Friday, December 7, 2012
2013 Economic Outlook: Austerity Lite, Austerity Regular, or Austerity Stout
For 2013, a theme of Austerity is clearly emerging with the uncertainty of the “Fiscal Cliff." The European Union is forcing austerity on its Southern countries, and the Fiscal Cliff and looming debt leviathan is forcing austerity on the US. Our outlook looks at three versions of austerity and the probable consequences for the New Year.
Cliff Note One: Austerity Lite
"Austerity Lite” is a Band-Aid style patch where some modest revenue increases are coupled with some very modest budget cuts. Light tax increases and light budget cuts will probably avert an immediate recession, but keep the deficit growing. This may be the form of extending all or most of the status quo. We’ll define “austerity lite” as any combination of revenue increase or spending cuts that total less than $2T over ten years. Incidentally, the deficit for ONE Year is about $1.2T.
Cliff Note Two: Austerity Regular
"Austerity Regular” would be a bargain that takes both sides into some serious movement. We’d call this a Simpson-Bowles scenario (more than $2T of cuts over ten years). Here there is movement toward deficit reduction and probably averting a recession, although this aspect may entail low or negative growth in the first quarter of 2013.
Cliff Note Three: Austerity Stout.
“Austerity Stout” is a drive off the cliff and the ensuing mess of the wreck. Our version is simply that $800+B of tax increases and budget cuts will trigger a recession, increase unemployment, decrease consumer spending and cut corporate profits. Any silver lining is that the stout version is so untenable it would most likely move the country toward serious tax reform, plus put a big dent in the deficit, at the cost of a recession.
The reason we elaborate the three scenarios is that each has a different effect on the outlook for 2013.
In one of the two lighter scenarios (Austerity Lite and Austerity Regular), we suggest that GDP will have modest growth, probably in the range of 1.5%-2.0%. Our take is that the Austerity Lite is most like the status quo, and so the prognosis of this solution to the cliff is that Lite is ‘continued anemia’. A more robust deficit reduction proposal (albeit only a modestly painful one) would probably have an initial damper on GDP in the first two quarters, and more growth in the third and forth. Austerity Stout would be disruptive and probably shrink GDP by 2-3% in the first two quarters and maybe for the year by a negative 3-4%.
US Equities (S&P 500)
Our version is the US equity market, as measured by the S&P 500, is showing relative undervaluation based on the political uncertainty. The S&P forward PE is lower than the 10 and 15-year average PE, and the S&P earnings yield is significantly higher than the Baa bond yield. The S&P dividend yield is higher than the 10-year treasury by a significant amount, and the alternate investment in bank deposits has an effective return of almost zero. In this environment, under the Lite scenario, stocks return to being one of the only viable investment alternatives (compared to both international and fixed) and the stock market will probably revert to a normal return. In the Regular scenario, stocks have a greater opportunity to operate under certainty, so we’d suggest that the market may lead the economy and grow faster. In the Stout scenario, corporate earnings and top-line revenue would both suffer and the market would likely decline.
We feel that there is a tendency among analysts to ignore consumer sentiment. Since markets are behaviorally driven, we’d suggest that PE and sentiment are correlated (the R2 is actually .75) as are real (inflation adjusted) yields (the R2 is .68). Under a Lite scenario, consumer sentiment will likely stay in the 80 range, probably keeping both PE and Real return at the status quo. Under a Regular scenario, the prospect of stability and growth may propel sentiment to 2006-2007 levels (around 100), which might portend an increase in PE and real return. Under Stout, we’d suggest a drop in sentiment and a drop in PE, with real return going negative.
The current monetary policy, which appears to remain unimpeded for at least the calendar year, is toward extremely low interest rates. We think that interest rates will stay low for the year. In the case of a Stout scenario, some federal rates (TIPS for example) could support negative yields.
Consumer debt service as a percentage of disposable personal income was 10.5% in the third quarter of 2012, compared to 14.1% in the third quarter of 2007. With the QE3 loosening and the surge in refinancing, this debt service percent will drop, likely increasing personal savings, and further decreasing debt service. In the absence of a Stout scenario, which would quash consumer spending, the consumer sector should be stable.
Basically CPI is relatively stable under 2% (headline at about 1.7% as of 09/30/12). In a Lite scenario, the status quo will probably prevail for 2013, and the inflation rate will likely stay under 2.0%. Under a Regular scenario, inflation may have a very modest initial decline (slight decrease in consumer spending, and the likely ramp up as economic activity increases. Under a stout scenario, inflation would likely drop to zero in the short run.
Commodities provide an interesting paradigm by changing their correlations dramatically in different economic scenarios. In the Lite and Normal scenarios we outlined, we think inflation will eventually increase, which historically bodes well for commodities (although equities do better in a low and rising inflation environment). In a Stout scenario, where inflation would likely be lower due to economic decline, commodities would probably suffer declines.
The Hidden Elephant in the Corner
The Money Multiplier: We think it is interesting how most projections summarily ignore the multiplier. The money multiplier, or basically the money supply (M2) divided by the monetary base, expresses how many times money moves when added to the system. For most of 2000-2007, the multiplier was about 8.5, peaking at 9 in late 2007. Basically, one dollar in the system moves about 8.5 times. The multiplier currently sits at 3.8. An expansion in the money multiplier will dramatically increase the money supply and have the effect of quick expansion, probably coupled with quick inflation. The current expansionary monetary policy QE1, QE2 and QE3, coupled with a low multiplier may be creating a ‘pent-up’ inflation situation.
Europe appears to be ahead of the US in the Austerity mode. Under the European ‘Austerity Lite’, except Greece, we are currently seeing a mild recession, and nominal GDP growth. In fact, developed market GDP is projected at about 1%. Emerging markets, on the other hand, are poised for GDP growth above 4% in total and in some cases, upwards of 8%. Emerging Markets now represent 50% of world GDP (on a purchasing power parity basis), while only being 13% of the MSCI All Country Index. Emerging markets appear to be a brighter spot on the 2013 horizon.
A Stout scenario, which would likely push the US into a recession, would likely create contagion throughout the world economy, including emerging markets. In turbulent times, the correlation of US and international markets reverts to 1.0. In a Lite or regular scenario, the markets will likely stay somewhat disassociated.
We have currently moved 50% of equity positions into short-term corporate bonds. Pending resolution of the cliff, we shall engage in a re-entry procedure based on the outcome of the negotiations. We’ll continue in emerging market exposure and keep durations short to avert possible inflation.