“Americans will always do the right thing, but only after exhausting all other possibilities.” – Winston Churchill
In the lead up to the Presidential elections that took place on Tuesday, November 6, 2012, there were many pundits who vocally expressed opinions that would lead one to believe this was the most important election ever. We would agree that there was a definite choice between the political platforms presented by the respective candidates. With the big fiscal issues that need to be resolved, it is clear that the choices made by voters will have a major impact on the ultimate resolution to the problems we face. Only time will tell if the 2012 election is as pivotal as the elections of 1864, 1896, and 1932.
In the very near future decisions will need to be made on the fiscal cliff, the debt ceiling, and a “Grand Bargain” on Federal Government spending. President Obama will be looking at finding replacements for both Treasury Secretary Geithner and Secretary of State Clinton. Further out, Fed Chairman Ben Bernanke is likely to not seek reappointment and will need to be replaced. Before we get into the ramifications of the election, we need to take a step backward to understand the state of the global economy.
As we have previously discussed, the European economy faces many challenges as they work through their economic crisis. For the past few years this region has been struggling through the economic and political issues surrounding its debt crisis, resulting in economic recession for many countries. The positive news is that over the summer months the European Union began to address their debt issues in a more serious, realistic way. On a more negative note, both Germany and France have recently shown economic weakness.
In China we have started to see a flattening out of economic growth after years of double-digit growth levels to what are still very good growth rates, relative to the rest of the world. Over the last 18 months China’s export sector has been challenged by the aforementioned problems faced by their largest trading partner, Europe, and the effects of a rising inflation rate. Currently, China is focused on political leadership changes.
In the United States, there are a number of economic issues that are of concern. First and foremost, we are engulfed in an economy which has been in muddle along mode for the past three years with 2% GDP growth becoming the norm. Household debt has been declining with current levels approximating what they were in 2006. Job growth has been moderate at best. Banks have been lending more money to both corporations and consumers, but write downs of past bad debts still offset the economic effect of new loans. On the positive side, Corporate America has a lot of cash that should be seen as monies available for future investment.
The Politics of It All
Eighteen months and $3.5 billion later, we have basically the same political players we had before the November 6th election. President Obama will be with us for another four years, the House of Representatives remains in Republican control, and the Senate will be led by the Democrats. The Democrats did pick up a few seats in both chambers, but not enough to make a real difference.
In the immediate future Congress and the President need to address the Fiscal Cliff, address the Debt Ceiling, and come to some longer-term resolution to the Federal Budget (a “Grand Bargain”). In the days after the election all sides have made public statements proclaiming willingness to compromise. They have also stated where they stand on some key issues. Positive? Sure. Convincing? Only time will tell.
There are three ways this can work itself out. In the best case scenario Speaker Boehner and President Obama make an announcement in the coming weeks of an agreement to terms that resolve these problems in a manner that ladders in the deficit reduction over a period of years. In the worse case, we get to January 1, 2013 with no deal; we fall off the “cliff,” and eventually a deal is reached. More likely, there is either a last minute deal after much public bickering, or a short-term resolution in lieu of a “real agreement” to be completed at a later date (we refuse to say “kick the can down the road”).
After years of political grandstanding, the seeds of a true compromise appear to be upon us. In the past month we have seen economic leaders become involved in the process, speaking out through the media while quietly working with Congressional leaders in Washington. The President, while unlikely to cave in on fully extending the Bush Tax Cuts, has been willing to put entitlement reform on the table. Coming off his victory, and with no future elections to deal with, he is in a prime position to influence a deal among Congressional Democrats. For the Republicans, Speaker Boenher has stated that revenues need to be a part of any solution, Senator Lindsey Graham (R–SC) has voiced strong support for the Simpson Bowles Plan, and cannot politically afford to be seen as obstructionists. Essentially, we have come to a time in which all the major players have every reason to come to the table with a sense of urgency to complete a deal.
Just as interesting and potentially significant are the likely cabinet seats that President Obama will have to address. Secretary of State Clinton has stated her intension to step down and Treasury Secretary Tim Giethner has wanted to leave for some time. The next four years will be shaped in part by these two significant appointments.
Economically, the appointment of the next Chairman of the Federal Reserve will be significant. Governor Romney publicly stated he would not re-nominate Chairman Bernanke while President Obama was mum on the subject. While Romney would have clearly moved in a different direction, it is not known who the President would look to as a replacement. This decision is important for asset prices as well as interest rates. The current Fed policies have worked to keep interest rates at historically low levels while boosting the value of most all investable assets. The next Fed Chairman is likely to be forced to deal with the aftereffects of these policies and the seemingly unavoidable inflation that is building up in the system. There is a fine line he or she will have to walk between fighting the effects of inflation and keeping the economy growing at a healthy pace.
The Real Investment Issue to Consider
Certainly, the political issues we face are serious and, if not resolved in a reasonable timeframe, investors will more than likely feel the pain. We cannot emphasize enough that the two political parties need to come together to find a bipartisan solution to all three “cliffs” we face. As an investor, however, resolution to these issues are likely short-term in nature, and in our opinion, should be seen in this light. You will likely see more volatility on a day-to-day and week-to-week basis. Over the coming 12- 18 months there is a much greater, less discussed reason for caution: corporate earnings.
In our October 2012 Market Outlook we voiced concern over the lack of both revenue growth and earnings growth from publicly traded companies. The earnings trend began in the second quarter and has continued into the third quarter. All the while, market indexes have sold off some, but remain near multi-year high levels. This is not rational, but markets have never been rational. In reality, over the course of a market cycle, market expectations have an effect on how equities are priced. In the April 2012 Market Outlook we put it like this:
“… the least concrete and most subjective area is market expectations. Market and individual company expectations move in predictable cycles due to the backward-looking nature of market forecasting. The typical analyst becomes overly pessimistic around the bottom of an economic cycle and overly optimistic before the peak of an economic cycle. Thus, at the beginning of the cycle a company will often times “beat” expectations with less than stellar earnings and “miss” expectations towards the end of the cycle with very good or even record earnings.
Since the market bottom in March, 2009, we have seen company earnings that have been both stellar and above analyst expectations. Over time, however, the size of the “beats” has become less dramatic as expectations become closer to reality. With earnings season starting in the near future, we will be diligently watching how earnings compare to expectations and adjusting allocations as necessary.”
Beyond the political and big-picture economic issues, earnings are our number one concern. It is very rare for stock prices to increase when earnings are flat or falling. In both the second and third quarter we have seen the number of companies who reported earnings and/or revenue misses increased to levels not seen since 2008. So far this has not been a major concern of the markets as QE3 has been a driving force behind asset prices. Market perceptions, however, change without notice.
Inside the market averages we have a market of stocks. The reelection of President Obama does have an influence of where there could be strength and weakness. Coal stocks, for example, are very likely to continue to underperform as government regulations should remain strong. Hospital stocks should have some wind in their sails as we know the Affordable Care Act (“Obamacare”) should become fully enacted as planned. And we would expect any budget deal coming out of Washington to include infrastructure spending that will provide a stimulus to both the economy and the sector.
With interest rates at historically low levels and no change expected at The Fed, we see little change in the current interest rate environment. We continue to take Chairman Bernanke at his word that rates will stay low for the foreseeable future. If there is change in leadership in 2014 things may change, but that is too far away for concern.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.
Where Do We Go From Here?
Unfortunately without Doc Brown’s Delorean from Back to the Future to take us a few months in the future to see how this plays out, there is no sure, guaranteed path on how economics and politics play out over the next few months. A political deal will likely get worked out one way or the other. In our opinion, the sooner a deal is reached, the better for both the economy and the American people. There are, however, some conclusions, based on our beliefs that we can come to:
- Market volatility should be higher over the next few months with big moves in both directions.
- Bond yields should remain low as The Fed continues with QE3.
- Corporate America will react in a negative fashion if the Democrats and Republicans do not come to a resolution to their policy disagreement.
It has been extremely hard for the average investor to come to grips with the new investment environment since the Great Recession of 2008. After seeing investment account balances drop as they did, it becomes too easy to focus on the events of the day and the latest musing from some talking head on CNBC. In our opinion, the average investor would be better off focusing on the things they can control that affect their investments than those they cannot. If you are saving for retirement you control the amount you are saving; if you are in retirement you control the amount you are spending. And everyone should have an investment portfolio that is balanced to his or her needs. If you have an investment plan, our recommendation is that you stick with it. If you don’t have an investment plan, please take the time to get one.
Past performance is no guarantee of future results. Dividends are subject to change or elimination and are not guaranteed.
Indices are unmanaged and you cannot invest directly in an index. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
Investments that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than investments that are more diversified.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
This and/or the accompanying statistical information was prepared by or obtained from sources that Magellan Financial, Inc (Magellan Financial, Inc is a separate entity from WFAFN) believes to be reliable, but its accuracy is not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Additional Information is available upon request.
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Robert I. Cahill, Managing Partner Rob.Cahill@wfafinet.com
Ann L. Drescher, Partner Ann.Drescher@wfafinet.com
Jeffrey T. Bogert, Partner Jeff.Bogert@wfafinet.com