Waddell & Reed

Market Perspectives

For the U.S., it’s all about elections, fiscal issues and manufacturing

Story Highlights

  • Despite concerns for 2012, we think growth is likely to improve in 2013.
  • U.S. elections are just the start of key events that may affect the economy.
  • Manufacturing is one sector that could bring increasing economic strength.
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Investment Management

Manager Name

Derek Hamilton

Vice President

While there have been contrary indicators about the U.S. economy, most recent data indicate economic weakness. That raises the potential importance of events in the coming months, including the national elections, resolution of several fiscal issues and a decision about another increase in the debt ceiling. In analyzing the potential economic impact, we think it is important to keep an eye on another key factor: a stronger manufacturing sector.

Weak 2012, improving 2013

The U.S. economy continues to see sluggish growth. U.S. gross domestic product (GDP) grew at an average rate of 1.6 percent in the first half of 2012, when adjusted for inflation. That is down from an average of 2.7 percent in the second half of 2011. We don’t see much change in the immediate future, and expect growth in the second half of 2012 to be at or below the rate of the first half.

There have been some positive data releases in recent months, including September’s improvement in the unemployment rate. However, the overall evidence continues to point to economic weakness:

  • Orders for durable goods – a solid indicator of capital spending – have weakened in the last several months.
  • Despite the most recent employment report, private sector job growth continues to be subpar.
  • Export growth has been weakening and is likely to be a drag on growth through year end.
  • Business confidence is down because of uncertainty about the economies in Europe and China, as well as domestic concerns about the November elections and the fiscal cliff of expiring tax cuts and mandated budget cuts.

Despite the concerns about 2012, we think growth next year is likely to improve as the year progresses. Housing has been a bright spot in the economy this year, and we think improvement in household formations means housing demand should continue to recover in 2013. In addition, recent action by the Federal Reserve (Fed) to purchase mortgage-backed securities in an attempt to lower mortgage rates further should make homes even more affordable. The Fed’s action also should allow current homeowners to refinance their mortgages, thereby increasing household cash flow.

In our view, business confidence will be the key driver next year. Policymakers in Europe, especially the European Central Bank, continue working to eliminate the risks of a eurozone crisis for at least the near future. In China, the leadership transition and weakness in exports and housing continue to weigh on growth. But we expect to know the choice of new leaders soon and housing seems to be bottoming, which we think should cause GDP to bottom, too. More certainty about Europe and China could help business leaders become more confident. If that happens, we think the recent weakness in capital spending probably would reverse and companies would begin to spend again. We also think it is likely that the employment rate would improve in that environment.

Elections are just the beginning

There are several key events in the U.S. in the coming weeks that will be critical to economic growth. Many consider the U.S. elections in November to be among the most important in many years. Elected leaders will face decisions about the size of government, potential changes to entitlement programs and ways to revive economic growth.

No matter which candidate wins the presidency, we believe the payroll tax cut and extended unemployment benefits are likely to expire at year end. That would translate to about a 1-percent drag on GDP from fiscal policy. If President Barack Obama is re-elected, we think Democrats are likely to retain control of the Senate and Republicans are likely to maintain control of the House, although the latter party may lose some seats. This could bring about continued gridlock on the key economic issues. However, we think there would be a shift to an increase in government activity, with a focus on driving growth through government spending. The fiscal cliff negotiations also could be difficult in this scenario. Whether through agreement before Jan. 1 or retroactive agreement in the new year, we think income taxes are likely to go up for high earners. We also think taxes on dividends and capital gains could increase.

On the other hand, if Governor Mitt Romney wins the election, we think the Republicans are likely to control both the Senate and House. Under this scenario, we think government spending will be cut, which could cause a short-term drag on growth. We also think Romney will extend most elements of the fiscal cliff issues until there is agreement on a more comprehensive plan, including a reduction in tax rates and elimination of some exemptions.

It also is likely that the U.S. will hit the debt ceiling sometime before year end. As was the case in the summer of 2011, the Treasury Department can use some accounting methods to keep the government running for a couple of months. But Congress will need to raise the debt ceiling sometime in 2013. House Republican leaders have said an increase in the debt ceiling will require additional spending cuts. However, it is unclear whether they will stick to this demand, given the uproar that resulted from last year’s battle over the debt ceiling, for which Republicans largely were blamed.

Manufacturing may again hold the key

The manufacturing sector is one area that could bring increasing strength to the U.S. economy. There has been a lot of discussion in the past few years about a revival in U.S. manufacturing. A number of variables have made this more plausible, including a weak U.S. dollar; increasingly available cheap energy, such as natural gas; more competitive labor costs; and rising business costs in China. We believe the U.S. already is seeing this shift, with an increasing number of companies becoming hesitant to move more production to China.

Many companies now say they are considering bringing production back to the U.S. because labor costs have become more competitive with other countries. In fact, Boston Consulting Group estimates that within five years, the total cost of production in certain states will be only 10-15 percent more expensive than in Chinese coastal cities. This difference is minimal when other costs, such as shipping, also are considered.

If these trends were to continue, we think the U.S. could see a longterm, sustainable uptrend in capital spending and employment. The importance lies in the job multiplier for manufacturing jobs, which is estimated to be as high as three times. In other words, for every job that is created in the manufacturing sector, three more are created elsewhere. These jobs could be anything from suppliers of parts to service providers to construction. This potential impact leads us to watch manufacturing closely for any structural improvements.

Past performance is not a guarantee of future results. The opinions expressed in this article are those of Mr. Hamilton and are not meant to predict or project the future performance of any investment product. The opinions are current through Oct. 15, 2012. Mr. Hamilton’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.

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.

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