Markets Love Certainty
Now that the election is over, all eyes are on the uncertain horizon of the "fiscal cliff." While the U.S. is not the only source of market uncertainty, it is currently the largest. Before we come back to the fiscal cliff and U.S. economy, let's take a trip around the world to look at other well-publicized sources of uncertainty and what impact they might have on equity markets.
Much has been written about China over the last few years, both bullish and bearish. The "hard" versus "soft" landing discussions and the future monetary and fiscal policy decisions are in constant debate. China's leaders have been very clear on their direction -- to slowly rebalance growth away from exports towards domestic consumption while maintaining full employment and social stability. They have shown remarkable resolve in slowing inflation and moderating house prices, so I don't doubt their resolve to rebalance growth. The real test will come when they start realizing losses from the bad loans that are a result of the credit fueled growth of the last several years. However, China has successfully cleaned up bad loans in the past, and will likely nationalize most of the losses this time around as well without blowing up their financial system. The upside to this is the potential development of a deeper market for Chinese sovereign debt, as China's debt to GDP will increase dramatically as a result of the cleanup.
The impact on global equity prices of a material slowdown in China's infrastructure boom has been largely priced in, however, one would be prudent to avoid the cyclical commodity plays as their best days are now past, and many of them may develop into value traps. The same goes for Korean and Japanese industrials, who rely on China as a key driver of their capital equipment exports. China's share of global exports has likely peaked, as the rapid cost inflation of the last few years has started to shift foreign direct investment to more attractive regions. Politically, the peaceful transfer of power in China is a clear indication of their desire to maintain stability, and there is no indication that the incoming regime will change foreign or domestic policy dramatically.
Bottom Line: China's risks are well known, largely priced in, and are unlikely to have a contagion effect on markets. Avoid direct investment in Chinese equities, especially financials, and global commodity related plays. Avoid most equities in commodity driven countries such as Australia, Chile, Canada and Brazil, as their income is largely dependent on a continued increase in China's infrastructure spending.
The Arab spring had very little impact on global markets, including oil. A further spreading of the Arab spring will also have limited impact, unless it reaches Iran. Iran's economy is in free fall and the currency has cratered, largely as a result of economic sanctions. Given the choice of fighting back a revolution or acquiescing to a nuclear inspection regime, the odds are that the Ayatollah will submit to inspections in return for an easing of sanctions. President Obama now has more political flexibility to negotiate a peaceful agreement, as there is no domestic appetite for another war.
Bottom Line: There is little chance of war with Iran and therefore, limited impact on global equity markets. If there is an agreement, oil prices may go down, benefiting consumers and consumer-related stocks.
The recent actions taken by the ECB effectively removed the risk of a disorderly breakup of the eurozone. It remains to be seen whether Europe moves towards further fiscal integration consisting of a banking union and common treasury. There is little political appetite in northern countries for further integration, however, European leaders have a history of defying popular will in the quest for a United Europe. The more immediate concern is the deepening depression in Southern Europe and the impact it is having on social stability. The capital flight out of the south and contraction of lending further exacerbates the economic conditions.
Banks across Europe continue to realign and match their assets and liabilities in each country, effectively unwinding a decade of financial integration. The ECB has not yet embarked on the path of quantitative easing to ease the de-leveraging, and it is not clear that the ECB has the political will to do so, as this would require massive unsterilized purchases of southern sovereign debt, which would devalue the euro and import inflation to northern countries. This basic dilemma may lead to a somewhat orderly breakup of the euro with the exit of one or more southern countries. How this would be managed with the large inter-central bank debts is unclear, and is still a major source of risk and uncertainty.
However, the global financial system should be able to withstand the exit of one or several European countries, as most corporate and financial institutions have been preparing for it for quite some time. Given the deepening depression in the south, continued de-leveraging of bank balance sheets and decreasing political and social stability, it would be prudent to avoid most European equities and debt, especially financial related. European companies do not have the benefit of a depreciated currency to boost exports, nor accommodative banks to finance overseas expansion. Therefore, corporate earnings will be depressed and multiples will remain low for the foreseeable future.
Bottom line: The risk of a disorderly breakup of the euro has been removed by the ECB. It remains to be seen what further steps are taken towards resolving the structural imbalances within the eurozone. The impact on global equity markets of the exit of one or more EU countries should be short lived, and mostly limited to financials. The prudent investor would avoid most European equities and debt, especially financials and sovereign. If exposure is necessary, focus on a limited allocation to healthcare and consumer non-cyclicals based in northern core EU countries that derive significant revenues from outside the eurozone.
The election has passed, removing one major source of uncertainty. President Obama is unlikely to pivot hard to the left in his second term, and he has a limited timeframe of two years to enact any meaningful legislation before he starts looking towards his legacy. He has already stated that immigration and taxes are on his domestic policy agenda. Action on either or both would necessarily be a result of compromise between the parties, thereby limiting their immediate impact on the broader economy and potentially acting as catalysts as businesses gain more certainty to hire and invest.
After the debt ceiling brinkmanship of last year yielded little popular support, it is unlikely that a similar drama will play out for the fiscal cliff. The odds are that most tax cuts will be extended or made permanent along side medium- and long-term spending cuts focused on defense and entitlements. With Chairman Bernanke firmly in control of the Fed, interest rates will remain low through 2015 and monetary policy will remain expansive. However, the risk-reward ratio for bonds is unappealing. When starting rates are this low, small moves in rates have an outsized impact on prices. If and when inflation expectations increase, or the economy further improves, interest rates will move up as investors shift from bond to stock funds, providing a potential upside and limited downside to stock prices. The equity risk premium, even under a normalized interest rate environment, is still quite favorable to stocks. While earnings will be pressured into the next leg of the bull market, multiple expansion will support prices as investors regain confidence and start rotating into stocks. However, the conservative nature of late bull market investors favors the more defensive mega-caps.
Bottom line: The fiscal cliff will not likely come to pass. The economy will continue to grow slowly into next year, with marginal pressure on corporate profits from medium-term spending cuts targeted towards defense and healthcare. Avoid defense companies and health insurers due to uncertainty surrounding government spending. Limit exposure to long duration bonds, utilities and other pure play yield instruments. For income, focus on high quality REITs and natural gas MLPs with strong balance sheets. specifically avoid mREITs as they are highly leveraged, lightly regulated, and especially susceptible to small moves in interest rates. Focus on defensive mega caps with strong balance sheets with the exception of deep cyclicals and commodity stocks.
The U.S. is currently the most attractive place to invest from a risk-reward perspective. A slowing China will put a drag on Northern Asia, and Europe is mired in a structural mess that may take years to work through. While both Europe and China may look attractive on a valuation basis, the continuing drag on earnings from their slowing economies will limit any upside. The U.S. fiscal cliff will not come to pass, and any fiscal retrenchment will be back-ended so as not to derail the current expansion. The late stage of this bull market will favor the more defensive mega caps with strong balance sheets, which will also limit downside risk during periods of volatility or the next bear market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.