2012 U.S. forecast: Opportunity for growth in still troubled economy

The U.S. economic recovery is anemic. Unemployment is high, and housing is depressed. Gyrations in the stock market leave investors dizzy. But in these difficult times there is cause for optimism, from the standpoint of both individual investors and the U.S. economy as a whole, according to two experts featured at the 48th Annual Economic Forecast Luncheon, co-sponsored by the Department of Economics at the W. P. Carey School of Business and JPMorgan Chase & Co. today.

The U.S. economic recovery is anemic. Unemployment is high, and housing is depressed. Gyrations in the stock market leave investors dizzy.

But in these difficult times there is cause for optimism, from the standpoint of both individual investors and the U.S. economy as a whole, according to two experts featured at the 48th Annual Economic Forecast Luncheon, co-sponsored by the Department of Economics at the W. P. Carey School of Business and JPMorgan Chase & Co. on Dec. 7.

"If we can return to the principles of economic freedom upon which the country was founded, we can get the economy moving again, which will raise revenue to provide the things we in this country are used to having," says John B. Taylor, a senior fellow in economics at Stanford's Hoover Institution and a former undersecretary of the treasury and former member of the President's Council of Economic advisers.

Anthony Chan, chief economist for private wealth management at JPMorgan Chase, asserts that while uncertainty has been a hallmark of the stock market in recent years, significant opportunities await investors today.

"While volatility is not viewed positively by investors or policymakers, across many periods of increased volatility, stocks have often still managed to generate positive returns," Chan says.

The Economic Forecast Luncheon, held annually in December, is the largest and most trusted economic forecasting event in the Phoenix metro area. The luncheon drew more than a thousand people to the Phoenix Convention Center.

Professor Taylor, who served in the administrations of Presidents George H. W. Bush and George W. Bush, presented his views about the principles that underpin the U.S. economy and why adherence to these principles is a key to economic growth.

Chan, a former economist at the Federal Reserve Bank of New York, outlined the major shifts that have occurred in the financial sector in recent years, and he identified areas poised for growth in 2012.

Economic freedom in a predictable framework

According to Taylor, the economic history of the last half century can be understood by examining how closely policymakers have adhered to what he calls "First Principles," the title of his forthcoming book. See John B. Taylor's slides

"At its most basic level, economic freedom means that families, individuals, and entrepreneurs are free to decide what to produce, what to consume, what to buy and sell, and how to help others," Taylor says.

These principles, which were established when the United States was founded, are meant to exist within a predictable policy framework based on rule of law, market-based incentives, and a limited role for government, according to Taylor.

When policy has strayed from these principles, the U.S. economy has suffered, according to Taylor. He cites the 1960s and 1970s, when the federal government boosted spending and intervened in the private sector, culminating in Richard Nixon's wage and price freeze of 1971. During this time, the Federal Reserve initiated a series of changes in monetary policy that brought pronounced swings in interest rates.

The results of these policies were "frequent recessions, high unemployment, high inflation, and low growth," Taylor says.

From the Great Moderation to financial crisis

Starting in the early 1980s and continuing into the early 2000s, the government became less interventionist, and the country prospered, according to Taylor. He says that during this period, known as the Great Moderation, the federal government applied market-based principles to Social Security, education, and health care, while the Federal Reserve focused on price stability and holding inflation in check.

"Economic expansions were longer and stronger, while recessions were shorter and shallower than they had been in the previous two decades," Taylor says. "It was a more stable and sustained growth period than ever before in American history."

This era of limited government began to shift in the late 1990s when the federal government intervened in the housing market, Taylor points out. Then, in 2003 the Federal Reserve moved aggressively to force interest rates down. "Of course, interventionism reached a new peak with the massive government bailouts of 2008 and 2009," he says.

Since the financial crisis, the United States has "doubled down" on government involvement in the economy, according to Taylor. The stimulus bill, the Fed's super loose monetary policy, health care reform, and the Dodd-Frank financial reforms all are part of this new interventionist approach.

Taylor says that the "swing back toward interventionism in recent years did not result in the intended improvement but rather an epidemic of unintended consequences—a financial crisis and a recession much deeper than any of the Great Moderation."

Prescriptions for growth

To get the economy growing again, Taylor proposes a series of policy changes, all based on a renewal of the principles of economic freedom.

On the budget, Taylor advocates gradually lowering government spending from its current level of 24 percent of Gross Domestic Product to 19.5 percent, where it stood in 2007.

"It's not draconian," he says. "It's a sensible position for government to take going forward, and it avoids the need to increase taxes."

Taylor favors a monetary policy that focuses on price stability, and he wants more accountability for the Fed. "I would require the Fed to report its strategy of monetary policy to the Congress. The Fed could still choose its policies, but if it wanted to change them, it would have to say why."

Taylor also would like to see the Dodd-Frank financial reform law rolled back, and he proposes that any new federal regulations be prohibited unless they are first subjected to a cost-benefit analysis.

"The too-big-to-fail problem could be resolved by reforming the bankruptcy code so that you reduce the discretion of the government and allow a rules-based policy to operate," Taylor says.

On entitlements, Taylor has a simple solution: keep them at the same level where they are now.

"The proposal is to keep them from growing and to do it in a way that improves people’s lives by allowing the market rather than price controls to allocate the resources," he says.

For investors, opportunity amid uncertainty

Although the economic environment remains volatile, stocks look to be a good investment, according to Chan, who appears monthly on CNBC and is a member of the Reuters, Bloomberg, and Dow Jones weekly economic indicator panels. "Even if we go into a recession, stocks are still attractive, and if we muddle through and don't go into a recession, they are even more attractive," he says. Read Anthony Chan's article

Chan has studied shifts in stock prices over the past three decades, which included several periods of extreme volatility. Annual returns were positive in 24 of 31 years, he notes. "Although volatility is very unpleasant, the record shows that stocks can go up even during periods of elevated volatility."

Chan sees risks and opportunities in other investment areas and holds strong views on U.S. Treasuries, high yield bonds, municipal bonds, and emerging market debt.

"When comparing current yields in U.S. Treasury markets to their historical yields, one has to conclude that the current low yields are emitting signs of bubble-like behavior," Chan says.

The Fed's Quantitative Easing and other monetary interventions have driven 10-year Treasury yields to historic lows, according to Chan. He says that this trend cannot last over the life of the long-term securities.

Fast growth ahead—when the uncertainty lifts

Chan sees opportunities in high-yield bonds, which are speculative bonds that carry a higher rate of default. The gap between returns on these bonds and default rates has widened considerably in the past year. "If no U.S. recession occurs, the wide spread between returns and default rates in this high yield corporate bond space is likely to remain favorable and continue to offer an attractive rate of return," he says.

Chan also sees municipal bonds as an attractive alternative to U.S. Treasuries, offering higher returns without significantly higher risks. And sovereign debt in emerging markets also has become more attractive as an investment, as less developed countries grow stronger, according to Chan.

The uncertainty that pervades the economy continues hold a great deal of sway over U.S. corporations, Chan believes. Companies are hoarding cash and curbing dividend payouts.

"A reduction of uncertainty and an increase in business sentiment would unleash 'animal spirits' and lead to faster employment growth and faster economic growth," Chan says. "The problem is that achieving this state of nirvana will not be easy."

Bottom line:

• Although the U.S. economy remains deeply troubled, opportunities for economic growth do exist, and investors can profit in this environment, according to two experts featured at the annual Economic Forecast Luncheon, co-sponsored by the W. P. Carey School of Business and JPMorgan Chase.
• The United States was founded on principles of economic freedom, predictable policies, and limited government, according to Professor John Taylor of Stanford University. When policymakers follow those principles, the country prospers, but when leaders stray from the principles, the economy suffers, Taylor maintains.
• Since the financial crisis and bailouts of 2008 and 2009, Washington has "doubled down" on government intervention in the economy, according to Taylor. Stimulus spending, new regulations, and aggressive Fed monetary actions have brought little benefit to the overall economy, Taylor argues.
• The path to prosperity lies in reduced government spending, a moratorium on new regulations, a cap on entitlements, and a monetary policy that focuses on price stability, according to Taylor.
• Despite the widespread uncertainty surrounding the U.S. economy, there are still attractive opportunities for investors, according to Anthony Chan, chief economist for private wealth management at JPMorgan Chase.
• Municipal bonds, high yield corporate bonds, and emerging market debt are several areas where investors can expect to find opportunities, Chan believes.