Secular Outlook Series

​The future of the U.S. economy may be in the hands of politicians.

In the following interview, portfolio manager Saumil Parikh discusses the long-term outlook for the economy, weighing some positive fundamentals against the need for political solutions to challenges that could derail growth. He also outlines potential risks and strategies for investors.

Q: What is the outlook for the U.S.?
Parikh: The secular outlook for the U.S. is finely balanced. There are very early signs of improvement in the housing market, and although it is a smaller portion of the economy today than before the 2008 crash, housing could still be a substantial tailwind for U.S. economic growth over the next three to five years.

Another plus is the shift in U.S. energy supply from imported oil to domestic oil and natural gas. This trend is somewhat significant over the near term and, we believe, will become much more significant over time as some of the hurdles in capital expenditures, deployment technology and regulation of domestic energy are overcome.

These two factors could boost U.S. economic growth by about half a percentage point a year over the next three to five years compared to the past.

However, the U.S. economy still faces significant headwinds from over-indebtedness, large imbalances, growing inequality and policy incrementalism – and these headwinds could hinder employment growth.

In addition, over the coming super-secular period, the changing demographics in the U.S. will likely affect growth as well. The U.S. labor force has, for all intents and purposes, peaked as a percentage of the population, and, therefore, many unfunded liabilities related to old age and retirement are beginning to crystallize on the private sector’s and the  government’s balance sheets. Over the secular horizon we expect the government deficit to remain large and become more structural in nature, which will potentially become a significant hurdle for future investment, employment and growth if policymakers do not address it in a meaningful way.

Q: Can the U.S. achieve “breakout” growth without further actions from the Federal Reserve, and will the Fed act again (beyond the recent extension of purchasing longer-dated bonds)?
Parikh: Despite legacy issues of debts and deficits, the U.S. economy remains fundamentally one of the most productive, innovative and vibrant. The question is to what extent that vibrancy overcomes hurdles to growth. If the creative elements of U.S. growth can be sustained – and that will heavily depend on policymakers making the right long-term decisions regarding the government’s role in the economy – then the U.S. can potentially achieve breakout growth. However, we do not assign a high probability of that occurring over the next three to five years, even though we believe the U.S. is the best positioned among the developed countries to achieve such growth.

As for the Fed, we see its role in the deleveraging of the economy as lowering the cost of servicing debt to a level that does not crowd out new investment and employment opportunities. From that perspective, monetary policy will remain critical as long as the Fed can achieve negative real rates that ease the deleterious effects of deleveraging.

Q: How do the November elections play into the secular outlook for the U.S.? What about other political and policy considerations?
Parikh: The elections will be critical both for the cyclical and secular outlooks. The worst-case scenario is an even more divisive mix of congressional and presidential leadership, especially if nothing is done this year to address the large fiscal cliff that kicks in on Jan. 1. As a result of the previous deal to raise the federal debt ceiling, a variety of tax increases and spending cuts will begin next year, and we expect they would result in a contraction of about 4% of GDP. Since the U.S. economy is expanding at a rate of about 2%, such a fiscal cliff would mean certain recession in 2013.

Both sides of the aisle have incentives to compromise on avoiding that outcome. In our view, the most likely scenario is that unless there is an unforeseen and incredibly divisive outcome from the elections, policymakers will likely agree in January to reduce the size of the impact of fiscal tightening on the economy to closer to 1% of GDP.

How they achieve such a compromise will have implications for the secular outlook. If they delay long-term structural fiscal adjustments for yet another year and agree to run large deficits in the present, then the secular outlook will remain cloudy and the environment very uncertain for businesses and individuals to take economic risks.

A better scenario for the economy would be if both sides agree to long-term adjustments in spending projections and give investors some level of comfort that there is not going to be runaway deficits or tax burdens.

Q: How do events in Europe factor into the U.S. outlook?
Parikh: The U.S. economy would not be immune from a financial crisis or deep recession in the eurozone. U.S. multinational companies, which have been one of the pillars of U.S. economic growth and productivity over the last few years, derive a significant amount of their revenues from sales in Europe. 

Further, the eurozone is not only the second largest economy in the world, but it also has the largest banking system in the world by a wide margin. To put that in perspective, the U.S. banking system’s assets are roughly equivalent in size to this country's GDP, while the eurozone banking system is about triple that area’s GDP.  Further, European banks lend extensively to borrowers outside of Europe, and it is likely they will withdraw credit from global markets before domestic ones. So if Europe were to have a financial crisis similar in magnitude to what the U.S. experienced in 2008 and 2009, or a deep recession, then we believe the U.S. would not be able to escape a recession as a knock-on effect within our secular horizon.

Q: What is the outlook for the dollar, and how does that change depending on what happens to Europe and the euro?
Parikh: Due to rapid increases in leverage, large deficits and ultra-easy monetary policy, the dollar has been one of the weakest global currencies over the last decade. But now the outlook for the U.S. dollar is relatively better than for several other developed currencies, as relative considerations including valuations begin to matter. The U.S. is running smaller current account deficits, has faster productivity growth, and has the best relative demographics among developed market peers.

For all those reasons, and because the dollar has already weakened substantially relative to such currencies as the euro, yen and pound, we expect the dollar to begin to appreciate over a secular horizon relative to those currencies.

But we still think that emerging market currencies will outperform the dollar and other developed world currencies over the secular horizon. 

Q: What are the investment opportunities and risks based on your U.S. outlook?
Parikh: We believe there is a growing risk that financial repression goes beyond monetary policy to include regulation and taxation that ultimately contributes, even if unintentionally, to transferring savings from creditors to debtors.

In our view, investors need to consider the implications of rising forward tax rates on their investment expectations. We see a high likelihood that the current tax regime in the U.S. becomes more progressive, such that the balance of revenues generated from taxing investment income rises relative to that from wage income and from consumption.

We also think price inflation will play a greater role in generating nominal GDP growth than in the past. Since inflation was brought under control in the mid-1980s, the balance between real (after inflation) and nominal economic growth has favored real. Going forward, because of the high amount of debt, the demographic changes underway, and the political and economic uncertainties, we believe the U.S. economy is unlikely to generate robust real economic growth and will instead resort to generating higher amounts of inflation to maintain critically important nominal growth rates.

Investors should therefore ask whether their investments are deriving value from real economic growth or inflation. For example, they may benefit more from exposure to real estate than to vanilla equities – if they can participate in the real estate market without relying on leverage and by capturing high real yields on a current cash-flow basis. Also, inflation-linked bonds are potentially a high quality form of generating returns based on rising inflation rates and inflation expectations. Equities in general, but small and mid-cap domestic equities in particular, which have benefited from a multi-year leverage and real growth cycle, will likely take a back seat for some time relative to high quality, unlevered, large cap equities,  and nominal bond returns will likely be painfully low for the foreseeable future. Within the nominal bond universe, focus should be continually paid to the concept of "safe spread,”¹ where additional returns can be generated without exposing portfolios to inordinate risks of confiscation via defaults on low quality borrowers or via the inflating away of low yields on "safe" borrowers.

Globally, we see emerging markets as potentially offering much more value from real economic growth. Although they are not immune to a decline in demand from developed nations, we believe their growth rates are likely to continue to outpace the developed world over a secular horizon, and they tend to have less leverage on their public and private balance sheets.