Waddell & Reed

Market Perspectives


2013 Market and Economic Outlook: Kicking the political habit on the road to recovery

Story Highlights

  • Political battles continue in D.C.
  • GDP growth expected to increase.
  • Foreign markets face various issues.
  • More:13 Ideas for 2013
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A new year provides each of us with a dose of optimism and a chance to begin again through resolutions that often seek to eliminate a bad habit.

In looking at the markets and the global economic landscape we see opportunities in several areas in 2013. The challenge once again, of course, is political uncertainty. Although the economy will always face unforeseeable geopolitical headwinds, the continuing appetite among policymakers for high-stakes political brinkmanship – particularly in the U.S., but also elsewhere as we saw last year in Europe – continues to present what we see as arguably the most significant risk. For lack of a better term, it has become our worst habit and one that we desperately need to break.

A look at some of the issues – political and otherwise – that we will be monitoring closely as we identify opportunities in the new year:

U.S. political

The political issue at the top of everyone’s mind at the end of 2012 was, of course, the fiscal cliff. Although Congressional leaders and the White House were able to broker a last-minute deal to avert a crisis, lawmakers surprised no one in falling far short of a grand bargain to address the nation’s budget issues. As a result, it is widely expected that the spending versus revenue fight between Democrats and Republicans will continue for additional rounds – the next one focused on the need to raise the nation’s debt ceiling.

The bitter and acrimonious debate that was a part of the 2011 debt ceiling debate led to the first ever downgrade of the nation’s credit rating. Unfortunately, the debate this time around could be even more heated since the fiscal cliff agreement only delayed by two months a decision on some $100 billion in 2013 spending cuts – moving it right into the same timeframe as the debt ceiling discussion. Finally, the deadline for a new federal budget will hit in late March.

Meanwhile, the last minute New Year’s holiday agreement, although largely seen as preventing a plunge over the cliff, did come with what might be considered its own hangover: tax increases for more than three quarters of U.S. households, according to the nonpartisan Tax Policy Center. While the deal prevented 99% of Americans from seeing an income tax increase, it allowed the expiration of a temporary reduction of the nation’s Social Security payroll tax. Combined with tax increases for higher earning individuals and families, the Center estimates 77% of American households will face higher federal taxes in 2013.

As a result, we expect a fiscal drag of about $200 billion next year, which will pressure first quarter growth, says Derek Hamilton, vice president and global economist.

“Further dealings over the next two months will continue in the face of a needed increase in the debt ceiling. These negotiations will likely result in some further fiscal tightening,” Hamilton says. “However, increasing clarity in Washington on fiscal policy should allow corporations to increase spending once again.”

U.S. economic

Despite some of the fiscal cliff agreement’s shortcomings, equities rallied in the aftermath of the deal, showing yet again that it is perhaps difficult to overstate the impact of political uncertainty on the economy.

“Government policy regarding taxes and spending has unquestionably held back financial markets,” says Hank Herrmann, chief executive officer of Waddell & Reed Financial, Inc. and chairman of the Investment Policy Committee. “As the drama of government policy wanes, it brings good news for businesses. It brings more willingness to increase capital expenditures and boost hiring. All of it is good for economic growth and good for investors.”

Assuming the U.S. can get through the political rhetoric that is bound to fill the first quarter and potentially spill into the second, we believe the U.S. gross domestic product (GDP) should begin to improve and bring job growth along with it through the year, particularly in the second half of the year.

The U.S. should be able to achieve around 2% growth for the full year thanks to three sectors where we expect to see strengthening performance:

  • Housing, which should continue to build on the strength we saw in the last half of 2012. In the third quarter of 2012, residential fixed investment hit its highest level since the end of 2008 and housing should continue to benefit from low mortgage rates, reduced prices and improving employment.
  • Energy, where non-conventional areas of exploration, development and production – particularly shale oil and gas – are on the upswing. Much has been written about shale, but to add some perspective: In 2012 shale gas represented 37% of U.S. natural gas production, up from only 2% in 2000, and the growth continues.
  • Industrials, which we expect will gain thanks to energy. Obviously, this includes the energy infrastructure from transportation to refinery construction and rejuvenation, but it also encompasses a wide range of manufacturers that can benefit from cheap energy. Some energy sector experts are forecasting that energy prices could remain low to moderate for a generation. In a speech last year, U.S. Steel Chairman John Surma called the development of U.S. energy resources a “once-in-a-lifetime economic engine” comparable with the role coal played 200 years ago.

It is important to keep in mind that growth in each of these areas, which are particularly labor intensive, should spur job growth in the U.S. and improve business confidence, potentially adding some degree of stability to the economic recovery.

Equities

For many investors, the challenge will be how equities respond to the evolving environment. One thing we believe is important to keep in mind is that difficult economic periods generally foster stronger companies. These firms usually have the large cash balances, extremely low debt levels and strong cash flow necessary to survive a downturn and potentially thrive in an improving environment.

“Yes, the macro environment has been tough, but many chief executives have looked at this situation as an opportunity to innovate and get more competitive,” says Philip J. Sanders, chief investment officer. “Today, we find ourselves, despite the challenging macro environment, with U.S. corporations that are in the best financial shape they have ever been historically. Companies all around the globe have used this difficult economic environment to learn how to run their businesses better, to innovate and become more competitive and productive. They are finding opportunities and appear to have the financial wherewithal to take advantage of them.”

We expect investors, who have been leery of risk assets for some time, to return to equities in 2013 as growth becomes more apparent and confidence grows among both businesses and investors. The large cash balances have led many corporations to initiate or increase dividends, which have become an important benefit for investors seeking income with the dividend yield on the Standard & Poor’s 500 Index now higher than most U.S. Treasuries. As a result, we expect equities to outperform bonds.

Fixed income

The short end of the yield curve is unlikely to move in 2013. The Federal Reserve has said it expects to hold its key interest rate at 0 to 0.25% for another two years. The question for fixed income investors is what happens at the long end of the curve if, as we expect, investors begin to move more aggressively back into equities.

Ten-year Treasury yields rose to their highest level in eight months after the Federal Reserve released a report indicating that Fed officials expect the central bank’s bond buying program to end this year – the first sign that the Fed will eventually tighten its extremely loose monetary policy. Those fixed income investors who view the primary risk in bonds as credit risk – or the risk of getting repaid – may instead find that they are facing more significant interest rate risk than they realized. The 10-year U.S. Treasury closed 2012 at a meager 1.78%, well below its 50-year average of more than 6% and far below what we believe investors will accept as the risks become more apparent and equities become more attractive.

International

We expect the global economy to continue to improve with growth of around 3 percent, which is not as strong as we might like, but is better than what we saw in 2012. Our view is based on developments we expect in several important regions.

In Europe, the European Union is moving to what we hope to be a less tumultuous period than what we saw in 2012. That is not to say there will be no challenges. Banking and sovereign debt have been addressed, but there still is not a fiscal union and a lot of uncertainty.

Among the developments that will be closely watched are, as always, the European elections, most importantly in Germany where Chancellor Angela Merkel will seek her third term. Although Merkel is expected to win, the bigger question will be the makeup of the German parliament and if Merkel ends up heading a bipartisan coalition.

We expect the European economy to muddle through this year with modest growth in the core. But, if the economies across the European Union merely stabilize, that is good news for investors.

We expect China’s economy can maintain its strong growth rate, with real annual GDP growth sustainable around the 7% level and inflation of 3 to 4% over the long term. The country named new members to the Communist Party’s Politburo Standing Committee (PSC) in late 2012, which also signals the new government leaders. Xi Jinping was named to the top position as general secretary during the party’s 18th National Congress in late 2012, and he will become president of China in March 2013. Li Keqiang, the No. 2 in rank on the PSC, will become premier.

We think Xi Jinping will have a better opportunity to push economic and political reforms than was the case for outgoing President Hu Jintao when he took over 10 years ago. China is the world’s second-largest economy and the world’s fastest-growing major economy. It has grown its economy by an average of 10% per year over the past 30 years. It also is a key driver of the global economy as the world’s largest exporter and second-largest importer.

“Mass market consumption in China is growing and we see much more room to grow. We think China can succeed in a push toward a market-driven economy, from an exportdriven one, with a focus on increased domestic consumption,” says Michael Avery, executive vice president of Waddell & Reed and co-portfolio manager of Waddell & Reed Advisors Asset Strategy Fund.

Meanwhile, China’s dispute with Japan has had a negative impact on Japan’s economy, which has hurt auto exports to China. Japan, which has also been hurt by the global slowdown, may benefit if Japan’s central bank eases monetary policy, which we expect as political pressure mounts. We expect the yen to weaken, helping Japan’s economy, which we believe has bottomed.

Similarly, we believe most emerging market economies have bottomed as well. India continues to have a problem with investment spending, as issues with government policies have limited the pace of infrastructure spending and corporate capital spending. We believe the government has realized its mistake, and is starting to push through some reforms to boost the economy, which we expect to grow around 6% this year. Meanwhile, we expect growth of more than 5% among the member countries of the Association of Southeast Asian Nations.

“About one person in seven lives in the developed world. We continue to believe that means there are significant opportunities in the emerging markets through companies that provide goods and services to the growing middle-class populations,” Avery says.


Past performance is not a guarantee of future results. The opinions expressed in this article are current through January 2013. Opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.

Consider all factors:Investment return and principal value will fluctuate, and it’s possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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