Lexington, KY - The fears put out by many “experts” of a European collapse leading to a global recession were once again overblown. As we have stated over the past couple of years, we are in a slow growth economic environment and a recession is unlikely given the monetary policy response by the Fed and central banks around the world. It is likely the U.S. economy will grow around 1.5 percent to 2 percent for the fourth quarter and for the year. While this growth is lower than the 3.5 percent we’re used to, it is not recessionary.
The policy by the Fed via QE3 (or the third round of quantitative easing) is the most aggressive action they have taken to fight off deflation. With QE3, the Fed will be buying $40 billion per month of agency mortgage-backed bonds until they believe the economy has improved enough. With this they are trying to keep interest rates low to encourage individuals to spend money, allowing the U.S. to avoid a recession.
Analysts expect that QE3 will add about 0.7 percent to GDP. This may not seem like much, but when you consider that GDP growth is around 1.5 percent to 2 percent, it is significant.
The biggest risk to the economy is the fiscal cliff, which occurs at the beginning of next year when a host of spending cuts and tax increases happen all at once. The Congressional Budget Office (or CBO) estimates that if nothing is done, the drag on GDP could be as high as 5%. Fortunately, we expect this worst-case scenario not to be realized. However, the odds of this getting completed in a timely manner are low. Considering the political races, there is little incentive for Congress to fix this prior to the presidential elections. This means we will likely be facing another 11th hour deal. Another possibility is that a deal is struck in 2013 and made retroactive to the beginning of 2013. With the ultimate outcome being uncertain, economic growth is hurting today because business owners are not willing to risk capital when they don’t know what the rules will be.
While many pundits have called for a recession or even declared we are already in one, the data do not support it. The four dominant areas the NBER looks at in defining a recession show growth is continuing albeit at a slow rate. Compared to previous recoveries, retail sales and industrial production are growing in line with historical averages while income and employment growth has been subpar.
Thus, we are definitely not in a recession right now based off coincident indicators and we believe we will avoid a recession based off leading indicators and a very accommodative Fed. The leading indicators typically move before the economy as a whole moves. Currently, the Conference Board’s leading indicator index shows that the economy should continue to grow. Specifically pushing the leading indicator index higher are stock prices, yield spreads, and credit expansion.
On the international front, we expect lower growth in the developed world with the Eurozone continuing to struggle to generate any traction with the austerity measures imposed on them. Europe is in a recession and we expect them to contract -0.5 percent this year.
The potential fallout from the European recession is the other major risk to our economy behind the fiscal cliff. Unfortunately, this risk will be with us for a period time. The important concept to remember is that this is a negotiation process; each country is trying to get the best possible deal for themselves and you do that by holding out to force the others’ hand. While many pundits expect a quick fix, that is not possible given the legal process and the treaties involved when dealing with multiple countries. Furthermore, any structural proposal requires all 17 member nations to unanimously approve. There may be minor membership changes (think Greece leaving), but the core should remain the same as a Euro breakup is highly unlikely.
The European Central Bank (or ECB) has stated they will do “whatever it takes” to ensure that the Euro survives. Shortly after that statement by the ECB Chairman, they announced an unlimited bond purchase program. In other words, they will finance troubled countries like Italy and Spain by buying their bonds. This is a very positive step, but it is not the last step. For the Euro experiment to succeed there will need to be a banking union and ultimately a fiscal union. Unfortunately, this is not an overnight quick fix, but a long-term process with many nations involved. It will take some time for all nations to come to a mutually acceptable agreement.
Even with the looming fiscal cliff and the troubles abroad, the stock market (S&P 500) managed to rally 6.35 percent in the third quarter, pushing its year-to-date gain to 16.43 percent. The main reasons for the advancement can be attributed to the Fed’s quantitative easing program, the ECB’s bond purchase program, and attractive stock market valuation.
At the beginning of the year, the stock market was trading with a 12.7 P/E ratio based on forward earnings expectations. Considering the long-term average P/E ratio is about 17, the market was considerably underpriced. Skeptics justified the low P/E ratio citing lower economic growth expectations and a high chance of a recession. When the recession did not materialize, stocks put together a nice rally. Even after the strong start to the year, valuation is still indicative of future gains with the forward P/E ratio at 14.7, which is still below the long-term average.
Andrew Stout, CFA, CFP® is the Sr. Investment Officer with MCF Advisors, which has offices in Lexington and Covington.