Political, regulatory, and economic uncertainty conspire to keep growth stuck in neutral.
The U.S. economy continues to defy the predictions of economists of all stripes by neither collapsing nor breaking out on the upside. Instead, after an initial burst at the start of this recovery driven by inventory restocking, inflation-adjusted GDP growth seems to have settled into a less-than-satisfying growth rate of 1.5% to 2.0%. About half that growth is coming from non-U.S. markets that have driven exports up to 14% of GDP, an-all time record.
In stark contrast to the weakness in Europe and the United States, growth in emerging markets remains robust. Companies serving developing markets are continuing to benefit from that growth, even as U.S. results remain lackluster. In fact, large, multinational companies continue to report decent earnings, again largely based on strong overseas sales. Meanwhile, small businesses, which generally have less exposure to foreign markets, continue to struggle.
Uncertainty Slows Spending
Another big theme among our analyst teams is how persistent uncertainty continues to weigh both on consumers and businesses. The unknown effects and resolution of the European debt situation have been particularly troubling to markets. One day it seems things are all resolved and just a few weeks later, it is back in the news again. The U.S. budget crisis in August definitely didn't help, either. That smoldering fire could burst into the flames again later this year if the bipartisan budget committee can't come up with enough cuts.
Uncertainty Causes Investors to Bid Up Safe Stocks
Apparently uncertainty has carried over to investors, who are now bidding up the more defensive portion of our stock investing universe and seeking stocks that provide income in addition to capital gains. While Morningstar's overall coverage list is selling at a 14% discount to our fair value estimates, the consumer defensive, real estate, and utility sectors are selling at very close to their fair values. Meanwhile riskier sectors with less good news, including financials, basic materials, and energy, are selling at bigger discounts than our overall average.
Corporations Have the Cash, But Are Afraid to Spend It
Although corporate spending is up, I believe it could be up a lot more if businesses had the certainty and the confidence to invest. Corporate margins are near all-time highs, and cash balances remain well above normal levels. The Federal Reserve recently reported that corporate cash balances reached a new high at $2.05 trillion in the June quarter. That compares to $1.96 trillion in the first quarter and $1.4 trillion in the middle of the recession in 2008. That cash continues to show up in increased merger-and-acquisition activity highlighted by some of our teams in their quarter-end reports. Borrowing money at exceptionally low rates and buying back stock seems to be another trend that is accelerating, according to Morningstar's analyst team.
Regulation Is Stifling the Economy, Too
Another theme I am hearing across our teams is the dramatic effects of regulation. The financial sector is being particularly hard hit with the new Dodd-Frank legislation that was more than 2,300 pages long and created more than 500 new regulatory regimes. While some reform is indeed necessary and overdue, the piece of legislation appears to have gone a little overboard. Unfortunately, many banks have stepped up their layoffs as the new legislation cuts into corporate profitability. Investors realize this, too, as the financial sector is now the most undervalued in our stock universe.
Zealous bank examiners and appraisers are not helping the housing market, either. After years of housing contract signings closely correlating with final home closing transactions, the relationship between pending home and final closed sales has broken down. In truth, we had a couple of months where pending sales were up and closings were down. Failure of homes to appraise and tight bank lending rules caused a midteens contract cancellation rate versus the more typical 8%-10% range, resulting in the disconnect in the data. Again, processes were certainly too loose before the crisis, but now those same regulators and bank examiners are going overboard in the other direction.
Our health-care team also reports that many device companies are being affected by increased regulation and proposed new rules this summer, though the team hopes that greater clarity on these new rules will come this fall, breaking some of the initial bottlenecks. Again these stocks are near the bottom of our sector valuations.