Also contributing to the onshoring trend, and having, in our opinion, an even more profound potential impact on US growth over the next couple of decades, is the complete shift in the energy picture over the past several years. The United States is now flush with domestic energy to the point that some analysts are predicting energy independence for both North America and the United States in the next decade. According to our friends at ISI Research, we are now importing 41% less oil than at the peak, with imports at a 25-year low; while domestic production has increased 32% in the past year. Reliable and sustainable energy sources are vital to a growing economy, boding well for the future, but perhaps more importantly, this again illustrates what creative minds in America can achieve when market forces are left to work.
The changing, and encouraging, energy equation
Source: FactSet, Institute for Supply Management. As of Feb. 8, 2013.
In a low-growth world, are global investors doomed?
Deleveraging by governments and households nearly globally has suppressed potential growth, possibility creating a fear that this subdued growth is bad for global equity investors. Put another way, do investors need higher growth to achieve good returns?
Paradoxically, higher economic growth doesn't always equate to the best investment returnsāacademic research suggests no clear correlation. While stronger economic growth creates higher sales growth potential; high earnings per share and dividend growth don't necessarily follow. Profits can suffer if wages in rapidly-growing economies rise faster than productivity increases. Low corporate governance can reduce returns when profits are expropriated rather than passed along to shareholders. Additional capital can be needed to sustain high growth, which can reduce shareholder returns. And of course, a high pace of growth can incite inflation which, in turn, can force the Fed to tighten monetary policy, a negative for stocks.
The role of expectations and valuations are also very important. High growth expectations can be accompanied by high valuations, resulting in future underperformanceāthe good news is priced in. Another important factor is the sustainability of future growth.
Europe moving in the right direction, but risks remain
Our international equity outlook incorporates the different global growth strategies, with the eurozone beginning structural reforms, Japan weakening the yen, and China using debt.
The European Central Bank's (ECB's) conditional bond purchase program provided a safety net and restored confidence, thawing credit markets for governments, corporations and banks; and potentially staved off downside risks to economic growth. The eurozone is broadly in recession, but the economic outlook could shift direction in 2013 from contraction back to mild expansion.
Economies in the eurozone aren't as market-oriented as the United States; but they are slowly changing, which could bode well for the longer term. Labor reforms have reduced unit labor costs (ULCs) in Spain, Portugal, and Ireland, improving competitiveness. These declining ULCs have either been driven by significant wage decreases, or by productivity growth, in part due to job cuts. Opening up "closed" professions to new entrants can reduce prices due to new competition. Reforms that allow companies to have more flexible labor forces to respond to changes in demand can improve profitability. The improved competitiveness is illustrated by Spain's recent success in attracting automotive manufacturing expansions by Ford, Renault, Nissan, and Volkswagen, despite a weak overall market in Europe.
Eurozone: those with lower costs more competitive
*Indexed to 100=Dec. 31, 2003.
Source: FactSet, OECD. As of Feb. 12, 2013.
Structural reforms to improve growth prospects have the potential to reap sustainable benefits. We have a near-term positive view on eurozone equities due to the reform progress, credit markets thawing, reduced global uncertainty, possible reacceleration in growth; as well as still depressed earnings and valuations. In addition to the potential for sales growth to accelerate, earnings have additional upside as margins have room to expand.
Meanwhile, there are still political risks in the eurozone:
ā¢ Italy's election on February 24-25 could result in new leaders reversing austerity and reform progress. We believe the most likely outcome is a fragmented vote that will need a coalition, resulting in stalemate and little change to policy. There is an outside risk the elections result in an inconclusive decision that could result in another vote in several months.
ā¢ Cyprus' bailout could raise concerns if it results in another debt "haircut," but we believe market reaction will likely be modest due to the ECB's safety net and Cyprus' small size.
ā¢ Spanish government corruption allegations could reduce support for reforms, and the ongoing housing bubble burst could result in additional bank capital needs. As a result, Spain could still need a bailout in the future, but the ECB's conditional bond purchase program has likely reduced this possibility.
The euro has risen due to improved fundamentals, reduced uncertainty, and a decline in the ECB's balance sheet, as banks have returned money and the conditional bond purchase program has yet to be tapped. A rising euro could hurt eurozone export prospects, particularly for countries with low-value exports more exposed to competition. However, as long as the rise is modest, it's not necessarily a barrier for higher eurozone equity prices ā eurozone stocks and the euro have tended to move together in recent years.
