Washington managed to avert the fiscal cliff at the last moment last week. Most of the Bush-era tax cuts remain in place, except for a 2% hike in the Social Security payroll tax and rates for high-income earners, in addition to a 40% estate tax on assets of over $5 million. Further drama will be postponed for a few months.
The news improved the outlook for the U.S. economy and rang in the New Year with the biggest one-day rally in stocks in over a year.
Another big story last week also added to investors' euphoria came via minutes from the December meeting of the Federal Reserve's Open Market Committee, which revealed that several members of the central bank's policy-setting arm expressed a desire to remove its quantitative easing sooner rather than later - perhaps by the end of 2013.
While we're encouraged by recent signs that the U.S. economy is improving - as is another important driver of global growth, China - we wouldn't put too much hope in the Fed's ability any time soon to safely remove its foot from the monetary gas pedal (via monthly purchases totaling about $85 billion in longer-term bonds and mortgage securities).
Mindful of the austerity likely to be imposed by Washington this year, through some combination of tax hikes and reduced spending, the Fed's policy statement from that same December FOMC meeting conceded, "The committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions."
Furthermore, the Fed defined its expectations, stating its anticipation that the current exceptionally low range for interest rates and quantitative easing will remain appropriate:
At least as long as the unemployment rate remains above 6 1/2%, inflation between one and two years ahead is projected to be no more than 1/2%age point above the Committee's 2% longer-run goal, and longer-term inflation expectations continue to be well anchored.
Unemployment continues at a lofty 7.8%. Moreover, the U-6 measure of unemployment, including those who work part-time due to the dearth of full-time work, also remains stubbornly high at 14.4%. So we'd need an impressive expansion in coming months in order for the Fed to retreat from its ultra easy monetary policies. And even then, Fed Chairman Bernanke will be reluctant to change course.
Let's recall that Bernanke is a scholar of the Great Depression. He knows better than anyone what happened after the Central Bank prematurely tightened credit in 1937: The economy, which had been on the mend, contracted sharply once again, prolonging the dreadful effects of the Depression. Bernanke has stated repeatedly that the Fed will not make that same mistake twice.
Given the Fed policies currently in place, we're somewhat optimistic on the economic outlook for the year ahead. However, that optimism does not preclude the possibility of a sizeable stock market correction along the way.
Actually, Bernanke would probably welcome such a pullback - as this would give him cover to stay the course on QE until the economy is truly healed. After all, a little inflation would be far more tolerable than longer lines at the unemployment office or a stiff downturn in corporate profits or both. Of course, judging from the December policy minutes, that view is apparently not shared by all his fellow governors.
Keep in mind also that the level of strong growth required to get the Fed to abandon QE would also entail considerable upward pressure on commodity prices. In turn, that would hurt corporate profits, quite likely short-circuit the recovery, and lead to a drop in share prices.
But for now stocks are acting well, so we'll give equities the benefit of the doubt. The advance has been broad-based with small capitalization shares hitting an all-time high this week. The healthiest markets are frequently those in which the small caps outperform the blue chips, as they are today. Those little guys, incidentally, will thrive if inflation picks up - as long as it's accompanied by at least some positive economic growth.
To profit from this trend, consider names like medical device maker Rochester Medical (ROCM), leading tire manufacturer Titan International (NYSE:TWI), or offshore oil & gas contractor Helix Energy Solutions (NYSE:HLX).