Second, we are encouraged by the vast array of policy stimulus which has been added to the U.S. economy since last spring. The 30-year national average mortgage rate has collapsed by more than 1 percent in the last year to an all-time record low below 4 percent (a boost for housing)! Annual growth in the M2 money supply has exploded from about a 5 percent rate in June to about a 15 percent rate (a general economic boost)! Even though the U.S. dollar has strengthened in the last couple months, the trade-weighted U.S. dollar index is still about 10 percent below its highs in 2010 (a boost for U.S. trade)! U.S. corporate profits remains extraordinarily strong. Total U.S. profits now reside at a record high, almost 20 percent above the peak of the last recovery cycle in the third quarter of 2006 and most recently rose at a healthy 8.5 percent annualized pace in the last quarter (a boost for capital spending and job creation)! The national average unleaded gasoline price has declined by 20 percent since last May, commodity prices in general have eased from earlier-year levels and the annual consumer price inflation rate is beginning to moderate which should help augment real income growth in the next year (a boost to real consumer spending)! Finally, the bounce of the Japanese economy in recent months in the aftermath of its destructive tsunami has already begun to repair widespread U.S. manufacturing supply chain problems as evidenced by a surge in U.S. auto sales during the last few months (a boost to the U.S. manufacturing sector)!
Third, “fundamental financial improvements” in the last couple years among both U.S. businesses and households suggest a stronger tone in 2012. Cash holdings by U.S. corporations remain at all-time records near $2 trillion and the ratio of U.S. corporate net cash flow to capital spending remains near a post-war high of about 120 percent! The U.S. household debt service burden which was at an all-time record high in late 2007 has subsequently declined four years later much closer to record lows! Finally, we believe most are underestimating (probably not even recognizing or considering) the potential positive impact “year three—the Gear Year” may have on the character of economic growth. Similar to the last two Gear Years (1994 and 2004), if the U.S. unemployment rate begins a slow but steady decline, confidence throughout the economy will rise producing new economic behaviors, largely absent so far in this recovery, which could add significantly to the feel of this recovery.
If businesses (both large and small) finally decide the recovery is sustainable, rising CEO confidence would likely augment “animal spirits.” More aggressive decisions regarding payrolls, capital investments, and inventory policies—perhaps utilizing some of the $2 trillion in dry powder currently on the sidelines—could be forthcoming during the Gear Year!
How positive would the impact of a steadily declining unemployment rate—that is, a perception the economy finally is gearing—be for the household sector? Not only would more households finally reestablish an income flow through employment, but confidence among those already employed would be enhanced by media headlines highlighting that jobs are finally returning! As the unemployment rate declines and with it anxieties among the employed, the housing industry might finally show signs of life further improving confidence the economy is on the mend. This could restart some mortgage activities augmenting the slow revival already evident in consumer credit and bank lending since the start of 2011. Finally, feeling less anxious, households may even go shopping for previously postponed purchases and perhaps satisfy some pent-up demands.
Tempered by a recession in the euro zone and by a slowdown among the emerging economies but boosted by significant policy stimulus, improved financial fundamentals and by a “Gear Year,” we expect real GDP growth of about 3 percent in 2012. Modest perhaps, but nearly 1 percent more than current consensus expectations.
Investment Implications for the Gear Year?
In both 1994 and 2004, stock returns surpassed high-quality bond investments. We expect they will again in 2012. The improvement in general attitudes and the reduction in anxieties associated with a Gear Year tend to be much more friendly to stocks than bonds.
Predicting the end of the “Great Bond Bull” has been hazardous for the last three decades—let alone the last couple years. Consequently, only with great trepidation do we suggest high-quality bond investors likely face the greatest risk in 2012. After the breathtaking collapse of the 10-year Treasury yield this past year, many have simply given up on thinking bond yields will rise anytime soon. A year ago, the consensus expected a serious rise in bond yields. Today, while most admit bond yields look too low, few are aggressively suggesting an imminent surge in bond yields. Contrarian thinking suggests next year could be bad for bonds.
Fear surrounding the economy has been the Treasury market’s biggest friend in recent years. We think this may end in 2012. If attitudes about the future of the economy do improve—if we “gear”—a major revaluation of bond yields will likely occur. Not only could investor sentiment about the U.S. recovery improve, but panic about an imminent calamity in the euro zone may also calm somewhat. Either or both could dramatically lessen the significant risk premium evident in the Treasury bond market.
We do expect a moderation in the consumer price inflation rate next year reflecting weaker commodity price trends since the summer. However, if we “gear” in 2012, inflation anxieties will still likely worsen (based on worries surrounding the overly aggressive easy monetary and fiscal policies of recent years in an economy which now appears to be gearing) despite moderating consumer inflation. Overall, the combination of an expected acceleration in U.S. economic growth (maybe growing about 1 percent faster than currently anticipated), somewhat receding euro zone fears, and escalating “future inflation fears” suggest substantial upside risk in bond yields next year. We would not be surprised if the 10-year Treasury bond yield surges to between 3.5 and 4 percent sometime during the coming year. The record of the stock market during the last two Gear Years (1994 and 2004) is more ambiguous. In both cases, the stock market did well until bond yields rose. However, in each previous case, the stock market did well in the early part of the Gear Year as attitudes were improving and we suspect stocks will react similarly in 2012.
The S&P 500 currently trades only slightly more than 12 times this year-end earnings. A very attractive valuation level considering the competitive 10-year Treasury bond yield is less than 2 percent, profit trends remain favorable, and the U.S. economy seems to be accelerating. Perhaps the biggest opportunity for stock investors next year is the likelihood a “Gear Year” could significantly lessen “Armageddon Fears” which have overwhelmingly and dramatically kept both bond yields and stock valuations far lower than they would otherwise be based solely on fundamentals. If attitudes “gear” in 2012, calamity fears will calm and risk asset valuations should improve. For these reasons, we would not be surprised if the S&P 500 reached the 1500 level sometime in the coming year.
Real U.S. final sales grew at a 3.6 percent annualized rate in the third quarter and appear to be growing at a similarly healthy pace in the fourth quarter. Despite this, the U.S. stock market has declined during the last half of this year while bond yields have fallen below 2 percent! An explanation of this dichotomy between stock market and economic performance during 2011 is “fears have dominated fundamentals.” A Gear Year is mostly about adjusting attitudes. Perhaps the 2012 Gear Year will be all about “fundamentals finally trumping fears”?
Copyright © Wells Capital Management
