Waddell & Reed

Market Perspectives

What kind of recovery is this?

Hank Herrmann 
Chairman of the Investment Policy Committee


Waddell & Reed Advisors Funds Market Perspective – April 2012

The first quarter of 2012 brought a sharp market rally, with The Dow Jones industrial average seeing its best three-month gain to start a year since 1998. Stock markets around the world also posted strong quarterly gains. Very recently we’ve experienced a bit of a turn in momentum in the equity markets caused by global economic concerns, leading to another bout of volatility. The question heard most often now: Has the U.S. economy entered a self-sustaining recovery, which would support an ongoing equity market rise? The following is our response.
Our belief is that the U.S. economy has reached a self sustaining recovery, with a likelihood of moderate growth in the near term, not modest growth. Moderate growth is around a 2.5 percent rate in U.S. gross domestic product (GDP). Modest growth is 1 percent. If some of the headwinds we face land more on the side of negative outcomes, we certainly could see modest growth. Modest growth, however, simply won’t create enough jobs to bring down the unemployment rate in this country. In that event, additional policy initiatives would likely be undertaken.
Our view is that the domestic equity market is likely to take a pause after the very strong run in late 2011 and early 2012. But that doesn’t mean a significant market decline is in the offing. Economic and corporate profit data will be positive drivers of markets from here. While there are numerous challenges ahead, it is unlikely that these will derail the upward momentum underway.
To elaborate on the important headwinds:
  • Facing the fiscal cliff. As we approach year-end, there are a number of tax, government finance and political concerns that must be resolved. The fiscal cliff refers to the potential for a steep drop in economic activity in the U.S. because of existing legislation that could go into effect in January 2013. This includes the potential expiration of the Bush cuts, the expiration of payroll tax cuts, a reduction in unemployment benefits, automatic spending cuts appropriated by the Congressional “supercommittee” for federal debt reduction, along with the resolution of questions surrounding the Affordable Care Act, the president’s health care initiative. Politics has delayed the resolution of most of these, as dealing with them has been put off until after the presidential election. Left unchanged, these issues could lead to a major drag on GDP in 2013, perhaps as large as 3.5 to 4 percent. Should events unfold in such an unfortunate way, talk of a self sustaining recovery will be misplaced. Given the past 12 months, predicting the vagaries of politics is a dangerous pursuit, but no intervention at all would be too disruptive to not expect some positive action.
  • Are we seeing data in an accurate light? Some analysts suggests that perhaps the positive economic data earlier this year was fostered more by the very mild winter than by any fundamental strength. That is, unseasonably warm weather gave a boost to economic activity and a return to normal weather could lead to less robust activity. Time will tell; our perspective is that there clearly was some pull forward, but not a great deal.
  • Gasoline. The rise in gasoline and oil prices associated with the ongoing uncertainty in Iran could stunt consumer spending. Currently, gasoline prices are falling, and strong retail sales in February and March suggest that the worry is overblown.
  • The euro zone and China. We’ve been talking about the European debt crisis for awhile now. Will the euro zone experience a recession in 2012? China’s economy, which remains vitally important to global economic growth, is slowing. How slow will it get? Can these issues derail the U.S.? While some have feared a hard landing in China, our view is that China is likely to see annualized GDP growth around 7.5 to 8 percent. Slower, yes, but still robust. Europe, however, is a concern. The southern countries in the European Union continue to push austerity measures as a way to deal with massive debt levels. The question here is not if the euro zone will experience a recession, but how big of a recession will Europe experience? While not positive, we believe the financial situation to be manageable. We may see, approximately, a 1 percent GDP decline in Europe. There are observers who foresee up to a 2.5 decline in euro zone growth, which would result in some collateral damage to the U.S. economy, again threatening any self sustaining economic recovery. We are not of that view at this point.  
These are major issues, without concrete answers until later this year. But one message is very clear: if economic data worsens, the U.S. Federal Reserve is poised to provide additional supportive measures. The same seems true of the European Central Bank. In addition, China has taken steps to roll back some of the tightening measures they put in place in recent years, and they have additional room to ease if they so choose.
P/Es remain attractive
Beyond the uncontrollable uncertainties, the U.S. economic data is important, and the underlying fundamentals are set to be supportive of equities. While price-to-earnings (P/E) ratios have expanded over the last three to six months, they are still attractive, in a range of 11 to 13 times. Relative to the long-term average of 16, it means there is still room to rise. But, in our environment of uncertainty, for all the reasons cited above, P/Es are not in a position to expand much.
What does this mean for investors and financial advisors? In constructing a portfolio, you have to think about all your options with your risk tolerance in mind. Right now, stocks still look cheap, especially relative to bonds. Stocks with attractive dividend yields can provide stronger income to investors in an environment where fixed income yields are low. Our analysis tells us that equities continue to offer strong potential, a higher implied rate of return than some other investment options, in an environment that carries a lot of ambiguity.
The Dow Jones Industrial Average is an unmanaged index of large U.S. 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 April 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. and of Ivy Funds Distributor, 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 the mutual funds offered by Waddell & reed, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.


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