The "do-nothing" approach out of Washington has brought us to the brink of serious consequences. The extraordinary set of circumstances that result if lawmakers "do nothing" enables a game-changing set of tax hikes and spending cuts. If Congress and the White House fall short of a resolution by December 31, or reach only a partial solution, we anticipate a very volatile year-end and into first quarter 2013. With less than two weeks to go, the stakes are high, and markets will only climb a wall of worry for so long. Investors are hoping that Santa Claus brings us a gift of resolve, but Mr. Grinch seems to be focused on stealing Christmas.
As many speculate on the outcome, no one can accurately predict the results of fiscal cliff issues. Resolving this mammoth conundrum will likely take months or years, just as it did to get us here. The issue of overspending without supporting revenue has been a common theme for decades -- that same theme has intensified in recent years. Simple calculators would be an ideal gift for lawmakers, except they don't have enough digits to calculate "trillions." Nonetheless, in typical Washington fashion, problems are ignored until the eleventh hour, followed by knee jerk reactions that "band-aid" the issue and disregard the underlying problems. It is this type of indiscriminate management that creates unintended consequences, which could (and should) be avoided. At this late stage, my cynical side expects little to be accomplished before the so-called "deadline."
Instead of waxing the Fiscal Cliff issue as we have for several months, let's focus on some economic highlights that must be factored into portfolio management, regardless of what happens in Washington. In times of great uncertainty, and this is one, we remain focused on high-quality names that appear competitively situated to thrive in any set of economic and market conditions. That's not to say certain stocks are immune from volatility. But one can't argue that some perform better than others during difficult periods. In our effort to remain invested, several macro issues come into play.
Of particular concern, Federal Reserve Chairman, Ben Bernanke announced a new round of monetary stimulus last week. Couched as a continuation of "Operation Twist," the devil is always in the details. Rather than using existing balance sheet funds, the latest round of stimulus calls for newly printed money at a rate of $40 billion per month with an open-ended timeline and a target unemployment rate of 6.5%. Of course, this comes with a caveat: inflation must remain below 2.5% and inflationary expectations "well anchored." Chairman Bernanke believes that unemployment will reach the aforementioned rate sometime in 2015. The Fed's balance sheet would reach an unprecedented $5 trillion in that period, unless the printing press malfunctions. This new round of easing will have little effect on the markets, in my opinion, as interest rates are at record low levels.
No matter how much money Bernanke prints or what happens with the "Fiscal Cliff," every tax-paying American is likely to feel a substantial pay cut after January 1 -- thus slowing an already protracted economic recovery. Launched in 2010, the payroll tax holiday was implemented to help spur consumer spending. According to Mark Zandi, chief economist for Moody's, the lowering of the payroll tax has been very effective. However, it is scheduled to end this month. There is a chance that it will be extended under a fiscal cliff deal, but you won't hear much talk about this since it was viewed as "temporary" from the outset. But this "temporary fix" lowered taxes for some 160 million Americans. A small cut of only 2% may not sound like much, but a worker making $50,000 per year saw an increase in spendable income of $960 for the year, while someone making $100,000 had over $1,900 in extra spending money. Taking that away will irrefutably reduce GDP at a time when it should be increasing. The expiration of this tax cut will be especially severe on those living paycheck to paycheck. Of course, keeping the payroll tax reduction in effect means Social Security continues to be underfunded, which Washington agreed to subsidize. The problem is, Washington has no money for subsidies. You might say that Washington has weaved a very complex web.
Assuming the economy avoids falling off the cliff, the risk of recession remains low. To avoid a worsening economy, however, the jobs environment will need to find more momentum and expand at faster pace. Yesterday's job report showed an increase in jobless claims in spite of the positive spin from pundits. According to analysts, unemployment is expected to reach the 7.5% range in 2013. Consumers will need to continue improving their balance sheets and consumer confidence, at five-year highs, will be watched closely. Housing has also started adding to the economy and that trend appears intact. However, we believe that continued price gains will draw more "shadow inventory" into the market, making further price gains difficult, at best. Representing 2.7% of the nation's GDP, real estate remains a critical component in the recovery. Exports have added to GDP for several years, and we expect continued growth in that area as the greenback continues to weaken and BRICs begin to come back on line.
The U.S. faces manifold challenges, which make us wary of being too optimistic. Of those challenges, the fiscal cliff carries the greatest weight. Our total federal debt is now equal to GDP and growing. The United States could ultimately become the next Spain or Italy. Conversely, too much focus on austerity, and the economy may well dip into another recession. 'Sounds all too familiar!
The bottom line: Santa Claus may be headed your way, but don't get your hopes up for the "present" on everyone's mind -- fiscal cliff resolution. With less than two weeks to make a deal, lawmakers will be hard pressed to accord. Democrats and Republicans want to point fingers at their opposing party while the county sinks further into ill repute. I agree, spending on entitlements and providing for those who can't (and in many cases, won't) provide for themselves is a very kind act. If it were only that simple. If we simply raise taxes on the rich without putting controls on spending, what have we accomplished? Certainly not reform.
Regardless, the Fed is keeping monetary policy extremely loose as a last-ditch effort to avoid an economic reversal. This strategy of keeping rates low, however, comes at a very large price in several ways, and threatens to unravel what looks like a recovery. Perhaps the most salient part of extreme money printing is a rapidly expanding balance sheet projected to hit $5 trillion by 2015. Unwinding this debt will be a daunting task. Furthermore, as the dollar weakens, stocks will likely continue to rise. For investors, this can only be viewed as good. However, when stocks go up, so do bond yields; mortgage rates could follow, which further reduces the consumer's ability to refinance at lower rates, which further reduces disposable income. As the economy limps at a slow pace, further growth is challenged by many prevailing issues. For now, the consumer sector somehow keeps showing signs of strength, and manufacturing is sluggish but not negative.
What's left of 2012 will likely be dominated by the fiscal cliff. Individual investors have yet to be fully invested in the U.S. equity market, which we infer from AAII bullishness index; a tepid 35.9% in 2012 vs. readings in the mid-40s late in the 2004-08 bull market, and in the high 40s at the end of the 1990s. We also look to fund flows of ETFs (an institutional investor vehicle) vs. equity mutual funds (used by retail investors). Equity ETF fund flows have been positive in 2011 and 2012, while domestic equity mutual fund flows have been negative. We believe this provides the backdrop for what could be a tiring bull market. We'll be watching these metrics to help us gauge retail participation in the stock market. Historically, retail investors are not always the best market-timers -- they usually get comfortable with the idea of investing as rallies begin to fade. Should the retail investor come back to equities, we would view this as a potential rally ending signal. Indeed, PE expansion cannot be sustained without rising earnings per share.
Our portfolio strategy remains one of caution for the moment, with cash positions exceeding 30%. Our trying to gauge buying opportunities in a market held hostage by Washington is a futile effort. With the latest setback, money is moving into Treasuries and the dollar, and falling off the cliff would be exacerbate this latest flight to safety, which drastically improves the debt situation but is very bearish for stocks. GDP is already under attack with the payroll tax cut set to expire on January 1, and going over the cliff will add additional pressure. Markets priced in a fiscal cliff solution weeks ago, and that optimism has now turned to fear. The stock market is quickly adjusting before the Christmas holiday, and lighter volume will likely intensify volatility. Without some form of resolution before year-end, we anticipate further selling pressure on stocks and a reversal in down-trending asset classes such as gold, Treasuries, and the dollar. Conversely, stocks could regain their bullish momentum if a deal is reached. Even so, we look for look for the yellow metal to continue its 10-year uptrend as monetary easing increases. For those seeking income, we prefer corporate bonds, REITs, high quality dividend paying stocks and select preferreds.
Additional disclosure: This information does not constitute a recommendation of any kind. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services.