Waddell & Reed

Market Perspectives


Politics are transitory; financial markets endure

Story Highlights

  • The U.S. economy is being driven by energy, industrials, auto demand and housing. These are private-sector drivers that should be conducive to ongoing growth.
  • A slow-to-moderate growth outlook suggests that current levels of low inflation will persist for some time.
  • Given the economic environment, we believe that conditions remain positive for domestic equities going forward.
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Investment Team

Hank Herrmann

CEO

Unfortunately, as we head toward year-end, the financial markets have been clouded by an unproductive political climate in the U.S. It’s not as if a political stalemate has never happened before. There is less visibility than we would like, however, and volatility rising from here is certainly possible.

Despite the disruption created by gridlock, we believe that eventual political compromise likely will result in somewhat stronger economic activity over time. As our investment team consistently analyzes global economic trends and data, we shall not overreact to what we believe is a short-term disruption. Over the next six to 12 months we are likely to see some improvement in the government’s contribution to U.S. economic growth, contrasted with the drag on growth we’ve experienced across most of this year.

Currently, economic activity in the U.S. is running at approximately 1.5 to 2.0% real growth, annually. As we put the current political issues behind us, we could see somewhere in the neighborhood of 0.5 to 1% further improvement in economic growth in the U.S., to the 2.0 to 2.5% range. The economic fundamentals are sound enough to allow some improvement once the short-term issues are resolved.

Current (slow) growth drivers

The U.S. economy is being driven by energy, industrials, auto demand and, to lesser degree, housing. All of these are private-sector drivers that should be conducive to ongoing growth.

Even putting government uncertainty aside, however, the economic growth rate is likely to remain gradual, and importantly, insufficient to have a materially positive impact on job creation. A slow-to-moderate growth outlook suggests that current levels of low inflation will persist for some time.

Presuming that job creation in the U.S. continues at a very slow rate, and inflation remains low, we believe that Federal Reserve policy will remain on the side of ease into next year and likely beyond.

What does that mean for investors? The combination of moderate growth and low inflation, with slowly improving job growth, has been the story in the U.S. for quite some time, and it has created a positive recipe for equities. The S&P 500 Index, despite the early October declines, is up approximately 17% year-to-date, and has risen in 13 of the past 18 quarters. Given the economic environment, we believe that conditions remain positive for domestic equities going forward.

Where do we go from here?

Heading into year-end and looking toward 2014, following are our key perspectives:

  • Despite current negative feelings brought on largely by political gridlock, we believe that companies remain in good shape and, with the U.S. economy on a modest upward trajectory, equities are in a position to outperform bonds over the next 12 months or so.
  • In the U.S., unemployment has been reduced, the housing market has improved significantly, economic growth and corporate earnings continue to be solidly positive, and the Fed remains extraordinarily accommodative.
  • Historically, market sell-offs caused by political uncertainty have been short-lived. For investors who are under-allocated to equities and have a long time horizon, this might be a good time to talk to your advisor about adding equities to your portfolio.
  • Active asset managers, who can adjust to macroeconomic developments and effectively analyze a variety of asset classes, are well positioned to help investors through this changing market environment.
  • Looking internationally, Europe, while perhaps stabilizing, has little prospect for any meaningful acceleration. Even though it may not be the source of systemic risk that it once was, growth likely will remain only very gradual.
  • There is a possibility that, from a relative perspective, growth in the U.S. equity markets will be aided by the reality that emerging markets are in a period of much slower economic activity.
  • Interest rates are likely to remain low for the foreseeable future, despite the rapid increases seen following the Federal Reserve’s comments in May regarding a potential reduction in its bond buying program. Though there remains a long-term probability that rates will rise, we are currently seeing very low inflation, emerging market growth has slowed, commodity prices have declined, all of which reinforce the idea that inflation in the U.S. will stay low. We believe the Fed is unlikely to taper its bond purchases until 2014, or raise rates until 2015. Therefore, bonds prices are unlikely to rise much and should provide a return about equal to coupon.
  • Given the above points, money is likely to gravitate away from bonds toward stocks.
  • While there are different viewpoints on whether equity prices are attractive now, price-to-earnings (P/E) ratios are currently at about the long-term average, around 16 times earnings. Given currently low interest rates, and the long term probability that they will rise, stocks look more attractive than bonds on a risk-adjusted basis.
  • In a slow-growing economy, how rapidly can earnings and equity prices grow? A basic equation to help determine that is to look at real gross domestic product (GDP) growth, plus inflation, to get the revenue growth rate. To illustrate, if the U.S. gross domestic product (GDP) grows 2.0 to 2.5%, and inflation is about 1%, that equals 3% topline growth. Add in productivity, which should improve at least 1%, and the fact that companies may on average buy back 1% of shares outstanding. If we add those numbers in, we should see earnings per share growth of approximately 7 or 8%.
  • With approximate 8% earnings growth and a P/E ratio at about the long-term average, the implication is that investors should see stronger return from equities than could be achieved through most fixed income instruments over the coming year.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered to represent the U.S. stock market. Investments cannot be made directly in an index.

Past performance is no guarantee of future results.The opinions expressed in this article are those of Mr. Herrmann and are current through October 2013. Mr. Herrmann’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. Waddell & Reed Financial, Inc. is the ultimate parent company of Waddell & Reed, Inc.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for any of the Waddell & Reed Advisors Funds or Ivy Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

 

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