Hunter Brackett, CFA
Senior Manager | CAPTRUST Consulting Research Group
In recent years, financial publications ran ominous headlines such as “The Worst Economic Recovery in History,” and “U.S. Hit by Weakest Postwar Rebound.” While the headlines may appear sensationalist at first glance, the current U.S. recovery is, in fact, significantly weaker than prior ones. According to the Congressional Budget Office (CBO), since 2009, U.S. economic growth is less than half of the rate exhibited, on average, during other recoveries in the post-World War II era.1 As shown in Figure One, the current recovery is now in its fourth year since 2009, but U.S. Gross Domestic Product (GDP) growth is still below its long-term average. Likewise, the unemployment rate remains well above the Federal Reserve’s 6.5% target, although recent signs of improvement are encouraging.
As illustrated in Figure Two, the CBO reports that U.S. GDP has been below its potential level (the CBO’s estimate of the maximum sustainable level of economic output) since 2008, and the gap is expected to persist until 2017. If this phenomenon occurs, it would mark roughly a decade of U.S. output operating below its potential level. The late economist Victor Zarnowitz, a leading scholar on business cycles, described the historical pattern in which deep recessions are usually followed by sharp recoveries. The current recovery has not followed this precedent due to both long-term demographic trends and cyclical factors.
A number of trends unrelated to the financial crisis could provide a headwind for long-term economic growth in the U.S. In particular, the U.S. working age population (typically ages 20 to 65) growth rate is declining as baby boomers retire, and cyclical factors related to the financial and housing crisis will likely dissipate as the recovery progresses. Deleveraging is a drag on economic growth, but the household and financial sectors made considerable strides in reducing their debt-to-GDP ratios in recent years. In contrast, the government debt-to-GDP ratio continues to increase at a rapid pace and is currently at historic highs. The fiscal tightening that is necessary to address this issue, likely tax increases and spending cuts, could be a drag on U.S. economic growth. Meanwhile, the housing market normally plays an important role in economic recoveries by increasing consumer spending and net worth. Given the severe housing market decline, consumer net worth fell sharply and grew unusually slowly in recent years. In addition, the economy has been less responsive to historically low interest rates due to the deleveraging process and tighter bank lending standards.
Despite the sluggish recovery, we see encouraging signs in coming years. Referring back to Figure One, the CBO forecasts U.S. GDP growth to remain subdued in 2013 as the economy adjusts to fiscal tightening, but expects improvement in 2014 and beyond thanks to dissipating effects from the housing and financial crises. Market observers expect housing to be a tailwind for the U.S. economy this year as housing starts and sales activity increase. Recent equity market gains provide another boost to consumer net worth, although this impact is more pronounced in higher-income households.
Despite the subdued economic recovery, we remain constructive on the capital market opportunity set and believe traditionally riskier assets such as equities can still provide reasonable returns. Conventional wisdom states that stronger economic growth should lead to higher corporate profits and, therefore, better equity returns. However, this relationship does not always hold true. Although U.S. GDP growth remains below its long-term trend, equities posted solid returns in recent years, including a 16% total return for the S&P 500 in 2012 and a strong start to 2013.
In our view, the combination of modest growth, contained inflation, and accommodative monetary policy provides a favorable environment for riskier asset classes. Some observers consider the current environment to be near the “sweet spot” for equity returns; the economy is growing fast enough to avoid another recession but not strong enough to spark inflation concerns and tighter monetary policy. If U.S. GDP growth follows the CBO’s projected path as in Figure One and the unemployment rate continues to improve, the Fed could begin to withdraw its accommodative monetary policy in the coming years. In that scenario, investors will have to weigh a more favorable economic outlook against tighter monetary policy, with an uncertain impact on equity returns.
Equity returns are comprised of three building blocks:
(1) expected earnings growth, (2) dividend yield, and (3) the impact from valuation changes. Many investors tend to focus on the first factor, but we believe that all three play an important role. While a sluggish recovery hampers revenue growth, earnings have proven resilient as companies reduced their cost structures during the recession. We expect earnings growth to gradually accelerate over the next few years, in line with our expectation for the trend in GDP growth. Dividend yield is an increasingly important component of equity total returns. In a slower-growth environment, companies tend to be more focused on returning capital to shareholders by way of dividend increases and share buybacks supported by a high level of cash on corporate balance sheets. Finally, equities benefit from a positive valuation impact primarily due to monetary policy and investors’ increased appetite for traditionally riskier asset classes. The Fed’s accommodative monetary policy provides investors an incentive to move away from lower-yielding asset classes. This incentive provides a further tailwind for equity returns, although we caution that it may not be sustainable over the longer term.
Our capital market assumptions, which are based on a period of five to seven years, utilize the three building blocks to forecast equity market returns. We forecast a 7% return for U.S. large-cap equity and modestly higher returns for U.S. mid-, small-cap, and international equity. These return forecasts are mainly driven by earnings growth and dividend yields; we do not assume much benefit from valuation1 changes. Our 7% return assumption for U.S. large-cap equity, while reasonable relative to historical returns, is less than half of the 16% return posted last year. This further underscores the favorable backdrop that we are currently experiencing. For more detail on our capital market assumptions, we invite you to read our newly published position paper, Capital Market Assumptions — Opportunities in a More Challenging Environment.
Although we believe equities can continue to provide reasonable returns, we stress the importance of diversification, both within and among asset classes. Over the five- to seven-year period of our capital market assumptions, we expect equities to generate higher returns than other asset classes such as fixed income, but also exhibit higher volatility. Within equities, we see the strongest returns in U.S. mid- and small-caps as well as international equities, but with the trade-off of higher volatility relative to U.S. large-caps. Investors should consider their return objectives and risk tolerance when determining the amount and composition of equity exposure in their portfolios. While the current environment is quite favorable for equities, we remain mindful of global macroeconomic risks that could reemerge such as the European sovereign debt crisis or an unexpected shift in U.S. monetary policy.
1 Congressional Budget Office. What Accounts for the Slow Growth of the Economy after the Recession? November 2012, pp. 1-4