Tue, 26 Mar 2013
In Session 1 of the 2013 Morningstar Individual Investor Conference, Northern Trust's Katie Nixon, Charlie Bobrinskoy of Ariel, and Morningstar's Bob Johnson tackle today's macro questions on government policy, economic growth, inflation, and more.
Jason Stipp: Hello, and welcome to Morningstar's 2013 Individual Investor Conference, a full day of panels and presentations designed to help you get the most out of your portfolio in a challenging market. I'm Jason Stipp, Site Editor for Morningstar.com.
We've a great lineup for you today. We've got several panels and presentations designed to really help you secure stronger returns. We're going to start out big. We're going to talk about those big-picture issues that have investors concerned, that are on investors' minds.
Later today, we're going to delve into individual investment selection, get some top ideas from Morningstar's experts. We're going to take a trip overseas, we're going to learn about some global opportunities, potentially uncover some global values for investors. We're also going to dig into your fixed-income portfolio; there is no shortage of bond topics today, as you well know.
And retirement income, maximizing retirement income, both from your Social Security benefits and your investment portfolio--a hot topic among Morningstar readers to be sure.
And Christine Benz, our director of personal finance will be walking you through a portfolio checkup today to make sure your accounting for all those timely issues that could be affecting your underlying holdings, so that's something you won't want to miss.
In all, we've got seven sessions for you today. Here is how it's going to work. We're going to go straight through. We're going to take 10-minute breaks between each session. You'll have a chance to stretch your legs. And at midday we're going to take a brief break for lunch, and at that time we'll recap some of the big takeaways from the morning sessions, and we'll also preview what's to come this afternoon in some of those important sessions we will be bringing to you later.
Before we get started, a couple of important notes. So, this is a live webcast. We're streaming live to you right now; that means we can take your questions in real time. To the right of this webcast viewer, there is a "submit-a-question" box. So, we would love to hear from you. We will try to get to as many of those questions as we can.
And below your webcast viewer, there is a chat module where you can interact with your fellow conference attendees, also in real-time, definitely two big advantages of joining us live today. So, be sure to take advantage of those during the day.
But no break for now, let's get right into it. Our first panel, "Deciphering the Big Picture."
Inflation, valuations, ultra-low yields, a slow growth economy, concerns and woes overseas: These are the issues that are powering the headlines today, driving all of the news, and seemingly driving the market activity up and down on a day-to-day basis.
So, how should a smart investor account for these big picture ideas? Well, I'm pleased to be joined today by three stellar panelists to give their insights. To my left here is Katie Nixon. Katie is chief investment officer of personal financial services at Northern Trust, where her responsibilities include investment policy development with a focus on portfolio construction and implementation. She also directs the investment management activities of more than 200 Northern Trust portfolio managers. Thanks for joining me, Katie.
Katherine Nixon: Thanks for having me.
Stipp: Next to Katie is Charlie Bobrinskoy; he is vice chairman and director of research at Ariel Investments, where he oversees Ariel's investment and trading teams, as well as all of the firm's proprietary research. He is also a co-manager of Ariel Focus Fund, and a member of Ariel's investment board of directors. Charlie, thanks for being here.
Charles Bobrinskoy: Thanks for having me, Jason.
Stipp: And next to Charlie is Bob Johnson. You'll recognize Bob as Morningstar's director of economic analysis. Bob has more than 20 years of investment industry experience, including both buy-side and sell-side assignments as a research analyst, and prior to assuming his current role as director of economic analysis he was associate director of equity analysis for the tech team here at Morningstar.
Bob, thanks for being here.
Robert Johnson: Nice to be here.
Stipp: So, let's get going. I have several things I'd love to touch base with you. But the first one, I think, that is on everybody's mind is from the recent headlines of Cyprus, and we have been seeing those over the past week, week and a half. The markets seemed to be really concerned. This is a pretty small island nation. I think it's 0.2% of the eurozone's GDP. What's the big deal? Charlie, there seems to be a lot of concern about this small island nation. The markets are moving up and down. Should investors be concerned about what's going on?
Bobrinskoy: I have to say upfront, I am a Russian. So this is a special place. The island of Cyprus, which is a tiny place, plays a very important role in the Russian economy; it always has. It's where Russians sent their money to get it away from the government, to get it away from the taxman. In modern times, it's been, unfortunately, sort of like Swiss bank accounts. It's where people who wanted to hide their money sent their money. And, unfortunately, what that means is that finance and banking are much more important to Cyprus than they are to most countries--much more important, for example, than the banking industry is to the United States. So think of this as sort of like Switzerland. And, unfortunately, it's Switzerland with a little bit of a Russian mafia overlay.
So what's happened now, I think, is it is small enough that it's not too big to fail. The European governments, and the European central bankers are saying we're not, we don't need to let this survive. We can be tough. We can set a tough example, and we're going to make the people help be part of the solution. So they're demanding that the people of Cyprus and the depositors and the banking system are going to help solve the problem. I don't see them backing down from that. So there's going to be probably a bank holiday. I think there is some chance that Cyprus will be out of the EU in a relatively short period of time. And if not, the only solution is going to be big taxes on these deposits.
Stipp: Bob, this is a small country, but I think there are worries that if they take deposits out of banks that there's going to be a contagion issue, and other European nations that are in trouble might consider similar measures. I think there are worries about how this may or may not affect the United States, and the possible contagion issues here. As you think about the eurozone as a whole, how at risk is the U.S., the U.S. economy, U.S. investors, to the troubles that they are going through over there?
Johnson: Well, let's take them one at a time; I think Cyprus to Europe first. I think that the worry there is that it would spread to Italy and Spain. And, obviously if you see the depositors and everybody gets a free ride in Cyprus, and everybody is going to say, oh, well, then maybe I don't have to pay or I don't have to worry or whatever. So that's certainly the concern that it does spread.
Now in terms of Europe in general, Europe is a very small part of the whole picture relative to the United States. It's 3% of our exports. So, it's not a big deal, and a lot of that's soybeans and gasoline. So, we don't have to worry from that standpoint. But, if the whole banking system fails or it goes in a bad situation like it did in 2008, then we are affected.
Stipp: Katie, you're responsible for investment direction for a lot of investors at Northern Trust. How are you thinking about the big picture risks out of Europe as you're making decisions for where assets should be invested right now?
Nixon: Right. Well, I think the events of last week were really interesting test, frankly, of how sensitive capital markets here in the U.S. would be to the devolving situation in Europe, and frankly, we passed with flying colors. I mean, the markets had a bit of a hiccup. We had certainly a little rally in Treasuries, but for the most part, I think markets shrugged off the situation in Cyprus, recognizing that it would be probably very contained in Cyprus; it wouldn't affect Italy or Spain, which are in very different economic situations than Cyprus, certainly. And I think, frankly, it's also a test of the ECB's resolve, and this enables them to really establish credibility around the conditionality that they have put forth for support, and that's a good thing.
Stipp: Do you think that there's any tail risk for contagion issues or things happening in Europe that might affect the United States financial system? Are you hedging any of those, sort of, long-tail events?
Nixon: We think tail risk has really dissipated since the Draghi "whatever it takes" announcement of last summer, and the establishment of the OMT [outright monetary transactions]. They are not eliminated, but certainly I think they're greatly reduced. And certainly, it all comes back, as Bob said, to banking and to the financial system. And to the extent that the financial system can withstand, or at least have structures that can support it during times of stress, I think the tail risk is much diminished.
Stipp: Charlie, if Cyprus ends up leaving the eurozone, which is a distinct possibility, is that going to cause a lot of handwringing because now a country has left; the possibility that countries could leave the euro is real now. Is this going to cause a re-ignition of all of the concerns over there?
Bobrinskoy: So short-term, yes; long-term, no. So, if there are bad headlines about Cyprus leaving the EU, then markets will be down and probably down big that day, but we would argue that long-term it actually doesn't make that much of a difference. But things are going to be bumpy, and we would actually say this issue is going to make them bumpy over the next couple of weeks.
Stipp: So, we've heard plenty about the eurozone over the last at least year, year-and-a-half. Let's talk a little bit about the U.S. economy now.
So the Fed had a statement this week; they're expecting a bit slower growth. GDP for sure has been relatively lackluster in recent years; 1.8% in 2011, 2.2% in 2012; below a historical trend line of what we've seen post-1960.
Bob, what are your expectations for 2013 GDP? Do you think that we're going to be able to break this cycle of mediocre growth here?
Johnson: I think we probably have to take another look at what we mean "mediocre," too. 2% to 2.5% growth is what I'm looking for this year, and I'm hoping we'll get to at least the middle of that range, and I think we probably will. People keep on thinking, well, we need 4% or 5% or whatever, and the reality is, we haven't had 4% or 5% growth since the 1960s. The number that we should all be focusing on is 3.1%. That's the post-1960 average of GDP growth. And even if you break that down, the only two periods of 4% or more growth were the 1950s and the 1960s. We've been in the 3s ever since then.
Then you layer on the overlay that population growth in the '50s and '60s was more like 1.3%-1.4% at that time, and now population grows about 0.7%. So, yes, we've got slower GDP, but we're spreading it over a smaller number of people. So, I don't think that this 2.5% GDP growth rate is a long-term disaster. It is a disaster for the people who are unemployed right now, unfortunately. That's the tough part of it.
Stipp: Katie, are we going to need to get used to 2% GDP as the norm going forward?
Nixon: I think, unfortunately, at least for the intermediate term, the answer is, yes. As we continue to go through, I guess, the transition from the private-sector deleveraging to now the public sector having to deleverage, I think it naturally suggests a lower rate of growth going forward, although we're not believers long-term in this new normal of forever 2% kind of growth. But I think this is a situation we're in.
Interestingly enough, though, this year we've come out of the gates pretty quickly, and we just increased our GDP forecast for the first quarter to 3%, tailing off as we get further on in 2013 to the 2%-2.5% range that Bob described, but we're starting out pretty strong this year.
Bobrinskoy: So, this is one of the first topics we've had where we have some disagreement, which is good. So, we are much optimistic. We do agree with Bob about those long-term numbers. But what's unusual about this is, coming out of a recession this is very unusual to have this slow growth. So, we think we are actually going to have much stronger than 2.5%-3% growth. We think we're going to exit the year closer to 4%. And what's been holding us back is that financial crisis and banking-led recessions do sometimes take longer to come out of, and that's clearly what we had here, and there have been some other headwinds obviously. But now, as we start doing, and we'll talk about this later, there are lots of tailwinds that are going to start helping this economy, and they are going to start showing up, and we think we're going to exit the year 3.5%-4%.
Johnson: I think the only issue that I would have with that is that the housing industry is coming back, and that's certainly what's helping now. Consumer confidence is a little bit better than it was. But … this is a slow, but what I call enduring economy, and I think what's going to happen is that, yes, the housing industry is going to be much better. But now the export part of the economy, which was so important at the beginning of the recovery is going to start taking a slowdown. Autos, which have moved from 10 million to 15 million units of production in three to four years, it's now going to go from 15 million to 16 million. The move isn't as big. So I think, it's not going to look as big because it's not all at once. We're not going to have one of these 5% rocket ships, where everything goes up and then everything goes back down. I think we have a market where exports were strong, we had a market where manufacturing was strong, and now we're going to have a market where housing is strong, but we're not getting them all at once.
Stipp: So the other issue, of course, that's an overhang on the economy right now is the sequester and some of the debt and deficit issues. We've got a question from a reader about the sequester, the cuts in spending. Do you folks have any ideas about who is going to be hurt by the sequester? Will the economy be hurt by the sequester? Are there any companies or sectors that you may be avoiding in the short term? Katie, let's start with you. How are you thinking about some of the wrangling going on in Congress right now?
Nixon: Well, I'll speak from the macro perspective that clearly the sequester is going to be a headwind to economic growth. It could potentially shave 40-50 basis points of GDP growth this year, and it will be a headwind to employment also. So, we don't think that unemployment is going to improve to the pace that it would without the sequester.
Stipp: At Ariel, how are you thinking about the sequester as far as portfolio management? Are you making any moves to avoid certain areas there?
Bobrinskoy: A couple on the edge--defense. There are a couple of defense names that we're a little bit worried about, but in general, no. We're still running deficits that are close to $1 trillion. So, we would say fiscal policy is maybe not as positive as it would've been without sequester, but it's still helping the economy overall. There is no monetary drag coming out of Washington. Washington is being very helpful to this economy this year.
Stipp: And based on what the Fed said, they're going to continue to do that for quite a while.
Let's talk a little bit about a few of the other drivers that we see behind the economy. It feels like we're picking up a little bit of strength here in the first part of the year. You mentioned housing, and I think that's finally starting to show up, and maybe it'll start to help employment as well.
Energy is another one that's going to be a big positive for the U.S., and this is something that we probably wouldn't have even thought about talking about 5 or 10 years ago. Charlie, I know that you've mentioned to me earlier that energy is one of the big theses that you're following. How big is that going to be for the U.S. economy?
Bobrinskoy: It's hard to quantify, but longer term, it's going to be huge, and it is an absolute change in the world that we've all grown up in, where the United States was importing energy from around the world, where it was a real drag on the economy, where if there was a fight in the Persian Gulf, it really hurt the U.S. economy. That is going to change. The United States is going to become an exporter of energy. We right now are producing natural gas at a cost of about $4 in the U.S. That number is $12 in England and it's $13 in Japan.
So, we have a huge advantage over the rest of the world. We can not only start sending them natural gas, but we can bring manufacturing jobs back to the United States, because making steel or fertilizer or chemicals; they are all heavily dependent on energy costs, and that reversal of manufacturing jobs is going to be a big tailwind for the economy over the next five years.
Stipp: Bob, housing is going to be a help for us, energy is going to be a help for us. What else is on your list as tailwinds for the U.S. economy right now?
Johnson: Well, you know I've always talked, and they need to fix some of the problems, but certainly we've talked about the manufacturing recurrence here, and the fact that we have Boeing here, is a big deal. And all the manufacturing technology that they have, and there are only two major aircraft companies in the world, and each one of these aircraft go for a couple of hundred million dollars apiece. So it's a really big deal. It gets us technology innovation. All the carbon fiber things and all the energy saving things that are going into this Boeing aircraft, and again it helps bring manufacturing jobs back here. So that's certainly another one of the positive tailwinds that I'm looking at.
Stipp: So long as Boeing can get some of their issues taken care of.
Johnson: On the 787. But in fairness, I mean they've got some of the new models, the 747 and the Neo aircraft and a couple of other things that are moving along just as well.
Stipp: OK. Let's talk about one of the biggest components of the U.S. economy--so energy is going to help, housing will help--the consumer, though, is really what you have to keep your eye on as far as health of the U.S.
Katie, when you're looking at consumer and the outlook for the consumer, we've had a few headwinds early in the year with the payroll tax holiday expiring. How is consumer going to do for us?
Nixon: Well, when I think about the consumer, I think about their income statement and their balance sheet. So, on their balance sheet they have had a housing recovery and a recovery in some of their equity assets. So, actually household wealth has improved and is back to where it was in 2007. So we've had a big resurgence in household wealth here, so their balance sheets are in much better positions right now.
Then look at the income statement. We've had unemployment improve, although not as fast as many would like. We've seen a tremendous improvement in the employment picture, which helps. We've also had consumers refinance a lot of their debt. So they're paying lower levels of interest. So, on the income statement perspective, things look pretty good for them as well.
So, the picture for the consumer looks relatively healthy right now. And probably surprising to most, consumer sentiment and consumer spending have been very robust this year, even in the face of the sequester, the fiscal cliff, tax increases, and all the things that we've been talking about for several months now.
Stipp: Charlie, consumer thesis, what the consumer is going to do for us here in the U.S. economy; what's your thinking at Ariel?
Bobrinskoy: Very positive about the consumer. It was housing that brought us down, and it's housing--I think, people are underestimating the positive impact of what happens when not only do you have an increase in starts, but you have an increase in housing prices. That means that there are going to be lower default rates at banks. It means that people are going to feel comfortable painting their house and buying new carpet and putting that small addition on the side of their house, which they didn't feel comfortable doing for the last three years. And these jobs they created are not $9.95 minimum-wage jobs; they're $25 an hour carpenter, plumber, electrician jobs. So, we just think that this is going to have a very virtuous cycle. Just like on the way down, it hurt the economy more than people thought it would. On the way up, we think it's going to have more of a positive [effect].
Stipp: Bob, I know you look very closely at the consumer, and there sometimes are squiggles up and down in how consumer spending is doing. When you look at it with a little more perspective, what's the health of the consumer right now and what are you expecting?
Johnson: We've talked about GDP growth of 2%. I think the consumer is going to grow at kind of over a 2% rate, and I think that's what's going to drive everything. Consumer is about 70% of the economy, as you point out.
I think he's in fantastic shape right now. There has been some up and down in the monthly and weekly numbers. But if you look at him over a year-over-year, three-month moving average basis, which is the real trick to looking at a lot of economic data; we're still in very good shape. We're ex-gasoline and cars, we're still right in the 4% range, and you adjust for inflation, we're kind of in the 2% to 3% range, and have been basically since the middle of 2010. So, I'm not seeing massive acceleration. I'm just seeing the consumer really hanging in there and being the driving force in this economy.
Stipp: Charlie, you're pretty bullish on the economy. I want to ask you though, in your opinion, what are some of the biggest risks or wildcards out there that's on your radar? What keeps you up at night?
Bobrinskoy: Unfortunately, it's the unknown-unknowns. It's the things that I am not expecting that come out of nowhere. I hadn't been thinking about Cyprus at all. And so, that's what happens, it's war in the Middle East. If the Israelis bomb Iran, which could happen, that's going to be a problem, and it's something like that, a natural disaster, a war; it's an unknown-unknown.
Stipp: Katie, the risks on your radar right now for U.S.?
Nixon: Well, I think one of the risks could be a growth scare, to the extent that that undermines Central Bank resolve to keep rates low. Were we to see a spike in interest rates that would change behaviors, that would create risk aversion, I think that could really undermine the economic recovery. So, counter-intuitively, faster growth than expected could have a relatively negative impact on us.
Stipp: How much do you think the Fed stimulus, the Fed's bond-buying activities, has underpinned the stock market right now? If they have to start removing some of that stimulus, are we going to see some crumbling of the current valuation levels in the market?
Nixon: It kind of comes down to two things. First of all, corporate fundamentals are so strong now, and I think that's really what's underpinning the buoyant market. We have a very strong corporate sector, strong profitability; strong balance sheets, lots of cash on the sidelines. So the U.S. corporate sector is very, very strong right now.
Now, that being said, valuations did a lot of the heavy lifting in terms of the return of stocks last year and this year, and that was driven by zero interest rates and by Central Bank policy. So to the extent that we still have very strong fundamentals, but we have a crack in the Federal Reserve resolve which undermines valuations, we could have a hiccup in the market.
Stipp: Bob, I know that inflation and rising rates assuming are on your radar as far as a recovery killer you call it, when inflation ticks to a certain level. Is that your biggest concern right now?
Johnson: Well, I think that is my biggest concern, because every time inflation gets at over 4% year-over-year, we have a recession. And it's never the exact cause of the recession, but it's always the most proximate cause. And it's pretty close in. It's kind of three to six-month warning time. So it's a really good indicator to keep your eye on, and that's what I keep my eye on. And I am worried, probably because of geopolitically what can happen with oil prices and energy, which is a big portion of GDP in consumer spending. So I watch that very closely. I'm worried about that.
I talk every day with our analysts about, how is that soybean and wheat crop and corn crop growing in Argentina and Brazil, because food prices, again, are a very important part of consumer spending that can't be avoided and tends to move the inflation rate. So those are the two really big things that I worry about.
The third thing that I'd add that's just creeping up in my radar screen is, of all things, shortages. We've now got a situation in the housing industry where the Homebuilders Association is complaining and saying half the firms in this business have gone out of business, and so when somebody needs something to go build a house, they can't do it. When somebody needs to go hire a plumber or whatever, they can't get it. When we need to go get supplies, there is not even a guy to buy it from. And when we do, lumber prices are up 50%, 60%, 70%, 80% from where they were a couple of years ago. And I don't think people have realized, but there is a couple of those little bottlenecks kind of creeping into the economy here that may surprise us all.
Stipp: We talked about the sequester a little bit earlier, but I'm interested to get your take on still the debt and deficit issues that we face short-term and long-term. Charlie, how important are solving these issues in the near-term, really important for investors to keep on their radar? And there's talk of, of course, the sequester is part of an austerity measure. There is debate about how well austerity has worked in Europe.
Johnson: There is no debate. We know what it's done.
Stipp: Should we take medicine now, or only a little bit of medicine? At least we are grappling with these questions here in the U.S.
Bobrinskoy: So these are very important long-term issues, but they actually aren't very important short-term, in my view. The analogy that I always use is, this is like your son having your credit card and running up big credit card bills. In the long run, it's really bad, but you are a good credit. And so he can run up an awfully big bill, and eventually it's going to have to get paid off, but it's not a short-term problem. And what's happening right now is, we're running up a huge credit card bill against our kids' and our grandchildren's credit, and some day they are going to have to pay it off. But they've got a lot of credit capacity, and they can run up trillions of dollars of debt. We can run up trillions of dollars of debt against our kids' credit, and that problem is not going to become a problem for, unfortunately, a long time.
Stipp: Katie, how do you think about the risk of government misstep and policy misstep causing problems with the market?
Nixon: Well, I think we've seen time and time again that political dysfunction can have a tremendous effect on the market. We saw it with the debt ceiling debate. We got a little taste of it during the fiscal cliff debate as well, but I think what gets lost in the shuffle here is … so, we have two things. We have the deficit issue, and actually we've improved on that front, which is something that is not typically hitting the headlines now. We had a 10% deficit to GDP. Right now, we are right around 5%. So, we've had a tremendous improvement there.
The longer-term issues with the debt, though, are acute, and we all recognize the fact that the higher your debt to GDP is, the lower your potential GDP growth becomes, which is one of the reasons why we do see the next five year being suboptimal, 2% or hovering around 2% kind of economic growth.
The good news, though, is I think we've learned from the European project that austerity, pure austerity is very, very painful, and can create some very structural issues in your economy. So, I think, I'm hoping, that our politicians have recognized that that's not the way to go.
Johnson: I mean the U.K. is on its triple-dip right now, triple-dip, and so I think the hardcore, let's fix everything now mentality is a disaster.
Stipp: How much medicine can we take right now, though, Bob, and have we taken enough for the short-term?
Johnson: We are getting painfully close to limits. I think what we implemented in the fiscal cliff was about $235 billion worth of either cuts or tax increases. And now with the sequester, which by the way, it escaped a lot of headlines, but yesterday the House and Senate did pass a bill that basically made the sequester law, and what they did is they took out some of [cuts] for the meat inspectors and some of the individual hard-hit sectors, so that it wasn't quite the meat ax that it was, but the sequester is done. We will get those cuts--that $70 billion of additional cuts. So, that's going to move us up to $300 billion more or less in terms of fiscal tightening this year.
And we had $200 billion in 2012. So I know we can endure that. The $300 billion gets to be … I think, we can kind of do that because economy is just a little bit bigger, too, but that's getting painfully close. And I know we couldn't have done the whole fiscal cliff at $700 billion. That would have thrown us back into a recession, but I really don't want to see any more tightening this year. We are at the limit.
Bobrinskoy: Just to remind everybody, we are not cutting government spending. The United States government is going to spend more money in 2013 than it spent in 2012. It is going to spend more money in 2014. So, all this talk about cuts are just cuts in growth rates, cuts from what they otherwise would have been. The U.S. government is growing, not contracting.
Stipp: Let's shift the conversation a bit now and talk about big picture, stocks versus bonds. So, here at Morningstar, we track asset flows into all kinds of investments, and despite the fact that we have seen ultra-low yields for so long; investors are still putting money to work in fixed income.
Income is also a hot topic among our readers. As more folks move into retirement, they need their portfolios to work for them. Yields are so low, the chance of interest rates going up seems a lot higher than going down any further from where they are. Charlie, I'm going to start with you, because I know you have some strong opinions about this. With the prospects for fixed income so murky, why are people still putting money into bonds at the rate they are?
Bobrinskoy: Because it's worked for a long time and because people have made good returns as interest rates have gone from let's say 10% on a 10-year when I entered the business in the early 1980s, all the way down to 2%, you've made a lot of money in bonds, and so people have felt very comfortable doing it, but I am a very, I will say, almost an extremist on this point. I think we have a bond bubble. I do think we are now at a level where the interest rates make no economic sense, where people have gotten here through emotion, fear, and where the government is manipulating rates.
Bernanke is buying $85 billion worth of bonds every month, and the effect of that is to bid up the price of bonds to a level they wouldn't otherwise be at. When that ends, we're going to have a reversal, and bond prices are going to come down, I think come down a fair amount. Interest rates are going to go up, and people are going to get hurt. People think that Treasury bonds are risk-free returns. It's a cliche, but we agree with it. Right now, they are return-free risk.
Stipp: Katie, when you're thinking about the portfolios at Northern Trust and the issues at an asset class level, stocks versus bonds, how are you making adjustments? Are you making adjustments for the, kind of, extraordinary circumstances that we're seeing right now?
Nixon: Well, we recognize, to your point, that there is an asymmetric return stream associated with fixed-income right now. The upside is very, very limited, and the downside is very unpredictable now. As most people say, it's a question of when, not if, rates are going to go higher. Our point of view is that it will take quite a while, given our low-growth economic outlook, as well as our low inflation outlook. We think rates are going to stay low for a prolonged period of time, so we're not worried about that.
Our base case is not worried about a spike in rates undermining bonds. We also don't think we're in a bond bubble in the traditional sense of a bubble where we were in a tech bubble in the early 2000s. We were in a housing bubble, where people lost everything. With high-quality fixed income, you have your par value. So you can lose opportunity cost, certainly, you could lose capital gains that you have embedded in your bonds right now certainly, but there's a floor with a high-quality fixed income. So, we're not quite worried about a bond bubble.
Now, when we think about relative value between equities and bonds, it is unequivocal right now that equities have a much better relative value versus fixed income, which is being, as you say, artificially manipulated by Central Bank policy.
Stipp: Charlie, if we are in a bubble, and maybe we are, maybe we aren't, but if we are and it pops, is it going to be … we're in safer assets, right, less volatile assets. Would it be as devastating as the housing bubble, as the tech bubble?
Bobrinskoy: No, you don't lose all your money, but you can lose 20% of your money relatively quickly. If the 10-year bond rate goes up by 100 basis points, 1%, you lose about 8% of the value of your 10-year bond; 200 basis points is about 15%-16%. So you can lose a lot of money fast.
Remember, it wasn't that long ago when we had a 5% 10-year, so that's 300 basis points. When I was growing up, we had a 10% 10-year.
So I think the downside is significant. And the other thing, Katie, you're right that you have the principal, but that principal can be eroded by inflation and what people obviously want…
Nixon: It's being eroded right now.
Bobrinskoy: That's right. So 10 years from now when that bond matures, and you're getting your principal back, you might be buying $0.50 on $1 worth of goods.
Nixon: I think, Charlie makes a really good point, too, which is, if you have fixed income in your portfolio that you are going to need to sell for a reason, you need to buy something; you need it for your lifestyle. That money should be very dry powder right now, because, to your point, you can lose on paper a lot of money if rates go up. But if you can hold that bond to maturity, you're going to get back your par value. So you have to really look at your portfolio and decide what is the purpose of these assets? I have cash on the sidelines, it's an insurance policy right now, it's a painful one, but I need that money. I have my fixed income to give me long-term stability and diversification. I have my equities for growth.
Johnson: One thing that I would add on that whole point is that you have to have equities to go with your bonds. Even with your equities, you've got to be careful that you don't duplicate your bond portfolio. I think what would kill bonds is if we have a higher growth economy than everybody is expecting. If we have a higher-growth economy, obviously equities are going to do well, and you're going to want growth-type equities.
So I think if you're going to have bonds as part of your portfolio, then you have to have equities as an offset. In other words, the bonds may go down if we get better growth and the rates go up, as Charlie points out. But you have to have that balance of equity, and I would suggest growth … it'd be disastrous to have a bond portfolio and then to have a high-dividend portfolio to go with it, saying, OK, that's my diversity between stocks and bonds, because then you're tied to the same factor. So, I think the key is, you've got to think about what is it that's going to kill bonds; it's economic growth. And how do I get economic growth? The stock market.
Nixon: Or inflation would kill bonds.
Nixon: You could have very stagnant economic growth, and you could still have inflation, which would argue for having inflation protection in your portfolio, and you can get that through the equity market.
Stipp: Well, here is the other question, too. The Fed came out [this week], and said we're going to keep on keeping on with the policies that we've had, right? But to what extent does the Fed really control interest rates? The Fed explicitly does through their policies, but might we have to see rates start to tick up for other reasons?
Bobrinskoy: Inflation, right. So, that's the big one that they can't control. So, I would argue that there has been an inflationary set of policies around the world with countries almost competing to depreciate the values of their own currencies. When that happens, you can get inflation everywhere. We saw that in the '70s, and the Fed cannot drop inflation quickly. They don't have the ability to control that, and then all bets are off. Then bonds can lose value in a big way.
Stipp: All right. So, we've mentioned that relatively speaking, stocks are much of an opportunistic value obviously than bonds right now, but we've also seen the stock market perform pretty well. We've come very far off the bottoms that we saw in 2008. We had a good year last year. We started the year off pretty strong this year. How are valuations looking in the stock market? Are stocks really an attractive opportunity at this point?
Nixon: On a relative value basis, they are less attractive than they were a year ago, for sure, because we've certainly closed that valuation gap. Stocks were dirt cheap coming out of the recession in 2009 and early 2010, and we've seen a steady progression in earnings. Right now with the market selling at around just under 16 times earnings, it's still under the historical average, which many would argue has been pushed up by the tech bubble and things like that. So, stocks look attractively valued here. There are very well valued versus bonds. But on an absolute basis, they are probably fairly valued.
Bobrinskoy: I just want to say that people talk about how far we've come. That's just a reference to the bottom of the market. We're just right now getting back to where we were five years ago. So many classes of stocks have had virtually zero returns since 2007. So it all depends on what your reference point is. I would argue, zero return over five years means that they've underperformed and there's an awful lot of possible opportunity from here.
Johnson: And I would point out that this time around, right now at the same level on the S&P 500 that earnings are considerably higher. So on a valuation basis, we're looking a lot better.
Nixon: On top of that, I would also say what's truly interesting is that price to earnings ratio is not the best forward forecaster of returns. When we look at price to cash flow, it looks very attractive right now. Price to cash flow has had the highest correlation with forward-looking returns, and looking at that, it looks very attractive.
Stipp: We've got a question from a reader before we move off of the bond-stock discussion. The reader asked if the bond bubble bursts, what might happen to the stock market? So if we see some issues with rates spiking or we see some loss of value in fixed income, how does the stock market respond to a situation like that?
Bobrinskoy: We spend a lot of time on that exact question, and historically, the good news is, there have been periods in which bonds did poorly, and the stock market did pretty well. So the '50s would be a good example of that; interest rates rose, but the stock market did pretty well. In the '80s, you had both bonds and stocks doing very well. So, more often than not, they tend to move together. But there are examples in which because of a strong economy, interest rates go up, bond values come down, and the stock market outperforms. Now, if it's sudden, and if there are people losing a lot of money in their bond portfolio, that's not going to be good.
Nixon: Like 1993-1994. It's unexpected and sudden increases in rates that really take the market by surprise and create that risk-off trade.
Stipp: Let's continue to talk a bit about stock market valuations, and we also had already mentioned corporate health a bit. So, the stock market has managed double-digit gains in two of the last three years and that's on top of a 25%-26% bounce in 2009. If, broadly, we still see some opportunities in the market, and we're just kind of getting back to the pre-crisis levels, my question is, how important at this point is selectivity in the stock market?
So, the market overall maybe looks a little more fully valued, what about certain areas of the market? Are we seeing some areas look more attractively valued than other areas, and are some areas looking little bit topped up?
Bobrinskoy: We would agree with that. We would say, a year ago, two years ago, you could blindly buy almost every sector and do pretty well, and now we would not say that. We do think there are a couple sectors that are still pretty attractive, principally, consumer discretionary and financials for the reasons that we've talked about. So, we think a housing recovery is going to be very good for financial stocks and consumer discretionary stocks, and multiples in finance – and banks. J.P. Morgan is at 10 times earnings. Goldman Sachs is trading at book value. Morgan Stanley at 80% of book. So, you still have good opportunities in financials. Industrials, we do think things have run pretty far. Consumer staples, things have run very far, and you have big multiple, so you've got to, we think, be careful in risk-off stocks.
Stipp: Katie, as you're looking at the portfolios at Northern Trust, are there any areas of emphasis, because you see certain opportunities in certain sectors?
Nixon: We share the views that Charlie just espoused. We also like energy here. That's a sector that we have an overweight to. And we like technology here, frankly, talk about a cheap sector that hadn't really participated in the market rally off the bottom. That's a very interesting place to look for opportunities.
Bobrinskoy: I'm glad you brought that up, some names like Microsoft and IBM. Microsoft is trading for less than 10 times earnings. Dell, which everybody wrote off as dead, was trading at three times EBITDA, and so value tech is still very cheap.
Stipp: We've got a question from a reader on health care, and this is, obviously, an area that's seen political/policy involvement. What's your take on health care, both from a valuation and also just a fundamental perspective because of the big changes we've seen in health-care policy?
Nixon: I'll just start off by saying I think it's very unpredictable right now to see what the effects of Obamacare and some of the changes in the health-care landscape will be. I think these stocks have had huge rallies also. So, from a valuation perspective, they might have had their near-term rally already.
Bobriskoy: I agree with Katie. We try to have a Rip Van Winkle test, where you could go to sleep for five years and be fine with the stock, and wake up knowing everything would be OK, and some of these stocks don't pass that test.
But having said that, we do think Obamacare is going to mean more utilization and more customers, and so things like orthopedic companies that sell hips and knees, we think the demand for those products is pretty undeniable. People are going to be buying hips and knees five years from now. The only question is what the reimbursement rate is going to be?
Nixon: How much money you make. Yep, that's it.
Johnson: And I think that the whole health care thing is … you asked for surprises maybe in 2013 and 2014, certainly [a potential surprise] is what Obamacare is going to do, because we're bringing 20 million to 30 million people into the health-care system as of the beginning of 2014, and those peoples are going to have to see doctors, get X-rays, be scheduled by a nurse, all of that kind of stuff, which potentially means a pretty big boom in some of the health-care-related employment things that help the overall economy.
Stipp: And, Bob, isn't it a pretty safe bet that we're going to be spending more money on health care five years from now than we're now?
Johnson: That's pretty good bet.
Nixon: And it dovetails into your shortages theme also, because I think we have a shortage of medical care in this country, and how to absorb that kind of demand.
Johnson: In the very short run.
Nixon: In the short run.
Johnson: On the other hand, on the employment side, we are now also facing things where people are finding every game in the world to make themselves a less than 50-person entity or they are buying from less-than-50-person entities. We have got little groups set up that work for two competing businesses, and they work 20 hours at one and 20 hours at the other, so they are part-time in both, and don't get health care. I mean, the number and things are going on, some of the big unions that compete with smaller businesses, and the unions have to provide insurance, and the small guys don't, is creating all sorts of problems in the labor world. We are just beginning to see that right now.
Bobrinskoy: I am glad you brought that up, and I should have mentioned risks. That would've been actually the top of my list is that, the effects of Obamacare and the 50-person rule could have more of a suppression on hiring than I'm expecting. And so you do have a lot of small companies that do a lot of hiring in this country, and if they don't hire that person, it could have an impact.
Stipp: I wanted to get your thoughts specifically on corporate health. So throughout the downturn companies became very lean and mean. They squeezed out a lot of the inefficiencies. We've seen margins do really well. We've seen earnings really doing quite well.
We have also seen cash building up on the balance sheets of a lot of companies, and this is a big issue in a lot of respects, \ an economic issue potentially as well. So my question is what's the best use for that cash on corporate balance sheets right now? Let's start with you, Katie.
Nixon: Well, I'm glad you asked the question, because I think that we could be entering the era of the shareholder-friendly action versus the bondholder-friendly actions that we have seen in the last several years. And I think whether it's dividend increases, which we have seen with increasing rapidity over the last several months and quarters, or share buybacks or, frankly, in an environment of very dear growth M&A activity, which we have also seen come to the fore this year in particular. So I think all three of those things are very good uses of cash. Unfortunately, a lot of the cash that's on the balance sheet that we talk about all the time is offshore. It'd be hard to bring that onshore to do some of these things. But, be that as it may, I think there is a lot of opportunity to enhance shareholder value aside from just margins and things that are on their current income statement.
Stipp: As a fundamental investor at Ariel, what do you like to see? What's good allocation of capital when you have that amount of money on the balance sheet?
Bobrinskoy: Great question. So, the best use is if you have an undervalued stock, and by definition if we own you, we think your stock is undervalued, we like to see people buy back their stock first. Second is dividends. Tied with those two is probably good investments in your own business. Obviously, the other reason we own your stock is we think you have some kind of economic moat around your business, so we're happy for you to spend your money on capital expenditures.
The worst use is usually acquisitions, and the absolute worst is diversification acquisition. So, that's kind of the hierarchy. And I want to emphasize one thing that Katie said, yes, there is a lot of cash on the balance sheets, but a lot of that cash is overseas, and so it is not as easy as people think to pay these dividends and make these acquisitions when your money is in Ireland for tax reasons.
Johnson: I would say that the other thing in terms of corporations, and I'm beginning to hear it bubble up from our analysts in some of the quarterly reports now, and they all use a different word. Some of them use innovation, some are using investment for the future, but all sorts of words about trying to get growth out of their business. I think we went through three or four years where it was like, we cut everything, the special programs, the things that mean growth, and now, I think some [business] are saying, you know what, I have been worried about uncertainty for the last three or four years. Amazon is eating my lunch. I now need to … if I want to stay in business … I need to invest in my infrastructure, my dotcom effort, if I'm going to even stay in business. I don't care what interest rates are. I don't care what ROI is. I don't care if the fiscal cliff is coming three times over in the next six months. People are beginning to invest in their own businesses again. And I think that's one of the really powerful things that I'm beginning to hear bubble up from our analysts.
Stipp: So, those business pressures are trumping some of the other concerns that have maybe held companies back. So, how much has this reluctance to spend held the economy back, in your opinion. Maybe that's changing now, but in the past corporations were kind of sitting it out and holding cash?
Johnson: They really have. I think that's been one of the real differences, that people have not invested in their businesses as much as they used to. And the other thing that's a little bit hard to get your arms around is that some of the real growth industries in this country are now things like Google and Facebook and so forth, which don't eat capital the way a steel mill and an automobile industry does. So, that's kind of messed up looking at some of the investment numbers as well.
Stipp: I got a question from a reader, Bob, since we're talking about corporate spending. Obviously one of the things that corporations can spend on is new employees.
Stipp: This reader is concerned that corporations are in sort of a new normal for the number of workers that they need. Do we expect that unemployment level because of efficiencies and new technologies and new streamlining, that will have higher unemployment because corporations don't need as many workers?
Johnson: We've seen a lot of that already. So much of the unemployment rates and so forth is blamed on a slower economy, and it's blamed on all the jobs are going to China. But the far bigger cause of the loss of manufacturing jobs in this country is automation and all the tools that we've done, and all the technology that we've developed. Versus 50 years ago, this country is producing probably twice as many manufactured goods as they used to with half the number of people that we had 50 years ago. A four-for-one improvement. And that's some of what we're seeing here. We have analysts every day that come back from factory tours and say, you know what, the last time I was here, five years ago, there were 400-500 people here; now there is 10.
Johnson: So, the reader is right. I mean this technology has certainly hurt unemployment in the short run. Obviously, that means goods are cheaper, people can spend more, and yes, it is a painful transition period. But, obviously, more technology has always meant eventually better employment, but certainly in the short run, he's dead-on.
Stipp: Okay. We have a few minutes left, so I want to make sure that we get some of our reader questions in as well. Charlie, this is something that we talked about before the session in a call we had. Dividend-paying stocks versus bonds right now. How do you think about those as an income investor and the opportunities that you have there?
Bobrinskoy: Fascinating topic. So, the example I use is that Johnson & Johnson is now paying a higher dividend than they are paying an interest rate on their bonds. So you've got a dividend that's in the mid-3%s, 3.5% let's call it, and the interest rate on their bonds is 3.2%. That hasn't happened in America since the 1800s, I think. We've tried to find data, and the data's a little bit funny, but you've got to go all the way back to the 1800s. So, to us, it's just crazy that you'd buy that bond when you get the Johnson & Johnson higher dividend yield, plus the dividend yield represents only 35% of the earnings, so you get that other 65% that's being reinvested in the company. And so we would buy the Johnson & Johnson stock all day long.
Nixon: And the dividend grows with inflation, so you've got your inflation protection built in there also.
Stipp: We also had before this panel a lot of user questions about inflation. We discussed inflation a bit here. There's a lot of worries about inflation, because of the monetary policy, because commodities can be driven by markets external the United States, that we could get some kind of a runaway inflation. In your opinion, Katie, what's the inflation risk of a big spike, not a gradual, but unexpected, prices are a lot higher?
Nixon: We think it's very low right now, although we do think that in any environment, investors should protect themselves against the effects of inflation.
We mentioned, right now, we're in a very low-inflation environment, we still need inflation protection, because we have negative real interest rates. So, even though we have very low inflation, we need to build these things into the portfolio. There are number of ways that you can do that. On the bond side, there is only one bond that will give you pure inflation protection against unexpected rises in inflation, and that is TIPS; very unattractively priced right now, because they show you that they have a negative yield, even though fixed income across the board has a negative real yield right now.
But two other areas that are kind of interesting; one is global natural resources, upstream natural resources, and then the second would be infrastructure. So, these are two areas--equity areas--that have a high positive correlation to inflation--and they tend to act very well during spikes in inflation. That's exactly when you want that kind of protection.
Stipp: Bob, we had a reader ask, what's the bigger concern for inflation, loose monetary policy or emerging market growth heating up?
Johnson: They're both bad. I think I'm a little less worried about emerging-market inflation right now than I was. I think that China was on a big boom phase, and they were being very wasteful with how the use their resources. They were doing anything to get growth, to get more people working in a hurry, and some of their steel plants, you might as well have been burning your furniture to light up some of those factories that were over there--horribly inefficient, growing at 10% for the sake of growing 10% or 12%.
Now I think the Chinese government said we want to grow 7.5%. We want it to be a little bit more consumer focused. We don't want all these steel mills; we want some of these little steel mills to shut down. Pollution in China is horrible. They're talking the talk right now, but I haven't seen all of the actions yet. I'm a little bit concerned. We will have more talk in today's sessions about China, but I think maybe some of the big spike from China doing all of the crazy things with copper prices and steel prices and even food and gasoline prices is probably, I'm feeling, a little bit behind us, because the last big boom they were growing at 12%. Now their plan is only to grow 7.5%. So, I'm thinking it's going to be, because they're so large, obviously, it's going to have impact. But I think it's going to a little bit less impact than the monetary policy.
But, on the other hand, I will remind readers that the fiscal policy, in my mind, we would disagree with Charlie just a little bit, I think fiscal policy is getting incredibly tight. We are taking $300 billion out of the economy in one year, that's a big deal, and thank goodness we have a little bit looser monetary policy.
And then I also look at something called the operating gap right now, and right now that's how much based on the number of people we have, employment and so forth, what we could produce in this economy. And it's about 6% more than what we've got right now, and we've never had a really long, sustained move in inflation without that number getting back to zero, and we're now at minus six. Now, we've had one or two little spikes in inflation, which are a major thing in gasoline or something that happens once in a while that might cause six months of pretty bad inflation that this doesn't help predict at all. But in long term inflation rates, we're at that operating gap of minus six, so I'm not terribly worried about inflation.
Stipp: All right, Bob. Unfortunately, we are going to have wrap it right there. This has been a great conversation. I want to thank my panelists again; Katie Nixon of Northern Trust; Charlie Bobrinskoy from Ariel; and Bob Johnson, Morningstar's director of economic analysis.