Financial Outlook for 2012

Associate Professor of Finance, Kelley School of Business, Indiana University Bloomington

Professor of Finance, Kelley School of Business, Indiana University Bloomington

Since last summer, the financial markets have been on a European roller coaster ride. We could call it the “Beast” but at least we know that ride ends safely. This ride depends on whether the Europeans can figure out how to keep funding the debt of nations that have promised more than they can afford. When the situation looks as if it will be resolved, the markets climb higher. When the agreements collapse, the markets plunge with frightening speed.

Sooner or later, the situation will stabilize and then fundamentals like earnings, leverage and risk will return to the market. At that point we can get off the ride. When we exit, we expect that the financial markets and the U.S. economy will move closer together with the markets showing positive but below average growth.

In the 12 months ending November 2011, the S&P 500 rose about 3 percent. While the return was positive, it was dramatically lower than for the same period last year. The markets peaked in April, but the drumbeat from Europe and the tepid performance of the U.S. economy has erased most of those gains. Short-term interest rates have remained close to zero throughout 2011, and the long-term bond rates are very close to historical lows. As expected, the Federal Open Market Committee (FOMC) decided to continue with the current program of asset sales and purchases (“Operation Twist”). This strategy is designed to lower long-term rates and promote investments in housing and business equipment. The FOMC reiterated its expectation that current economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”1

Economic Fundamentals

Stock prices are a very good indicator of future economic activity: investors buy stocks anticipating the real economy will pick up in the near future. There are many positive reasons to believe this story now:

However, there are negative issues that could make the market recovery short-lived:

Forecast

Looking forward to 2012, the positives outweigh the negatives for the economy. We expect the recovery to continue, albeit at a rate much slower than a typical recovery with GDP growth in the 1 to 3 percent range and inflation in the 2 to 4 percent range. The pace of the recovery, however, will not improve until consumers have increased their savings and repaired their balance sheets. This process will extend beyond the end of 2012.

In this environment, we project the return to equities to be positive, but below the long-run average return of 9 percent. With Treasury bonds already at extremely low yields, there is little potential for gains with these investments. In addition, we think there are material long-term inflation risks which could make long-term bonds unattractive. In contrast, the low Treasury rates make mortgage rates extremely attractive, with 30-year fixed rates at 3.875 percent and 15-year fixed rates at 3.25 percent. Homeowners who are paying 5 percent or more on their mortgage and expect to stay in their home for several years would likely benefit from refinancing their mortgage.

Summary

The U.S. economy appears to be heading to smoother waters but unemployment remains a stubborn reminder of the recession. Partisan politics may continue to disrupt economic relationships. The adjustment process to full recovery and full employment, however, will likely take at least two years. Until a complete recovery is in sight, we expect market returns to be positive, but below their long-run average.