as the $69 trillion of household net worth in 2007. Add in
population growth and average household net worth is still below 2007. Less
debt, housing prices up 12 percent in 2013, and stock prices up 29 percent have
all contributed to the record levels of household net worth. One thing that
has not contributed has been interest
rates; historically low interest rates, both short and long-term, have caused
financial repression for households. Since 70 percent of household assets are
financial in nature, interest rates and stock prices are the main drivers of
household wealth.
Household net worth is 615 percent of after-tax income in
2013 compared to a peak of 662 percent in 2007, so households may not feel as
wealthy today versus 2007. Plus the distribution of net worth is more unequal
today than any time since the 1920s. The same is true of the distribution of
incomes.
[xi] One
of the major milestones in 2013 was that the U.S. became the world’s largest
producer of energy, surpassing Russia. This is mainly due to natural gas
production, but oil production also is ramping up. Because of horizontal drilling
and fracking, the U.S. has the potential to become North American energy
independent. The U.S. has started to export liquefied natural gas and has
become the leading exporter of products derived from oil and natural gas. Lower
energy costs have given the U.S. a real competitive cost advantage over
European and Asian manufacturers, and the U.S. has started to attract direct
foreign investment to the U.S. because of cheaper energy. This cost advantage
should be sustainable for a decade or longer.
[xii] The
star of 2013 was the stock market; the S&P 500 had a return of 29 percent,
including dividends, the best one-year return since 1998. The consensus
forecast at the beginning of 2013 was 8 percent. The NASDAQ and Russell 2000
did even better. In 2013, the Dow Jones Industrial Average hit 16,000 for the
first time and the S&P 500 1,800. The NASDAQ crossed 4,000 for the first
time in 13 years, except back then it was on its way down from its peak of
5,048 in 2000 and in 2013 on the way up. Bonds have been a mixed bag in 2013
with corporate bonds, both investment grade and high yield, providing positive returns
of 5-7 percent.
However, long-term U.S. Treasuries did have negative
returns. The big losers in 2013 were most commodities, especially gold, which
fell more than 30 percent from its peak price of $1,800 per troy ounce. Some
believe the commodity super cycle that started in 2000 may be over. Short-term
money market instruments were also losers, as the Fed continued its zero
interest rate policy. Real short-term interest rates were negative after
adjusting for inflation.
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