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.
Deficits and Defaults[iv]
The Volker Rule[v]
The Financial System[vi]
The Corporate Sector[vii]
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.