Mon, 7 Apr 2014
BlackRock's Heidi Richardson, University of Chicago professor Randy Kroszner, and Morningstar's Bob Johnson tackle today's key macro issues--including employment, housing, consumer and corporate spending, the Fed taper, and much more.
Jason Stipp: Hello and welcome Morningstar's 2014 Individual Investor Conference. I'm Jason Stipp, site editor for Morningstar.com. If you've attended our conferences in the past, welcome back. If you are a first-time attendee, we are glad that you're spending some time with us today. I promise you it will be time well-spent.
Without further ado and no breaks for right now, we are moving into our first panel, the Big Picture.
So if you thought the weather was hard enough to get through, imagine what the economy is facing right now. We have of course the weather issues. We have the Fed fretting about removal of the stimulus that the Fed has enacted over the last several years. The housing market, which was supposed to be the big driver of the recovery, is seeing some slowing growth there, and emerging markets of course, which had so much promise coming out of the 2008 downturn, haven't performed perhaps as well as investors might have expected.
So what should we take of all this data, this conflicting data, the revisions to data? How can we make sense of it? I'm joined today happily by three expert panelists who will be able to help us put all of this big-picture economic data into perspective.
First up, we have Heidi Richardson. Heidi is from BlackRock. She joined BlackRock in 2010 with 23 years of experience in active investment management. As a global investment strategist for BlackRock, she can offer perspective on all the asset classes, equities, fixed income, alternatives, and multisector approaches, and of course she's plugged into the BlackRock investment strategies team, research, and investment views.
Heidi, thanks so much for joining us today.
Heidi Richardson: Thanks for having me, Jason.
Stipp: Next to Heidi is Randy Kroszner. Randy is the Norman Bobins Professor of Economics at the University of Chicago's Booth School of Business. From 2006 to 2009, Randy served as a governor of the U.S. Federal Reserve. He chaired the Fed's Committee on Supervision and Regulation and the Committee on Consumer and Community Affairs. During that, he was taking a leading role in developing responses to the financial crisis, so he has a lot of insights on the Fed's activities. From 2001 to 2003, he was a member of the President's Council of Economic Advisers.
Randy, thanks much of being here.
Randall Kroszner: Great. I'm really happy to be here.
Stipp: And next to Randy is my colleague and friend, Bob Johnson. Bob is Morningstar's director of economic analysis. He's also a Morningstar.com columnist, and he has more than 20 years of investment-industry experience, including both buy-side and sell-side assignments as a research analyst. Prior to assuming his current role in 2008, Bob was an associate director of equity analysis for the technology team at Morningstar.
We have a lot to cover today. Let's get going. I think there's, as I had mentioned, not a short list of issues the economy is facing right now, but let's kind of start off, and I want to get, from each of you, a picture of your take on the overall U.S. economy.
The recent data have been mixed. We've seen revisions to data. It's been volatile. It's kind of been difficult to read, and I think it's leaving a lot of questions about where are we right now? What is the overall health of the U.S. economy?
Heidi, I'd like to start with you, your overview take on what is the situation?
Richardson: Well, I think we are in the middle of a globalized synchronized expansion, not only in the U.S. but outside of the U.S. If we look at the U.S., we've come off of multiple years of this 2% economic growth, and this year, we are forecasting about 2.50%-2.75% in terms of the economic growth.
But one concern is the consumer. I think the biggest issue that we're looking at with the implications of the growing economy is wage growth, and we haven't seen wage growth for the consumer. So if we look over the last few years, we've barely outpaced inflation. And so the implications of that, the numbers we are watching very, very closely are the employment numbers, and not only just the pure unemployment number, because a lot of the decline in that is coming from the participation rate falling off, but we are looking at really wage creation, looking at job creation, and seeing the implications for consumer there.
But if we look at corporate balance sheets, corporate balance sheets are very strong. There's record level of cash on the balance sheets. We're seeing a pickup in merger and acquisition activity. We are seeing a pickup in share buybacks. We're seeing a pickup in increasing dividends for corporations. So, the end result for consumers I think from an equity standpoint is still a positive moving forward.
Stipp: Randy, she mentioned some good things and some bad things, some concerns and some bright spots. But we've seen it seems to be adding to kind of slow growth for the U.S. economy and it's been that way for a while, but with a lot of volatility. So, how would you characterize the current state where we are today?
Kroszner: I think where we've been for the last couple of years, I call the sideways slide. We've been growing around 2%, sometimes a bit above, sometimes a bit below, but not really getting breakout growth that we need to kind of get back to where we were.
There's a chance that we can do a little bit better this year for many of the reasons that Heidi had mentioned. If you look at corporate balance sheets, they in principle are ready to invest. There are very, very strong balance sheets and reasonable profit growth, but there are a lot of headwinds that are out there.
We've addressed some of the fiscal uncertainty that we had. We had these fiscal follies in Washington, where we were shooting ourselves in the foot for no particular reason. That's not really helpful in a difficult economic recovery. We've addressed some of those. The clouds are not completely gone, but that's helpful.
We have a lot of regulatory uncertainties. I'm glad that one of the later sessions is going to focus on health care because I know in my travels around and talking with a lot of people in the corporate sector, that's a big uncertainty, both for larger firms as well as for the small and medium-size firms.
There are still these headwinds that are there, but the basic structure should allow us to go forward. Corporate balance sheets as well as household balance sheets have improved significantly from five years ago. We really need to turn the corner and confidence. We could be there, but I'm not quite sure we're going to break out in the sideways slide yet.
Stipp: Bob, you've been following the economy and the recovery, and a lot of what you've been writing is "We're seeing more of the same, we're seeing more of the same," despite the fact that short-term data looks volatile. It looks like we're having one quarter of, "Hey, things are turning around," and another quarter of, "Hey, things are falling off a cliff." So, where are we really when you look past some of that short-term noise?
Bob Johnson: The noise has been extensive. I mean, we've had one quarter as low as 0.1% growth in this recovery and one as high as 4.1%. So we've been what would appear to be all over the map, if we take one quarter and multiply it by 4 and annualize it. But if you look at the year-over-year numbers, they are a little bit less volatile. And then, if you really look at the fundamentals of the economy, it indicates that may be it's more of a statistical problem than reality, that the volatility really hasn't been there, and it's been a much more steady-state economy than we all thought.
You look at employment growth, and since 2011, we've grown employment about 2% year over year on the private sector every year and every month practically when you look at it on the average basis.
While we see the number as "Oh, it's 50,000! Oh, it's 250,000," well, you know, that's statistical noise from month to month. There are margins of error in there that are huge. But you really look at the numbers, we have three years straight of a very, very stable employment growth and also very, very stable consumption growth, which would follow. If you've got stable income growth as given by wages, you would expect consumption to be relatively stable, and sure enough it has. I'm not a big buyer of all this volatility, and a lot it is statistical-measurement issues and not the reality of the economy.
Stipp: When you step back and look past some of the noise, you do sort of see perhaps steady growth, but not inspiring growth. Why didn't we see the kind of rocket-ship recovery coming out of 2008 that we might've seen in past recessions? Heidi, what are your thoughts on why the growth has been kind of slow?
Richardson: Well, I think it's a number of things. One is, so if you just look at the demographics of the U.S. population and aging of the population, not only in the U.S., but post-World War II developed economies in Europe and Japan, as well, you are into a period where people are entering the retirement phase, and they're taking money out of the system as opposed to putting money into the system.
And I think corporations--because of all this uncertainty with Washington [questioning their tax rates and future costs of health-care benefits]--they didn't want to spend. They weren't increasing wages and salaries for their employees. They weren't thinking about investing in capital-expenditure spending, and we are starting to see a pickup of that now, I think which will help lead to this over-2% economic growth. It is certainly not robust. We're not looking at that 3s and 4s in the short period of time, but I think people were just on the fence in terms of really spending because they weren't sure what it was going to cost them in terms of ensuring their employees and those types of things and the taxation that they were going to be facing, particularly with the sequestering.
Stipp: And Heidi, mentioned some demographic shifts, Randy, that we're going to be facing? And I think one of the questions in investors' minds is, we saw the normalized growth rates in the past, and people are worried that we're not going to be able to meet those growth rates going forward; that normalized rates will be slower in the U.S. and kind of a slowdown that we've seen in other parts of the developed-world economy. What's your take? Should we expect slower gross domestic product growth going forward than maybe we saw over the last 20 years?
Kroszner: There has been a demographic shift, and ultimately economic growth is the number of hours worked in the economy times the output per hour, that is productivity. And so let's for the moment assume that productivity hasn't really changed that much, but exactly as Heidi said, we're having a demographic shift, we're having more older people in the workforce.
Now, interestingly, we thought we'd get much less labor force participation from older workers. That hasn't been as much of the case, but we've been seeing lower labor force participation basically across the whole spectrum, a little bit less than we expected at the older workers, but a lot less for younger workers. There seems to be a sort of a broader discouragement that's out there. We have a low employment/population ratio. And so, what that means is that even if we have the same productivity growth, we're going to have slower economic growth, but there's just aren't as many labor hours being offered in the economy.
Stipp: Bob, we had a reader ask, "I have a 25-year time horizon, so why do I care about the economy today?" Well, I would say, if we do expect to see slower economic growth over the longer term that could potentially have an impact on how you would think about the markets that you're investing in. But my question is kind of similar to the reader's, but maybe a take on it is, is it such a terrible thing that growth is a little bit slower? Is slower growth really bad or can we have slow, sustainable growth where people can still do OK?
Johnson: I think I almost have to answer that on two levels. I mean, one thing on a personal level, obviously, if you've got slower population growth and you've got slower GDP growth, that's fine. The per capita number turns out to be still pretty much the same. You might even be able to improve it because you're more efficient when you're not growing in these cycles where you've got 6% GDP growth, and then you go to a big recession. You go up and down, and maybe if we've got slower growth, we're not quite as volatile. So that's one positive of the slower growth. And certainly, you aren't racing around trying to find things quite the way that you are in [a highly volatile] environment. So I think that's certainly a positive.
It's not as good news for corporations. Whereas the individual depends on the per capita number, corporations depend on what's going on in the overall economy. So if the economy is growing 2% instead of 4%, that's a big deal to a corporation, and it can't be offset by a lower population like it can on the income front.
So, I think it's probably OK news for the individual, but probably bad news to corporations. [Corporations] are going to face issues like labor shortages, and older consumers are going to want to spend less. And it is going to be harder to target those customers. So, I think, probably good news for the individual, probably not-so-good news for corporations.
Stipp: Heidi, we have another reader question, and I think this is a good one that people often conflate these two. The reader--Richard--says, "Are we going to have a better economy and potentially a worse stock market?"
He's basically saying, the economy and the stock market aren't the same thing. And we can see an economy doing really well and growing really fast, but the stocks aren't performing very well. We're going to talk about the emerging markets in a little bit, that's one area where it's pretty apparent. But how can people think about what the connection is, if any, between the expectations for economic growth and what you'll see the stock market do?
Richardson: I don't see a high degree of correlation there. I mean, there are some drivers, obviously, with the growth of the economy and consumer spending and the emergence of the middle class in these regions, but the emerging markets are a great example. If you look at the emerging markets compared to the developed markets, they're growing at 2 times, sometimes 3 times, in terms of their regions and the environments. Yet we're not seeing the capital flow into these emerging markets because of some of the geopolitical uncertainty.
Emerging markets, as you mentioned, is a great example of looking at that. If we look at an average growth in emerging markets coming in at 5%--the U.S. marketplace and developed Europe and Japan coming in at less than 1% economic growth, the U.S. coming in at sort of 2.5% or so, and then these emerging markets at 4%, 5% and 6% in particular regions--if the capital flow isn't going there and the money flow is not going into those regions, we're not going to see a big expansion in those markets from a return standpoint.
If we look at the U.S. marketplace, though we're in this big expansionary mode coming off of this sort of great idle of 2% economic growth, last year I would admit, we were surprised with the 30% return in the U.S. marketplace we were not anticipating. This year in terms of our forecasts, we're anticipating mid- to high-single-digit economic growth in the U.S. marketplace. So we're looking at stock market returns coming in at 6% to 8%, more in line with the earnings growth of the corporations within the S&P 500 as an index.
So there's not a high degree of a correlation. I mean, generally if we're seeing these periods of growth, we're seeing, again, the emergence in the middle class, the consumer spending driving to that. But in the U.S. marketplace, I think looking at economic growth coming in; we are seeing the consumer slowing down. And when we're looking at some of these consumer stocks [our team at BlackRock is] underweight consumer stocks right now because of the issue with the employment level, the wage growth level. And if we look at the consumer discretionary sector right now, it's trading at 21 times, compared to the broad market of 16, 17 times in the S&P 500. So, we think it's just an expensive area of the marketplace and we're seeing the consumer in the midmarket being squeezed. So, not a direct correlation.
Stipp: I'm glad you mentioned the consumer because, obviously, as 70% of the U.S. economy, the consumer is going to be the big driver there. So, Randy, what's your take on the health of the consumer part of the economy and the trends that we've been seeing with the consumer? I do think we're seeing consumer spending perhaps be a bit disappointing, especially in recent times.
Kroszner: We certainly have come back a lot from where we were because the entire economy but particularly the household sector was very highly leveraged. And that has come down. That's been painful for people who've taken losses on their homes. But that is stabilizing in almost all parts of the country. And over the last year the housing market came back.
It looks like it's not likely to have the same sort of robust recovery this year that had it before, but there's no particular reason to see it fall off. This is very important, both for people's wealth and confidence because for most households, a lot of their savings, if not almost all of their savings, comes through their home. And if they have more housing wealth, they're more willing to spend. Also, it just broadly gives people more confidence.
So, I think that's going to be helpful going forward, but with a lower employment/population ratio, lower labor force participation, we're just not seeing the same kind of income growth for the economy as a whole. And exactly, as John had said, that might put a little bit of pressure on corporations.
But broadly, I think we can move ahead this year, a little bit more than we have other years, so broadly in line with Heidi's forecast for a somewhat stronger growth to break out of the sideways slide. But we keep having some sort of a headwind often, unfortunately, from Washington, where we don't need it. Now maybe it's coming from some other capitals in the world.
Stipp: And you mentioned consumer confidence there. Can we rely on consumer confidence as being an indicator that people will actually spend more; they might say they're feeling more confident? But is that really a reliable indicator what they'll do when they go to store?
Kroszner: It's one indicator that tends to be correlated, but it's correlated with a whole bunch of other things. So, I wouldn't just say if one month you see an uptick in consumer confidence, then go out and buy because everything is looking rosy. It's basically one of a set of indicators that one would look out for the overall health and robustness of the consumer sector.
Stipp: So Bob, consumer confidence is not one thing that you look at. But there are other things, and a lot of it has to do with the dry powder that consumers have to actually go out and spend, such as the credit that they have available, the wages that they have available, and how many are employed. What does that add up to for the dry powder? Do consumers actually have the ability to spend a little bit more if they feel like spending a little bit more?
Johnson: I think they do, and especially the higher-end consumer I think is probably doing a little bit than the lower-end consumer. The lower-end consumer right now is getting hit from every direction, between the food stamps program being cut back rather drastically. The so-called 99-week or the extended unemployment ended cold turkey at the end of December. And now we've got food prices kind of going through the roof again with the dairy products and now vegetables and fruit in California with all the drought things going on there.
And now gasoline prices, the spring bump came a little bit later, but unfortunately it came pretty strong as we all know by driving by a gas pump on the way here today. It's certainly back up again. And those are all things that are going to impact the lower-end consumer.
And certainly that end of the market has been pretty hard-hit, and I don't know if I see a way out in that market for that. On the higher-end of market, I think we still can. I think they can spend money. When you get into the upper quartile of consumers, they have a lot of choices. They don't have to buy. They just need to feel more confidence.
Stipp: This is an interesting question, and it alludes to a broader social issue that we're hearing a lot about especially in politics, which is, income inequality and some studies suggesting that we're seeing more income inequality than we've ever seen before. And I think one of the issues from an economic perspective is more wealth is held by folks that more of their spending is discretionary on a proportional basis. What does that potentially mean for economic growth from the consumer perspective?
So Randy, I'd like to ask you, what do you think about the distribution of income from an economic perspective, what the impact might be if we're seeing more inequality of income?
Kroszner: Certainly there's been a stagnation of median household income. There are a variety of statistical factors that may be driving that because households have become smaller over time. And so you might expect less income in a smaller household. So you have to make some adjustments for that. So some of those headline numbers may not be quite as bad as they have been portrayed, but still we haven't made the progress that we really would like to see in the U.S.
And there has been a particular growth at the upper end. So that's where most of the drive and the difference is coming from, is really that the top part is really growing much more strongly than many of the other parts of the economy.
There's a longer-term trend that's here. Actually there is an excellent new book that just came out called Capital in the Twenty-First Century, making reference to Karl Marx's Capital, which he wrote in the 19th Century by Thomas Piketty where he has put together data, looking at these very long-term trends over hundreds of years. And what he argues is that the postwar period, which was sort of a great leveling period, is actually the outlier, rather than the regular part of the way the economy goes.
The book just came out in English. My French is a little bit rusty. So I haven't gotten through all of it, but I would recommend looking at that because there might be some very interesting data to try to address this issue.
Stipp: And Heidi, when you think globally about consumer spending, do you see that there is some variance in what we might expect for the shift to consumer spending being drivers in other parts of the world, as well?
Richardson: Yeah, for sure. I mean, if you think of it, we talked about the post-World War II aging of the population and the boomer society, particularly in the U.S. and Europe and Japan and even China has an issue with an aging society and aging population from the one-child policy from back 30, 40 years ago. But where we are seeing the emergence of the middle class and this demographic shift toward a very young population is in some of the frontier markets and the truly emerging of the emerging markets. The opportunity set there for the growth and the demographics there we think look outstanding over the longer term.
So if we look at some of these smaller Asian economies, they are looking very robust. If we look at some of the economies in the Middle East, as well--the Persian Gulf states--they are looking pretty strong and very robust. I do think that you see the emergence of the consumer there. Part of the reason why we have an overweight position in the megacaps here in the U.S. marketplace is to take advantage of that consumer in the emerging markets. I think that they offer us some tremendous growth from the consumer and consumer spending there, but again, it's the population and that young population in some of those sectors of the marketplace.
Stipp: We've alluded to the consumer, and we've also alluded to the employment market which is obviously a big part of how the consumer is feeling. But I want to turn the conversation to employment and its connections to consumer spending. The employment recovery has really seemed slow across-the-board, volatile. It seems like we take a couple of steps back for a few steps forward that we take, and part of that could be the noise.
But Bob, generally speaking, when you look at employment growth and how long it's taken to try to recover the jobs that we lost, why has it been so slow this time around? We just haven't seen breakout employment growth that we might have liked to see?
Johnson: Yes. Well, I think a big part of it is the construction market hasn't come back. We lost 9 million jobs in the recession; 2 million of them directly were construction. That's both residential and buildings. If we add in probably the mortgage brokers, the lumber companies, the furniture companies, the moving companies, and all the assorted landscape companies that go with that, you're probably talking 4 million of the 9 million jobs that were lost were pretty closely related to the housing industry.
Housing has come back. We've gone from 500,000 housing starts to 900,000 housing starts, but we're certainly not back to the 2.2 million that we were at before. That's one of the reasons the economy is growing slower, and part of that is because of what I believe is overly tight credit in the housing market.
The number-two thing holding back the economy is the government. Government spending has never gone down for so many quarters in a row in any recovery since World War II. It got close in the Vietnam War, and it got close after the Korean War, but we have never seen government be such a big negative. We've actually lost 500,000 or more jobs in government since the recovery began. Since the recovery began, we've lost 500,000 government jobs. Those are the one-two negatives. But I do think in the next year or two, for those very same demographic reasons we've all been talking about, we come back to this panel next year, and certainly, by two years from now, we're going to be talking about labor shortages.
Stipp: That would be a good situation as far as the pressure on the employment market and potentially finding a job more easily.
Randy, I want to turn to you and ask you this question and this is tied to a question that we got from a reader which is, "How closely is the employment market tied to the market recovery?" So I think we would traditionally expect that employment would be a lagging indicator, but on the other side of the coin, you need a job to be able to spend money. So if I don't have a job, how is consumer spending going to improve? How do you see the connection between unemployment and underemployment and the economic growth prospects?
Kroszner: Also, an important piece of it is how much people are making when they actually are employed. So we've seen very little real wage growth over the recovery. It's basically been roughly at the level of inflation. It's important not only for people to have jobs, but also to have jobs that give them enough money so that they can do more consumption as well as some more savings. I think that's been a key challenge in this recovery because though maybe there will be a labor shortage down the line, I could only have my fingers crossed for that and I'm not quite as optimistic on that.
We've seen so many people in the labor market that the employers have been very choosy and it's been very competitive for the people who want to become employed, so they might be willing to take lower wages than they otherwise would. So we've seen very low wage growth. This is part of the reason why we're seeing in the recovery, even though we haven't had super robust recovery, corporate profits have been very good because wage costs have been relatively low. And that's something that's really got to turnaround.
Part of that I think has to do with what Bob was talking about, that we've got this mismatch between the skills of the people who are coming out of the construction-related sector and the growth sectors in the economy. So a lot of the growth sectors are in tech areas, and in the old days the sort of prime-aged males with relatively low skills could move back and forth between construction and manufacturing.
Today, U.S. manufacturing has nothing to do with the skills that are needed to construction--that sort of strength and hardiness. Now it's all about running a computer program.
Stipp: Randy, you're raising a good point and big concern that I think people have structural changes that may mean the employment market in the future is different not just for its cyclical reasons, but structural reasons. Heidi, as we're looking forward and thinking what is a normalized unemployment rate or what does the normalized employment market look like, do we have to set our expectations lower and basically say, maybe the employment rate will be a little bit higher and there won't be as many jobs available in the future.
Richardson: Well, it's interesting in terms of the way the unemployment rate is calculated. If we look at where we were at the end of the year, we were at 7.1% for unemployment and got down to 6.6%, 6.7%. The Fed originally had a threshold of if we get to 6.5% unemployment, we'll think about stopping this tapering and think about potentially raising interest rates. But they realized that that having that threshold of just a number is arbitrary, and it doesn't really show what's going on in terms of labor markets in the U.S. marketplace if unemployment is coming down because participation rates are at a 35-year low.
If we look at the participation rate, obviously, with some of the job creation and the mismatch in jobs obviously is an issue. But if we think of the participation rate in the 13 million people that have left looking for a job--they left employment since 2007--5.5 million have retired, 2.9 million are disabled, 2.5 million went back to school, and then we've got another 1.4 million who'd like a job but they're not looking for one.
So we have this structural issue with participation, and if we look at not only the jobs mismatch, not only retirement and the aging of the population, we do have that subset that has to work longer, so they're not creating jobs on the front end for people to come into it. But if we look at the situation with a structural issue, this is sort of a new dynamic for us, and I think unemployment levels are going to be very different than what we had seen in the past. Then the advent of technology, not only are jobs being created if you have some sort of background in technology, but I live in San Francisco, the Golden Gate Bridge is fully automatic now. There's not a single toll both operator. You can take your smartphone and take a picture of a check; you don't even need to go to the bank anymore to deposit the check. With the onset of this technology it's displacing jobs, as well.
Stipp: I think you might be physic because I actually just got a question from a reader about the effect of increasing technological progress on unemployment. Bob, I think I maybe let you off the hook a little bit easy when you mentioned that you think there might be a labor shortage coming up a little bit here. I want to ask you this question because we are seeing some structural differences and potentially some skill mismatch between the kind of jobs that are available and the kind of skills that workers have. So if you do think that we'll see a shortage, where will they happen? Do you think that that will ultimately be a good thing? Or will it just be that we don't actually have the workers where the jobs are available, and we're still going to have a lot of people that can't find jobs?
Johnson: Well, I mean, for a lot of things already, you can see some broad outlines of them. I work closely with our trucking analyst here at Morningstar, and the average age of a truck driver is like 55 years old. There are incredible shortages of truck drivers right now. So that's certainly one area. Airline pilot is another one. The Wall Street Journal has been writing forever about the retirement of the pilots now, and that's forcing some shortages there. There are airlines that had to cancel services to some of their secondary markets because there aren't enough pilots to fly the planes. That's right now that I'm talking about, that's not the two years when we're getting down to having this meeting again.
In the oilfields with the stuff happening in North Dakota and Texas, there's no shortage there of jobs. If you want to go out there and drive a truck in either those two states, you can make an income of $100,000 a year, they can't get enough people to move to North Dakota and South Texas right now.
Stipp: Well, that might have something to do with the housing market, as well. I can't sell, or I can't move right now.
Johnson: Unfortunately, tents don't count in the housing starts.
Stipp: So there are very interesting dynamics in the employment market, and I think we could talk about it the whole hour, but I want to move along now to another big player in the room and that's the Federal Reserve. Randy, of course, I'm going to start with you here with the Federal Reserve. Of course, we have seen extraordinary measures taken by the Federal Reserve since 2008, and probably no one knows more about some of the intricate inside workings of those measures than you do having been there at the time. Talk to me a little bit about the exit from these measures. The taper has been a big issue and last year just talking about the taper caused issues in the market. Now the Fed seems determined to continue with this tapering program. Is it going to stay the course? More importantly, will it be successful in getting the stimulus removed?
Kroszner: Remember the taper is just about reducing the pace of additional purchases. So it's not actually a contraction, I think some people are a little bit confused about that, it's just reducing the pace of increase. So they had been buying $85 billion a month and now the projection is down to $55 billion. That's additional liquidity that's being put into the marketplace. So I think it's important to get that definition out first. So it's not a contraction, it's just a slowing of the addition that's being put in.
But obviously that's caused a lot of tremors in the markets, both in the U.S. fixed-income market as well as in emerging markets around the world. I think the Fed is on course to continue to do this as long as the economy doesn't go too far out of its forecast range. The forecast range is basically the kind of range that we've been talking about. They're thinking about 2%-3% growth as their broad range. Inflation is staying relatively low. We have inflation significantly below the target level that the Fed has.
If it gets too low and starts to get toward sort of a Japanese-style or 1930s deflation, they will stop this, and they'll start buying more and more. I don't see that happening, but I also don't see any big inflation pressure coming that's going to lead them to have to pull back. But these are the uncertainties that we have. We've never been in a situation like this before. All the models and all the commitment from the FOMC members five years ago, when I was there, as well as today, is to make it as smooth as possible. Will it be smooth? I can almost guarantee you there will be bumps along the way because we haven't done this before.
But I think the Fed has a strong commitment to respond, if there is something that gets a little bit out of alignment to try to respond to that. We saw that last year in May and June when the taper talk started some tantrums in economies. The chairman talked that back a bit and tried to smooth things out. And now we see that the 10-year Treasury rate is not too far from where it was back a year ago. So I think they've been able to smooth out something that's a very difficult exit, but you're going to see some volatility in between. There is no way getting around it.
Stipp: Randy, you mentioned that the tapering is actually just easing up on the gas a little bit, it's not actually applying the brake.
Kroszner: Exactly. It's just a little bit off of the accelerator, but no brake yet.
Stipp: But, [Fed chair] Janet Yellen did say that it's conceivable that after they're finished with the tapering, that rates could rise six months after that, so that is putting on the brakes. What do you think would cause them to stray from that? And do you think that is something that should be on the markets' radars at this point? It seemed to be. But then markets seemed to say well maybe they won't do it.
Kroszner: I think there was a little bit of an overreaction because what Janet Yellen said, was not too far from where market expectations were to begin with. But then I think when she was a bit more specific about what a considerable period would mean--that it would be perhaps six months after the winddown--that seemed to get people a little bit upset.
But by the next day I think it was forgotten because if you look back to where the expectations were the previous day, it was sort of six to nine months anyway. So when you're talking out a year, year and a half, if you can get things roughly right within a quarter, you're doing pretty well. So, I think the markets reacted a little more strongly than they should have.
Stipp: Now you said that you're not seeing the inflationary pressures, which would crimp the Fed's ability to be responsive.
Stipp: Why is that? We have seen extraordinary stimulus measures. We have seen extraordinary bond buying. We've seen a lot of liquidity coming in, so where is the inflation? It hasn't happened?
Kroszner: Well what's extraordinary is the Fed's balance sheet went from about $800 billion now to more than $4 trillion. In normal circumstances this means duck and cover. This means inflation is coming and you have to worry. But as you can see, over the last five years we've had low inflation, not high inflation. And the difference is that what the Fed is doing in responding by buying the bonds and expanding their balance sheet is they're providing more short-term, safe liquid assets in the system. That's what people want.
When there's a very strong demand for those, if the Fed didn't respond, we would get severe deflation, like [the ongoing deflation in] Japan and like what we had in the 1930s in the U.S. Those people wanted short-term, safe liquid assets. There wasn't any place to go, and so they weren't spending. They were hoarding things, and prices then fell.
And by the Fed responding like this, we've avoided the deflation. And hopefully, what they will be able to do is, as confidence is restored, people are willing to invest and spend in other areas, take more risks, that they will be able to pull back in a way that will prevent inflation from coming. I think there is a very strong commitment by the FOMC to do that. And if you look at both market-based measures of inflation expectations, as well as survey-based measures, they seem to be pretty successful. If you look even five or 10 years out, inflation expectations are pretty well-contained.
Johnson: And I think it's really held things back, too. You can't easily get a loan for a mortgage. The FICO score on an approved mortgage today is not much different than it was in 2009, and it's about 50 points higher than it was at the beginning of the recession. So we've really tightened down on credit. So, they're putting the punch bowl out there, but they're putting a ring around it and not letting anybody get to the punch bowl so to speak.
And businesses, we've talked about very low revenue growth. We've talked about that they've had low labor costs and cut costs, but they haven't got much revenue growth because of the poor growth in incomes. And so, that's created a problem where they don't need working capital loans as much as they used to. They don't need these giant expansion loans to put in new plants. There has also been less demand for all that money that's sitting out there.
And certainly, the Congressional Budget Office output gap shows we still, four or five years into this recovery, have this big gap between what the economy could produce and what we're actually producing. Until that gets closer, it's doubtful other than maybe a little commodity-based inflation, which we may see in the next six months, inflation should be under good control.
Stipp: Heidi, I want to talk about the intersection between the Fed and the stock market. I think there are a couple of angles here. One reader was asking about the low-interest-rate policy and how that's affected the stock market.
The first thing is I think people feel as if the Fed's activities have really bolstered the stock market and a lot of the growth that we've seen is just underpinned by this artificial involvement of the Fed in the economy. And when the Fed starts to remove that we'll see a big collapse in the stock market because the fundamentals aren't there.
But then I also think people are worried about interest rates going up overall and what that means for the different parts of their portfolios. How does the Fed factor into your market outlook, in your market recommendations, from BlackRock's point of view?
Richardson: There are a couple of questions in there. I'll address the interest-rate scenario first. I think when we take a look at what we're seeing with the Fed and raising interest rates, if we look at the 10-year Treasury, by way of example, and Randy made a great point talking about just the talk of tapering last year. The 10-year yield was at 1.86%; it went up and closed the year at 3.03%. We're back down to about 2.75% today because people didn't understand what tapering was.
What is tapering? They think it's tightening, right? So, we spent so much time last year, just talking to our clients, helping them understand that we're still adding money to the system. We're still doing quantitative easing. We're just doing less of it. And if we're doing less of it, it's because the economy is showing signs of improvement. It's a good thing, that we don't need the stimulus.
And so, I think we spent a lot of time just trying to help them understand what is tapering, tapering will eventually stop. The Fed will pause and then somewhere down the line will raise interest rates. So that's on the federal-funds rate, that's on the short end of the curve, what the Fed can control in terms of raising interest rates. So we don't think that's going to happen until sometime into 2015 that the Fed is actually going to raise interest rates, and that's a forward guidance that they've been giving us.
So, the bad news is for all the people dialed in today, the money that they're making in their banks isn't going to much more in their savings accounts. With that you're almost forced to go elsewhere and take on additional risk to try to get it. That has helped drive some of the returns that we've seen in the equity markets. We saw what happened when we talked about tapering and pulling up the easy money, and easy monetary policy and the implications on emerging markets.
And so there was a dry-up there because people were just afraid that now they are just not going to have this easy money and the liquidity is going to dry up. And we saw the volatility in the emerging markets. I think most of that is close to being done, if not pretty darn close to coming to some sort of bottom in the emerging-markets equities in particular.
In the U.S. marketplace, though, when we looked at that volatility with the 10-year, once we rip the Band-Aid off and we started quantitative easing, and we went from $85 million of bond purchases to $75 million to $65 million and now $55 million in terms of repurchasing of mortgage-backeds and Treasuries, we've seen, since the end of the year, the 10-year trade in the sort of 2.70%-2.80% yield range. There's not a lot of volatility because the tapering is now priced into it.
I think if we look at the advance of the 10-year between now and say the end of the year or 12 months out. The end of the year, [there could be a] 50-basis-point change in the 10-year yield, and 12 months out, [there will be] maybe a 75-basis-point change. So, we're looking at a 10-year coming in at 3.25%-3.50% over the next sort of say nine to 12 months in the marketplace, nothing that's going to be too disruptive to what we're seeing in the housing market recovery and those types of things.
If we look at what's happened, yes, it's helped to propel some of the equity markets because you're forced to essentially look to other places for returns. If you're getting zero interest rate in your bank, [in order to get yield] you're stepping up into some of the equitylike fixed-income investments. You're buying bank loans. You're buying high yields. You're buying some emerging-markets debt. You're getting dividend-paying stocks. You're buying MLPs. You're buying preferreds. You're buying REITs. You're buying these other income-producing things because you need income for retirement and to survive. So, sure that was there. But if we stop tapering and eventually raise interest rates, I don't see a huge pullback in the U.S. marketplace by any means.
It was interesting when we just talked about inflation and looking at the implications of inflation, it's all about the velocity of money, right? And so, we hadn't seen banks lend, as Bob was mentioning. But in the latest Fed survey, we saw there's actually been a pickup in lending now, and so that translates into inflation down the road over the next two to three years, if we see that continuations of banks actually starting to lend again.
Stipp: We're talking about monetary policy, let's turn a little bit and talk about fiscal policy and what's going on in Washington. Randy, I think you had mentioned earlier that it's been an unnecessary hindrance for us over the last few years. Bob, I know that you've been looking at fiscal policy and the sequester and the effects that it's had on the economy. So, what might we expect from government's fiscal policy and how it might impact the economy going forward? Are we through a lot of the worse of what we had seen?
Johnson: I think we're through the worst of it and [former Fed chair] Ben Bernanke said a couple of times, citing a Congressional Budget Office document that maybe we took a 1% to 1.5% off of the economy because of all of the fiscal things that have happened over the last 12 to 18 months, and that includes the sequester, the increase in the payroll tax, the increase in some of the income taxes, some of the special Affordable Care Act taxes. All kind of came in, in one fell swoop, and those things all held back the growth of the economy, and I don't know that I agree it was a whole 1% to 1.5%, but it certainly held it back.
So, if we're all kind of here, sitting here and talking about 2%, a lot of people are kind of going, "Well we take the 2%, you add 1% back for government, and we're at 3%." I think that's probably a little bit optimistic, but certainly government has been holding back the economy, and I don't think it's going to come back as fast as people think. I think some of the war spending has permanently wound down. I think some of procurement items aren't going to ramp up the way some people think they are.
And then you've got the state and local government, which I don't think will do really well either because so much of their growth was driven by more real estate, more sewage plants, more roads to faraway suburbs, and this time the move seems to be back into the cities, where some of the big developments are coming closer to the inner core again, which doesn't require any more infrastructure.
So, I don't think we're going to see a big spurt in government, but I think it is going to be a less of a drag than last year. I mean it's hard to argue with that. The deficit went from $1.1 trillion to just under $600 billion in one year, that's the biggest fall that that number has ever had.
Stipp: Bob was talking about some of the spending that government decided not to do as part of the fiscal-policy wrangling that they had, but coming up in the future, about 10 or 15 years, there is going to be a lot of spending that the government needs to do on certain social programs, especially, Medicare and health-care programs. So, looking a little bit beyond the savings that they are having right now through some of the cuts, what's the fiscal situation going to look like, Randy, when we get to some of these big programs that are going to cost a lot of money. The government won't have a lot of money to spend on other things.
Kroszner: We still haven't dealt with these issues. So, the long-term is still quite dicey. I really think that it's an unsustainable situation. We have to deal with the longer-term health-care costs. We have to deal with the aging the population that's going to affect that. We have to deal with Social Security, and so we haven't. We've been able to paper with things in the short run so at least we're not sort of on the edge ready to fall off to start have people questioning whether we're going to pay our debt or not. That was sort of a silly exercise that didn't really help to generate a lot of confidence and help us move forward. But we still haven't dealt with these fundamentals.
I very much agree that in the short run we have a much better-looking fiscal situation, and actually a number of states have done quite well, like California has moved from being in a significant deficit to a surplus. Unfortunately Illinois, where I am, we're still in a deficit. It looks like that is going to be there as far as I can see. So, some states have been able to turn around, and I think that's been important. Other states haven't been able to. But we've got these longer-run issues like Illinois with the pension fund issues. We've got the longer-run issues for the federal situation, and we just haven't dealt with those. We've got to deal with those. Otherwise, we're going to be back at this in a few years.
Stipp: And I would like to follow-up because you actually mentioned some of the deficit issues. A reader is asking about the debt levels of the United States government, and will that be a problem for the economy in those future years, when we do have to do more of that spending, especially on some of these social programs?
Kroszner: It certainly gives you less breathing space. Just like if you had come into the financial crisis with very low debt levels, there are lot of good opportunities for taking advantage of things because lot of asset prices were depressed. But if you had very high debt levels, you were very leveraged, you couldn't take advantage of those. And so it's the same thing going forward, when we've got these expenditures that are coming up, it's going to be much more difficult. Those trade-offs are much tougher when you don't have that same kind of breathing space. And unfortunately we don't.
Johnson: And there are other issues with the debt, too, because it's going to go from a relatively small percentage of GDP to a high percentage just as we move back from these record-low interest rates that we've been at to kind of rates that we've been talking about. If they start having to pay 4% or 5% on the 10-year bond, a few years out and we continue to run a deficit, deficit begins to snowball and the interest payments on it likewise. And the increase in the interest rates is almost the bigger problem than the health care in the out years of the program unless we solve some of these problems now.
Stipp: I was worried this was going to happen to us. The time has flown by, and I didn't quite get to all the questions that I wanted to get to on my list. But I do have a bonus question for the three of you. I want to get your take for each of you on what do you think is the biggest point of optimism for the economy right now and what's the biggest worry spot? What's the thing that keeps you up at night about the economy, the biggest unanswered questions? Heidi, let's start with you, most optimistic and most worrisome part of the economy right now?
Richardson: I'd say the most optimistic is probably this energy revolution and becoming much more self-sustained in terms of energy. It has implications on geopolitical risks and relations there, and I think with infrastructure and the jobs, that can be created, we mentioned North Dakota and some of these areas in Texas, as well, I think that that could be a real positive for the U.S. marketplace. In fact we have an overweight position on energy, right now particularly because of some of the infrastructure, as well. But I think that could be just a really big thing for us moving forward over the next three to five years.
In terms of the biggest concern, I'd say wage growth and employment is a big concern in the implication for the consumer. And this income inequality, it's real. If we think about the U.S. stock market, if you had money to invest, it was up 30%. If you owned your home, nationwide, house prices were up 10%. If you didn't have the benefit of having either one of those, you are still flat, right, or less, if wages aren't outpacing inflation. So, I think that issue is something that worries us, and then of course the unknown unknowns, such as if there are some geopolitical tensions and anything that could be potentially attacking on U.S. soil is of course something that's always looming in the background.
Kroszner: On the negative side, I think the point that we were talking about, about the long-term fiscal situation in the U.S., we're just not facing these issues. We have to face these issues, and they are going to continue to be a drag on us because we have to deal with that, and that will continue to have uncertainty for both for individual consumers as well as for corporations because they won't know what the structure and level of taxes are going to look like to deal with this. And so I think that's an uncertainty that really needs to be dealt with.
On the positive side, I agree, the energy piece is something that's very good for the U.S., and I think that's one piece of it. In the short run I think the strength of the corporate balance sheets is something that is very important. We've seen some improvement in household balance sheets. There is still lot more way to go, but corporate balance sheets are in a very good position, and so, if we can turn the corner, deal with some of these uncertainty issues, and we've mentioned a lot of them, and get both corporations and individuals to be more optimistic, we'll see more people come into the labor market. We will see more production, we will see more wage growth, and we can come back. But we've got these clouds that are out there. The crystal ball is cloudy.
Stipp: Yeah. Corporations have gotten lean and mean, and they've gotten a lot of cash, so it's a matter of being able to try to deploy some of that out.
Kroszner: Right, they can do it fairly quickly, but they need to have the reason to do it. When you have these clouds of fiscal and other uncertainties out there, they are unlikely to move ahead with lightning speed.
Johnson: Yeah, I think this will continue to be a slow, but longer recovery. What we lack in robustness in this recovery, we may get back in longevity. And I think the housing market is going to be the key driver of that. Housing still remains about 3% of GDP right now. That number got as high as 7%, and the average is right around 5%. Housing has got a lot of runway room yet in front of it, but we may have some short-term issues, but I think housing is going to be a key driver. And I think the key to that market is going to be looser lending standards, just as Randy says. So, I think that's potentially the biggest positive.
And I'll take a positive and turn it into the negative. I think where one shale train accident here in Chicago that kills thousands of people that upsets the whole oil shale revolution here in the United States. We're about the only country that's really letting this go in such a robust manner. Even countries like Poland are saying, "You know what, maybe we need to be a little careful about this shale thing." And maybe it's a leakage from out of one of these shale things, or maybe it's a train crash. I hope that we don't get one of the situations; I really do. But really, that's one of the things that keeps me up awake at night. I mean if that accident in Canada had happened with that multi-car train with that explosive fuel in a Chicago rail yard, it would have been a whole different situation.
Stipp: I could sit here and talk to you guys all day. This has been a great conversation. Thanks so much for joining me and for your insights. Heidi Richardson, Randy Kroszner, and Bob Johnson, it was great to speak with you today and to get all of your input on the economy.
Richardson: Thanks Jason.
Johnson: Thank you.