Waddell & Reed

Market Perspectives


Three legs of potential growth in U.S. could move economy forward

Story Highlights

  • Uncertainty surrounding government policy is holding back the economy.
  • We see the U.S. economy moving forward on three legs of support: housing, energy and industry.
  • China, although still growing, has a similar situation to that faced in the U.S. in the 1970s, with the interplay between two forces: growth and inflation.
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Investment Management

Manager Name 

Hank Herrmann

CEO

As we move toward year-end, there are several important issues facing the global financial markets, including the euro zone’s sovereign debt crisis and the U.S. fiscal cliff. Let’s look at how these and other questions facing us over the next several months could impact the economy and financial markets.

The U.S. equity market is up significantly so far in 2012, despite sluggish economic growth. Why, and what is in store for the new year?

Uncertainty surrounding government policy is holding back the economy. Despite this, the market’s improvement is supported by companies with strong balance sheets and record high productivity. A better understanding of the outlook should come after the U.S. presidential election. Will taxes be raised and how much? Will there be big cuts in government spending? Will government intrusion into the economy expand further or contract? All are very important open questions. In the meantime, businesses and consumers will remain risk averse.

Despite the confusion surrounding government policy, as we look toward next year, we see the U.S. economy moving forward on three legs of support: housing, energy and industry. A quick look at why these three hold potential:
Housing:

 We have under-built new homes relative to the increase in the working age population in this country since 2007. New home construction has fallen from more than a 2 million annual rate at the peak to less than 600,000 at the low. The U.S. requires a rate of about 1.2 million homes annually, just to stay even, given the growth in the working age population. As the unemployment rate comes down as the economy stabilizes, we’re likely to see an increase in new home demand. An improving housing sector benefits many areas, including construction materials, durable goods, furniture and so forth. To sustain improving housing demand, we need better job creation, and happily, the trend currently appears to be up.

Energy:

It’s become obvious to us that non-conventional energy resources, particularly shale oil and gas, are creating an upswing in exploration, development and production in the U.S. energy patch. Energy companies we’ve talked to report that, based on their production estimates, domestic oil and natural gas production will grow substantially over the next 10 to 15 years. This increase in supply of cheap energy allows the U.S. to become much more competitive globally, and reduces our dependence on foreign energy supply. Most important, getting the resources out of the ground and transporting them has and will continue to create many new jobs.

Industrials:

Boosted by lower energy costs, the industrial sector in the U.S. is becoming more competitive. The past few decades have seen meaningful declines in industrial activity here. That trend is now reversing. The new supply of energy has boosted the need to rejuvenate old refineries, build new ones, lay pipeline and build out infrastructure for transportation, etc. Add in new home construction, and you see industries in position for a phase of resurgence.

It’s evident that growth in China is slowing. Do you still see China as a growth story longer term, and what is its influence on global economic growth?

China remains the world’s main growth story, but a slower pace than we’ve seen in recent years is likely. Given the expanding middle class and continued desire for improving lifestyles, we think we’ll see growth in China at a rate of 5 percent to 7-plus percent in GDP for quite some time. This compares to a rate of approximately 2 percent or so in the developed world. For the past decade, China grew at a rate in excess of 10 percent per year, and even faster prior to that.

The reason that slower growth in China is important is that companies around the world have planned on higher Chinese growth rates. China now is going through a de-stocking phase, causing suppliers to begin to experience demand shortfalls relative to their expectations. The unwinding of inventory in China therefore can have a big impact on world growth, albeit perhaps only temporarily.A reduction in government policy flexibility in China is an added consideration impacting the growth level. Wage increases of approximately 10 to 20 percent over the past few years have created inflation risks. China has a similar situation to that faced in the U.S. in the 1970s, with the interplay between two forces: growth and inflation. The government wants to see more growth, but if it is not managed effectively, China will face inflationary consequences via labor and import costs. It is likely this quandary will retard growth rates somewhat, relative to the past.

Is the sovereign debt crisis in the European Union being effectively addressed?

The European Union has effectively addressed the bank liquidity and the sovereign financing crises. What remains is the fiscal crisis. That is, many of the 17 EU members are running unsustainably high deficits, with no apparent effective measures to reduce them. A common fiscal union among the member countries, or at least a common agenda in terms of taxing and spending, is needed. As Margaret Thatcher said when the EU was formed, you can’t have monetary union without fiscal union. The process of developing a workable fiscal union is likely to be prolonged and politically difficult. This would likely translate into very low, if any, growth in Europe, and a recession for southern euro zone countries.

What opportunities to do you see for investors in this environment?

There is a reasonable case to be made for U.S. equities, given the three legs of growth we’ve identified, along with ongoing easy monetary policy. We are broadly anticipating around 7 percent appreciation in the S&P 500 in 2013, driven by an expansion in the price-to-earnings (P/E) multiple, primarily. We expect that the government will, at worst, “kick the can down the road” in some fashion before the fiscal cliff is reached. Significant action regarding taxes and spending will need to be enacted before confidence can be fully restored. If none is forthcoming, markets will react, forcing something perhaps more painful to occur.

The yield on domestic stocks is higher in many cases than the yield on their outstanding bonds. Further, many companies are increasing dividends more aggressively, as balance sheets are strong. Domestic equities remain attractive to us relative to other alternatives.


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 not a guarantee of future results. The opinions expressed in this article are those of Mr. Herrmann and are current through October 2012. 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.

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