Economic Commentary -- January 2012

By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company

Wave After Wave?
“A night on the sea in an open boat is a long night. As darkness settled finally, the shine of the light, lifting from the sea in the south, changed to full gold. On the northern horizon a new light appeared, a small bluish gleam on the edge of the waters. These two lights were the furniture of the world. Otherwise there was nothing but waves.” – Stephen Crane

The current investment landscape feels a little like a boat at sea – not just any boat, but “The Open Boat” from Stephen Crane’s novel by that very title. “A singular disadvantage of the sea lies in the fact that after successfully surmounting one wave you discover that there is another behind it just as important and just as nervously anxious to do something effective in the way of swamping boats,” writes Crane in what many literary experts consider to be his best work on literary naturalism, the conflict between man and nature and just plain feeling despondent.

Ever since the Great Recession officially ended in June 2009, economies in the U.S., Europe and most of the rest of the developed world have struggled to gain traction (fig. 1). 2011 was the story of the recovery that wasn’t. While the economy looked at the beginning of the year like it was going to break out on the upside, a number of factors conspired to spoil that budding recovery: incipient inflation, a devastating tsunami in Japan, overleveraged consumers, a dreadful housing market and an ongoing crisis in Europe, to name a few.

Is the fate of the markets beholden to an overwhelming natural force over which we exert no control? Are we doomed to paddle the literary dingy wave-after-wave just to keep from overturning while making no measurable progress?

Many of the economic issues that weren’t resolved last year could continue to overshadow the economy this year. Chief among those issues is Europe. Despite numerous summits and bailouts (the cook, for the literary astute among you), serious questions remain about the financial viability of Italy and the other countries on the periphery – Ireland, Portugal and Spain. It’s become widely accepted that Greece will eventually bail overboard and drown in the waves – or default on its debt.

Meanwhile, the good news is that inflation didn’t take off. But overleveraged consumers, cautious business owners and a lagging housing market are issues that are still on the table this year. The 2012 elections also adds uncertainty to this year’s economic climate. As politicians jockey for position, it’s unlikely that a gridlocked Congress and presidency can get much done to help the economy either way before the November elections.

In this month’s commentary, we review 2011 and consider the factors that are likely to influence the course of the economy and the markets in 2012.

Rough waters ahead? Probably. Should we feel despondent? We think not. Even Crane, in his book, shows some glimmer of hope among the four characters in the boat: “To express any particular optimism at this time they felt to be childish and stupid, but they all doubtless possessed this sense of the situation in their mind. A young man thinks doggedly at such times,” he writes.

Europe
As events continue to unfold in Europe, one aspect of the crisis seems clear: European leaders are unable – or unwilling – to take the concrete steps necessary to resolve the crisis once and for all. For the first time, official European documents have referenced what was previously an unmentionable possibility: the potential for a breakup of the eurozone. Will it happen? Odds are still against it. But the continuation of this perpetual crisis doesn’t bode well.

Crane writes, “A seat in this boat was not unlike a seat upon a bucking bronco, and by the same token, a bronco is not much smaller. The craft pranced and reared, and plunged like an animal. As each wave came, and she rose for it, she seemed like a horse making at a fence outrageously high.” Just like Crane’s boaters, investors continue to get their hopes up for every European summit, only to have them dashed again when the solution put forth doesn’t hold water.

Simply put, European leaders face an intractable dilemma: the people of Europe aren’t disposed toward a political union, but without a political union any steps toward further economic union won’t work in the long term. So they are left putting Band-Aid after Band-Aid on the problem, throwing money at one sovereign debt problem after another. So far, Greece, Portugal and Ireland have needed explicit bailouts, while Italy has required an implicit bailout in the form of support from the European Central Bank. The ECB has been purchasing Italian sovereign debt to keep the yield below 7%.

Europe doesn’t have unlimited funds, and the International Monetary Fund’s support, so far, has been fairly minimal. To expand that support, Europe needs votes from the United States and many other developed and developing nations, most of which either have economic problems of their own or aren’t willing to spend money to support the euro.

If Europe can continue its half-hearted plan to rescue the euro until the global economy recovers in earnest, there’s a good chance that the zone can weather this crisis. It doesn’t look like Europe will recover economically this year; a recession in and of itself might be enough to tip the balance and force the exit of one or more countries from the euro, causing an economic crisis. Or it might not. The Eurozone Purchasing Managers Index (PMI), a leading indicator of eurozone GDP, is already signaling that the eurozone is heading toward recession (fig. 2). A PMI reading of less than 50 signals an upcoming economic contraction and it currently reads 46.4.

Overall, Europe poses as a large headwind to the economic recovery in the U.S. and worldwide. Why? Europe remains one of the largest export markets for U.S. goods and services, so a crisis surrounding the euro is bound to affect the U.S. economy and could be enough to tip it into a recession in 2012. And despite the Federal Reserve and U.S. government’s efforts, the banking system isn’t fully recovered from the Great Recession. In addition, global banks – especially those in the developed world – remain dangerously interconnected. A euro crisis could freeze up the banking system, much like what happened during the Lehman Brothers crisis in 2008, necessitating another large bailout of systemically important and “too big to fail” U.S. and global banks.

Overall Economic Growth
Overall economic growth has been uneven this year, and forecasts for next year vary. The Organization for Economic Cooperation and Development, a Paris-based think tank, cut its forecast for U.S. GDP growth in 2012 from 3.1% to 2%, citing sluggish growth in the U.S. and threats from the eurozone crisis. Growth forecasts for the 34 member countries were cut from 1.9% to 1.6%.

In Bloomberg’s survey of its contributors, real GDP was forecast at 2.1% for 2012. The Federal Reserve Board is predicting 2.7% GDP growth for this year. The Conference Board, a business membership and research association, forecasts a 2.1% GDP growth rate for this year.

These projected GDP growth rates aren’t sufficient for the U.S. economy and developed economies to grow their way out of the current sluggish economic conditions that are producing high unemployment. Economies need to grow at a rate of at least 3% to place a significant dent in unemployment and encourage businesses and consumers to spend more robustly.

U.S. Economy: Housing
Outside of Europe, housing is a major area of uncertainty for the U.S. economy. Deleveraging consumers, still weighed down by debt – much of it housing debt in the form of underwater mortgages – are not inclined to spend. Banks worked through some of the issues surrounding flawed foreclosure proceedings in 2011. Although foreclosure filings are still somewhat depressed by these issues, they are expected to climb next year, increasing the inventory of unsold homes, which could negatively impact home prices (fig. 3).

Foreshadowing this potential burst of activity, foreclosure data tracking firm RealtyTrac reported an increase in scheduled foreclosure action sales, which rose 13% from October 2011 to November 2011 – the most recent data available – reflecting a nine-month high of 96,540 properties. In addition, seriously delinquent mortgages – those that are 90 days or more past due or already in the foreclosure process – rose to 7.89% of all mortgages, according to the Federal Reserve Bank of Cleveland.

In another blow to perceptions that the housing market might actually be recovering, the National Association of Realtors reported that it was broadly revising its data on existing homes from 2007 through October 2011 due to errors in the way it counted home sales. Although the revision wasn’t yet complete as of mid-December, the new figures are likely to indicate a much weaker housing market than was previously predicted. This is because the association erroneously counted some listed properties and sold homes twice.

Programs designed by the Federal government to help homeowners in foreclosure and help those who are underwater avoid foreclosure haven’t exactly been a smashing success. In fact, through 2013, they are projected to help only a fraction of those who were initially targeted. Even a revamped Home Affordable Refinance Program (HARP), designed to help deeply underwater homeowners refinance to lower rates, is expected to help fewer than half of those it targeted. And in reality, it’s likely to help even fewer due to bottlenecks at the banks administrating the modifications and government regulations.

U.S. Economy: Jobs
Although the overall employment picture for 2012 isn’t bright (most economists and analysts expect unemployment to remain high for the year), there are some reasons to be optimistic that the unemployment rate will continue to decline, albeit slowly. A late December Manpower survey of 14,000 U.S.-based employers revealed that 14% plan to add employees in the first quarter of 2012, while only 5% plan to cut employees, a net potential increase of 9%. That represents the most positive outcome to this survey in the past year.

In addition, jobless claims for unemployment insurance, reported by the government in mid-December, fell to their lowest level since mid-2008 (fig. 4). The moving average of jobless claims, a measure that smoothes out the volatility of week-to-week numbers, fell by 6,500 claims to 387,750. That’s below the key threshold of 400,000, which signals an improving employment market.

Still, no one is predicting a strong rebound in employment anytime soon. Consumer and business demand is still anemic, and that needs to pick up before employers will start hiring. And many of the available jobs are not a match for available workers. That’s because many of the unemployed lack the skill sets needed by employers who offer more technologically oriented jobs. And many workers with the necessary skills can’t move to locations where they could get jobs because their homes are underwater, financially speaking.

In The Open Boat, Crane writes, “None of them knew the color of the sky. Their eyes glanced level, and were fastened upon the waves that swept toward them. These waves were of the hue of slate, save for the tops, which were of foaming white, and all of the men knew the colors of the sea. The horizon narrowed and widened, and dipped and rose, and at all times its edge was jagged with waves that seemed thrust up in points like rocks.” Much like those waves, the state of employment in the U.S. seems to jostle both its citizens and its investors, as encouraging and discouraging reports seem to occur without much indication. While it’s difficult to see how high (or low) the next wave of employment data will be, right now it looks as if some of the seasickness is beginning to subside.

U.S. Economy: Inflation and Interest Rates
The inflationary pressures that were building in the U.S. economy and overseas during 2011, led by higher commodity prices, seem to be lessening (fig. 5). The read on inflation last year was less clear, as prices rose fairly steadily throughout the spring and summer only to start falling again in the fall. For example, crude oil prices peaked at the end of April at $113.37 per barrel, but by early October, the price of a barrel of oil had fallen more than $35 to $77.34. Prices did bounce back toward the end of the year, trading between $95 and $105 a barrel in November and December. At the pump, where prices tend to lag behind crude oil prices, consumers paid an average of $3.91 per gallon in June; that average fell to $3.38 a gallon in November, according to the U.S. Department of Energy’s national average survey.

While Europe continues to be plagued by high sovereign debt interest rates, the U.S. has not suffered a similar fate. In fact, the spread between the two regions is extremely high, as interest rates on U.S. government debt are at all time lows. In truth, the outlook for U.S. economic growth and the prospects for the U.S. government to meaningfully address the deficit aren’t much better than they are in Europe, so neither of those two factors explains the difference. The fact that the U.S. isn’t as deeply connected to its banks as European governments are and that the U.S. bond market is so large means U.S. government assets are viewed as a safe harbor by investors. This does, at least in part, account for the spread. With the Federal Reserve committed to low rates for at least the next year and a half and with the ongoing turmoil in Europe, it’s likely that sovereign debt interest rates in the U.S. will remain at or near all-time lows.

Lower inflation in 2012 would be a positive indicator for economic growth and the equity and bond markets. As government bond rates aren’t likely to rise anytime soon, investors continue to be encouraged by the Fed to hold risk assets such as equities, another positive for the stock market.

What to Watch For
Watch Europe and China for progress, or lack thereof, on the global macro front. The ideal solution would be for European leaders to come up with a long-term fix to allow the peripheral countries to grow their economies without being crushed by debt that doesn’t cause too much damage to European banks, other members of the eurozone and sovereign debt holders.

As far as Europe goes, bond yields for Italy and Spain need to stay at reasonable levels so they can borrow through the markets and not be forced to receive massive bailouts from other European Union members, the International Monetary Fund or the Group of 20 nations. Italy is particularly critical because the Italian bond market is the third largest in the world and the Italian economy is the 11th largest economy in the world by gross domestic product, according to the U.S. Central Intelligence Agency’s 2011 Fact Book. Italy’s10-year bonds need to stay below 7% in order for Italy to be able to fund government operations via international bond markets. If yields exceed that level for a sustained period of time, Italy may need a bailout, which would be a bad sign for Europe and the U.S. economy (fig. 6).

Here in the U.S., housing, unemployment and retail sales numbers are all indicators of where the economy will head in 2012. If unemployment claims stay below 400,000 on an adjusted basis, further recovery in the employment markets could be in the cards. A good holiday shopping season, a critical period for retailers, could signal more of an economic recovery. A number that meets or exceeds the National Retail Federation’s predicted gains of 3.8% would be good news.

Where We Are Headed
In 2012, we expect the mild economic recovery to continue – real GDP should grow between 2.25% and 2.75% with low inflation. Moderate economic growth and low inflation, however, won’t do much for the persistently high unemployment rate, which should remain in the neighborhood of 8% to 9% through this year. Whether the housing market makes a sustained recovery will likely be determined by the unemployment rate. As foreclosure inventory continues to stream into the market, it will be difficult for that key market to gain traction.

While the news isn’t good for the unemployed or those who are trying to sell their homes, the equity market environment looks favorable for U.S. stocks and emerging markets stocks.  With inflation remaining low, continued favorable monetary policy and high corporate profitability, we expect a cyclical bull market within the overall secular bear market in 2012. In addition, as political turmoil continues in Europe and political stalemate rules in the U.S. ahead of the 2012 elections, the dollar is likely to strengthen against the euro and the Japanese yen.

As for bonds, we believe that the bond market will begin to price in higher rates. The Fed has said it will revisit its low interest rate policy in 2013. This year, we believe corporate and high-yield bonds are set to outperform government bonds on a relative basis.

Of course, these predictions are making two rather lofty assumptions: 1) that Europe will get its act together and 2) that the Chinese economy will have a soft landing. If either of the assumptions fails to materialize, equities will suffer and Treasuries will continue to outperform as investors flock to safety.

In The Open Boat, Crane writes, “As each slatey wall of water approached, it shut all else from the view of the men in the boat, and it was not difficult to imagine that this particular wave was the final outburst of the ocean, the last effort of the grim water.” Similarly, each failed European summit or spike in European government rates feels like the walls of water trying to do us in. Like the four men in the boat who succumbed to despondency, consecutive negative market days – or weeks – cause a similar feeling in investors’ financial psyche.

In the end, three of the four men in The Open Boat survived. Those are not great odds when lives are at stake, but they’re not all that bad when allocating to investment policies. Keep rowing.

Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Bond or debt investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. Government debts are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest when held to maturity.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics and news.

The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country.

The European Central Bank (ECB) is the institution of the European Union (EU) which administers the monetary policy of the 17 EU eurozone member states.

The International Monetary Fund (IMF) is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments.

The Organization for Economic Cooperation and Development (OECD) is an international economic organization of 34 countries founded in 1961 to stimulate economic progress and world trade.

Bloomberg L.P. provides financial software tools such as analytics and equity trading platform, data services and news to financial companies and organizations around the world.

The Conference Board is a global, independent business membership and research association working in the public interest.

RealtyTrac, Inc. operates as an online marketplace for foreclosure properties. It provides a database of pre-foreclosure, foreclosure, auction, bank-owned, for-sale-by-owner, resale, MLS and new construction properties.

The National Association of Realtors (NAR) is a real estate trade association involved in all aspects of the residential and commercial real estate industries. NAR also functions as a self-regulatory organization for real estate brokerage.

ManpowerGroup is a workforce solutions and services provider headquartered in Milwaukee, Wis. The company's Employment Outlook Survey offers an extensive labor forecast covering 39 countries.

The European Union (EU) is an economic and political union of 27 member states which are located primarily in Europe.

The Group of Twenty (G-20) Finance Ministers and Central Bank Governors was established in 1999 to bring together systemically important industrialized and developing economies to discuss key issues in the global economy.

The Central Intelligence Agency (CIA) is an independent U.S. government agency responsible for providing national security intelligence to senior U.S. policymakers.

The National Retail Federation's global membership includes retailers of all sizes, formats and channels of distribution as well as chain restaurants and industry partners from the U.S. and more than 45 countries abroad.