A Tale Of Three Gorges

Includes: SPY
by: Michael Chandler

I am so tired of writing and reading and listening about Congress and its "Fiscal Cliff." Hats off to Bank of America's research team for coming up with another name for it. I kinda like the name "The Three Gorges," but then again, as Shakespeare wrote in Romeo and Juliet, "What's in a name? That which we call a rose by any other name would smell as sweet."

I don't know about the sweet-smelling part, but the reality behind the two names is basically the same. Perhaps we should borrow from Herman's Hermits instead of from Shakespeare: "Second verse, same as the first!" Anyhow, from now on we will refer to gorges instead of "cliffs," and to punts rather than to "kicking the can down the road."

In this article we will define "The Three Gorges", the timeline, probable outcomes and finally the economic effects going forward. We will also address what this all means for Corporate America and how the markets will be affected.

As of this writing what do we know? We know that the Bush era tax cuts have been made 98% permanent. We also know that the automatic budget cuts (sequestration) have been punted. If Congress doesn't agree on budget cuts, these cuts will automatically happen March first. This is now known as Gorge 1. We also know that the debt must be extended by the first of March. This Is Gorge 2. Finally, a vote on a continuing resolution must be done by the end of March --- Gorge 3

I do not believe tax reform of any type is on the table anymore. Let's face it --- the Republican House got most of what they wanted. The Bush tax cuts were almost made totally permanent. I don't think it gets any better than that for the House Republicans. The disappointment for everyone was that they could not agree on spending cuts to add some balance to the tax cuts and limited increases.

President Obama has said that any reduction in government spending going forward will be balanced with some form of revenue increases. (That's political slang for tax increases.) If he holds that line, the automatic cuts may have to kick in. Under this scenario we have no tax or revenue increases, and cuts in the spending are made automatically through sequestration --- in other words, the cuts are made through legislative inaction, not action. In my opinion this is the most likely outcome. Such an outcome would put to bed the issue of Gorge 1.

The President has also said he will not debate over the debt ceiling. (Gorge 2). Will it be used as leverage to enhance budget and entitlement reform? Probably! Will that leverage be successful? I doubt it, if only because America's credit standing is simply too important to the nation. I don't believe Congress will not pay the bills. Ultimately the debt gets extended. This will, however, be Congress' best shot at getting big entitlement reform.

The third and final Gorge is the Continuing Resolution in late March. This is simply a vote to continue operating the Government. Once the debt extension is complete this will be nothing more than a formality. I think this will not be an issue, but technically it could be, and for that reason we will name it Gorge 3.

I expect we will get budget cuts of some kind, but how deep will the cuts be? That's the question. I doubt we get much more than the sequestration. I do think this will be the fallback position. Tax reform will not happen, and ultimately we will get balance with cuts to offset the most recent tax hikes. I think more budget cuts than tax increases is inevitable.

Let's take a closer look at the mandatory cuts and see how much of an economic drag the economy will suffer as a result. According to David Grant from the Christian Science Monitor, sequestration was the result of last summer's debt ceiling deal, which cut $1 trillion in government spending over the next decade outright and then put responsibility for finding another $1.2 trillion on Congress.

Because Congress failed to agree on the mixture of lower spending and higher taxes to hit that figure, a mechanism in the debt ceiling-raising legislation causes automatic spending decreases to hit the $1.2 trillion figure: about $109 billion in lower government spending every year for the next decade.

As you can see the actual spending cuts total 1.2 trillion dollars over a 10 year period. That works out to 109 billion per year for the next ten years. About half of these cuts will be from the Defense Budget and the other from non-discretionary spending.

According to The Committee for Responsible Federal Budget the "Cliff" would have cost 2.9% of our GDP. Their best calculation with the new tax changes and sequestration is that now it will cost "only" 1.3% of our GDP. This is still relatively costly, since no more than 2 to 2.5% GDP growth is expected. This would certainly bring us well below our 2012 GDP growth rates.

It's only fair to mention there has been talk of postponing the mandatory cuts until 2014-2015. Time will tell.

So, as I said above, we are essentially hearing the second verse, same as the first. And yes, it's a little bit louder, and a little bit worse. What conclusion does the savvy investor draw from all this?

Well, to begin with, Corporate America is still very lean and mean. Expenses are well under control for the most part ,and we are seeing growth in the housing market, a sector that could put a lot of people to work and add growth to earnings for companies in many sectors.

Money seems to be flowing into equities, especially out of bonds. If this movement continues to build momentum, money will finally move off the sidelines. There is no better indicator for investor sentiment.

Last year we were all so focused on the Fiscal Cliff that we lost sight of the fact Corporate America financially looked very good. As the results we enjoyed a double digit return in the S&P.

I believe the fear of a double dip recession is now off the table, and at the same time I expect slow GDP growth. Barring any big shock, such as another downgrade of US debt, I think we will have another good year, and I would not be surprised to see another double digit return.

There are nonetheless some areas of concern, such as the bubble in the Treasury markets. I expect we could see loses here, and I would avoid long-term government debt. I would be concerned with the health insurance industry because of the ramp-up in the Health Care Act. From a macro basis, the defense industry could see a difficult year with inevitable cuts in the defense spending.

On the other hand, sectors that should do well would be Financials, Home Builders, and Suppliers, all due to the long-awaited recovery in the housing industry. Energy should benefit from the economic turnaround in China and Asia. Here in the US, natural gas should do well --- supplies are abundant, and the ability to export and to convert to liquid could be the next big growth story in the world.

When I look at 2013, I for one have become a little more optimistic. Expect some additional volatility, keep your eyes on Washington, but remember that Corporate American is still lean and mean and seems to be looking beyond Washington.

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.