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The Stevens Advisor Stevens, Foster Financial Services, Inc. Securities offered through LPL Financial, Member FINRA/SIPC 7901 Xerxes Avenue South, Suite 325 Bloomington, Minnesota 55431 www.stevensfoster.com [email protected] Ph: 952.843.4200 January 11, 2013 Volume 10, Issue 1 Toll Free: 877.270.4200 2013 INVESTMENT OUTLOOK Calendar year 2012 was characterized by another year of slow global economic growth, but markets generated solid gains. The U.S. continued to grow at a relatively slow rate, Europe maintained sufficient liquidity to defend their currency and China avoided a hard landing. All in all, developed country central banks provided sufficient liquidity to help mitigate the debt overhang and austerity. As a result, preliminary data shows the global economy expanded at an estimated 3% rate for 2012. For each of the last three years we have maintained an expectation of slow U.S. economic growth, but no “double dip” recession, and this has been the outcome. As we look to 2013, we see another year of slow economic growth. Although Europe remains in recession, their downturn is not so negative that it drags the global economy into recession. Finally, emerging markets look poised to generate increasing growth. U.S. Economy: President Obama and Congress have reached an agreement to avoid the so-called “fiscal cliff”. The U.S. tax and spending negotiations have generated both domestic and global attention, and these deliberations have caused daily market volatility. This agreement represents the first round in dealing with tax and spending issues. A second round of budget negotiations is expected later this year that will deal more broadly with the longerterm fundamental imbalance between tax receipts and spending. There is discussion of a “grand bargain”, but time will tell what comes of this process. While the current U.S. political wrangling captured the market’s near-term attention, the broader fundamental economic factors continue to play out on a longer-term basis. To counter the negative effects of the past recession, the U.S. Federal Reserve pursued an aggressive monetary policy starting way back in 2008 to help stimulate the economy. At this point in time, economic growth and employment data are still not improving enough to achieve the desired stronger growth. As a result, Ben Bernanke says that we need to extend this monetary policy into 2015. If the current plan actually extends into 2015, it will mean that our economy will have spent roughly 7 years of near zero short-term interest rates. The Federal Reserve’s balance sheet was under $1 trillion four years ago, but through various stages of Quantitative Easing-QE the Fed’s balance sheet has grown to the current $2.9 trillion level. Moreover, it is expected to grow to nearly $4 trillion by the end of 2013. It is estimated that they Fed bought more than 70% of new U.S. Treasury debt issuance this year. Meanwhile, there continues to be significant slack in the U.S. economy, particularly related to high unemployment and weak capacity utilization. Consequently, inflation is not an imminent concern. Nevertheless, we remain vigilant for inflationary pressures on a longer-term basis. The prospects for rising inflation also impact the U.S. government budget deficit. The Congressional Budget Office says that every 1% interest rate increase will add $100 billion to annual interest costs. During this four-year period of monetary stimulus, the U.S. economy grew roughly 2% on an annualized basis, and it is tracking along at a 2.2% growth rate for 2012. This pace is less than half the historical average at this point in the business cycle. We see this trend continuing into the first half of 2013. We believe that the U.S. economy should grow closer to 3.0% for the second half of the year. The U.S. recession ended in June 2009, and the domestic economy has made modest progress since then. Household debt has fallen and the banking sector is now well capitalized. For the first time since 2005, the housing industry is improving and contributing to economic growth. On a longer-term basis the prolific domestic shale gas and oil production is contributing to a re-industrialization of the U.S. manufacturing sector. Europe: Europe survived 2012 in much better shape than the consensus forecasts expected at the beginning of the year. European markets also performed much better than expected. One of the fears was that Greece or some other country might leave the Euro. It was feared that such an event would precipitate a liquidity crisis reminiscent of what happened in 2008. Mario Draghi, President of the European Central Bank, said in July that the ECB would do “whatever was necessary” to preserve the Euro. More recently the ECB established a structure for Outright Monetary Transactions to provide ‘unlimited’ European sovereign bond purchases. Because of these central bank actions, the worst-case prospects were mitigated. Europe moved past discussions of breaking up the euro zone to focusing on greater integration and cooperation to achieve economic growth. Another positive step involves the European Union agreement to create a new overall bank supervisor. This is significant because it will allow for the pooling of debts and fiscal transfers within the euro zone system. This agreement was controversial because countries in crisis will lose some of their sovereignty. For example weak banks will be forced to hold more capital or sell assets. Ultimately the system will provide a more integrated European structure to replace the current highly-fragmented euro zone banking system. In the end, the euro zone banking system avoided the downside scenario. Bank transparency has improved and there is greater visibility related to bad loans. Moreover, the banks have been recapitalized to improve capital ratios. Europe is making slow progress in structural labor market reforms that are pushing labor costs lower so that goods will be more competitive. Rules are being eased to make it easier to down-size union workers, and protected industries are being opened to competition. Reforms are also being achieved in the unemployment benefit system and the wage bargaining framework. These changes are also helping improve current account trade balances. Although overall productivity is improving, employment continues to decline and this will be a problem for many years. Southern euro zone current account trade deficits are also narrowing and this implies that economic imbalances are slowly shrinking. This also suggests that the peripheral economies are regaining some of their trade competitiveness. A recent Standard & Poor’s upgrade of Greek government debt indicates a reduction of systemic risk in the euro zone. Based on recent ECB funding operations, S&P raised Greece’s government bond rating six notches from “selective default” to single-B-minus. The new debt rating is still below investment grade, but the rating upgrade shows improved prospects that the government can weather the crisis. Economic analysis completed by Deutsche Bank says that euro zone fiscal austerity is past its peak, and is likely to fall from a 2% annualized economic drag during the last two years to a 1% drag for 2013. Inflation also remains contained due to substantial excess industrial capacity and high unemployment rates. Despite the signs of progress, Europe faces significant ongoing risks and the continent has a long way to go before they achieve improving growth rates. The euro zone recession has pushed unemployment for the currency bloc to11.7% in October, the highest level since the introduction of the euro in 1999. The wider 27-nation EU unemployment rate moved up to 10.7%. Spain and Greece have the highest unemployment rates at over 25%, and the youth unemployment is heading towards 60%. Political leadership risks are also a concern, and there is potential for escalating civil unrest in Greece, Portugal, Spain or Italy. Italian Prime Minister Mario Monti recently announced his resignation when the 2013 Budget Law was approved. He has indicated that he may be involved in upcoming elections in February, and that would be a very favorable outcome. ECB President Mario Draghi says that he expects euro zone economic recovery to start in the second half of 2013. Northern Europe is expected to be bottoming in early 2013, and then end the year with a slightly positive growth rate. Meanwhile, Southern Europe looks to decline -1 to -1.5% for 2013. We believe that aggregate euro zone growth will be negative in the first half of 2013, and then will turn modestly positive later in the year. We expect euro zone growth to resume in 2014. Japan: Japan has been a perennial laggard for investment performance for the last decade. Although Japan is the world’s 3rd largest economy, the economic growth rate has consistently trailed the rest of the world. The recent election of Liberal Democratic Party Prime Minister Shinzo Abe looks to represent a major change from past policies. Part of the reason to expect change is that the LDP party and their political allies took 325 of the 480 seats in the lower house of Parliament, more than the two-thirds super-majority needed to override decisions in the upper chamber. Consequently, Abe will attempt to kick start economic growth and pursue structural and regulatory reforms. He plans to increase spending and increase pressure on the central bank to stimulate the economy to pull the country out of recession and deflation. Japan has a debt-to-GDP ratio of roughly 200% and their ability to borrow and spend to stimulate demand is negatively impacted by their high debt service levels. Nevertheless, we expect that he will achieve a higher economic growth rate and we also expect that the Yen will continue to depreciate. Emerging Markets: Emerging markets are experiencing an estimated 5.2% growth rate in 2012, and we expect this to increase to nearly 6.0% for 2013. The emerging market countries are currently benefitting from the unwinding of this year’s food price shock, and this has helped to keep inflation in check. A generally benign inflation outlook allows policy makers to keep interest rates lower, and this will support increasing growth. We are currently seeing a 4Q12 pickup in emerging Asia and Latin America as household consumption is proving to be the key driver of this growth. China, now the second largest global economy, completed its 10-year leadership change in the fall, and the country is shifting policy from investment/infrastructure spending to a consumption-driven economy. When the new leaders came into power, they stated that they would significantly escalate the pace of reforms. The reforms are focused on the financial system and social spending. Recent data show improving commodity inventories, improved money supply liquidity, and improving industrial production data. South-East Asia, particularly Indonesia, Malaysia, Philippines, Singapore, Thailand, Vietnam, and Laos have potential to provide the next Asian growth leg. We expect sovereign debt rating upgrades, currency appreciation and ongoing positive investment fund flows. Emerging Europe is still weak. The industrial sector and exports have turned positive but exports to Europe are still declining. Russia is attempting to stop their capital outflow, and to attract more foreign investment. Vladimir Putin is also coming to support ownership rights and a more credible rule of business law. Latin America is showing solid economic gains. Brazil is experiencing moderating inflation and improving fundamentals. Mexican President Pena Nieto was recently elected, and he is aggressively pursuing economic reforms. He also hopes to reform the national oil and gas industry. Mexico is also a direct beneficiary of rising U.S. consumer demand. Nearly 80% of Mexican exports go to the U.S. and the country is benefitting from “near-shoring” where goods manufacturers are physically close to their end markets. Market Fundamentals: Crude oil prices are always a wild card. Fears of potential Iranian nuclear weapons and an Iranian oil embargo drove oil prices higher earlier in 2012, but Saudi Arabia and other countries increased production and drove supplies up and prices down. Iran has threatened to close the Strait of Hormuz and any attempt to close the strait would send oil prices up sharply on a short-term basis. The civil strife in Syria complicates this situation. Another concern relates to whether Israel will launch another land assault on Gaza as it did in December 2008. Overall oil production and inventories are ample and demand is weak. Consequently we do not see higher oil prices on a longer-term basis. Corporate earnings for the S&P 500 achieved an all-time high of an estimated $102 in 2012. Earnings momentum declined, however, over the course of the year. By the 3 rd quarter, revenue growth and margins were flat. As we look to 2013, we see single digit revenue growth and S&P 500 corporate earnings growing modestly to $108. Equity valuations are cheap compared to historic levels going back to 1990. For example, the forward Price/Earnings ratio for U.S. stocks is currently 12.4 times, compared to 15.6 times for the historic average. Europe is trading at a 10.3 times P/E ratio, compared to a 14.0 historic level. Emerging markets are trading at 10.1 times, compared to the historic average level of 14.2. Meanwhile, long-maturity “safe haven” U.S. Treasury bonds have extremely low yields and the bond prices are subject to significant price erosion in an environment where interest rates eventually return to more typical levels. Summary: On an overall basis, we see continued slow global growth, mild inflation for the year, and reasonable valuation levels. Under these conditions, we expect equity markets to generate positive high single-digit returns and to beat bonds. As a result, we are holding a modest tactical equity overweight compared to bonds. Our equity exposure is overweight in emerging markets. Our bond holdings have shorter maturities and greater credit exposure to improving economic fundamentals. As always, markets will remain volatile and they will react in both directions to short-term factors. We will continue to monitor the markets over the course of the year, and to work with your client account manager to help ensure meeting your long-term goals and objectives. —Jeff Johnson, CFA, Vice President-Investments, 1/3/13 “The Stevens Advisor” is a market update from sources deemed reliable, but Stevens, Foster Financial Services, Inc. does not make any warranties of its accuracy. The opinions and forecasts are those of the author and may not actually come to pass. The opinions voiced herein are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is no guarantee of future results.