Outlook For 2013 And Beyond: Exploring The Endgame For Financial Markets

by: Eric Parnell, CFA

I have been an active participant with Seeking Alpha for several years now. The articles posted on Seeking Alpha form the foundation of its service and many of the daily posts from its broad range of regular contributors are truly excellent. But beyond the articles themselves, some of the best information on Seeking Alpha is often found below the "Comment" line after the end of each article where readers share their own perspectives and engage in lively debate with both the author and other readers. Some of the most insightful participants on Seeking Alpha are the readers themselves, and I have benefited both professionally and personally over the years from the opportunity to exchange views and ideas with those that have commented on my articles or have contacted me directly over e-mail. For this I am grateful, and it is from these collaborations that many of my article ideas are derived.

Over the last few days, an issue that has repeatedly come up in my conversations with readers is the following: where does the global economy and its financial markets go from here over the coming year and beyond? And what is the endgame for this continuously unpredictable post crisis period? This is a critically important question that I hope to address with this article. Of course, mine is only one view, so in writing this post I also look forward to exploring the views shared by those that comment on this article.

To understand where we are going in the future, we must first assess where we are today. In short, the global economy is a mess and its financial markets are highly unstable due to years of repeated fiscal and monetary stimulus injections. This is not to say that we are not currently in a better state then we were a few years ago. After all, I still remember early October 2008 like it was yesterday, literally working around the clock to monitor events as they unfolded with the entire global economy seemingly on the verge of total collapse. But while we have come a long way back from the brink, the rebound has been sluggish and the distortions that have been created in attempting to repair the problem have the potential to cause even greater damage than the original crisis several years ago. It has been a pyrrhic victory to say the least.

The solutions to the problems that caused the financial crisis have been flawed. When the crisis first erupted back in late 2008, policy makers had a unique opportunity to intervene with actions that could have truly fixed the underlying imbalances that existed in the financial system. This included establishing a better operating structure for global markets, the restructuring too big to fail financial institutions, discouraging future irresponsible behavior by effectively punishing bad actors, and helping the global economy saddled with too much debt to carefully navigate through an orderly deleveraging process. While this would have been a painful experience at the time, it would have allowed the global economy to cleanse itself of excesses built up over prior decades and would have formed the foundation for a healthy new secular bull market. But instead of trying to fix the problem, policy makers effectively tried to pretend the problem away by rescuing at risk financial institutions and allowing them to return to their previously dangerous behavior, imposing broader rules on businesses that has led to regulatory uncertainty and discouraged capital investment, and trying to solve a major private sector debt problem by piling on with even more sovereign debt and printing incredibly vast sums of money. While these solutions have resulted in a sluggish recovery for the global economy and a major sugar high for its markets over the last few years, they have left us with problems today that are now even more complex to resolve going forward.

So how does it all play out from here? The following is what I believe to be the highest probability outcome from where we stand today. I offer these views with the caveat that given the extreme uncertainty that exists in the global market place today, this outlook is subject to change as events unfold in the coming days, weeks and months. Thus, I will seek to regularly update this view on Seeking Alpha as events unfold.

The U.S. fiscal cliff is the first variable to consider in the outlook. I have little doubt that fiscal policy makers in Washington will come to some sort of solution in the coming weeks before the end of the year. Politicians are many things, but they are not suicidal, and allowing the economy to roll off the fiscal cliff at the end of the year would be mutually assured destruction for all involved.

The bigger issue in my view is the actual resolution to the fiscal cliff, as it effectively means that a prolonged period of expansionary fiscal policy will be coming to an end on December 31. And in its place will be austerity arriving on U.S. shores, which will be an increasing drag for economic growth.

The basic math behind fiscal austerity shows why it is such a negative for economic growth. Two things are almost inevitably going to result from the fiscal cliff debate in the coming weeks - higher taxes and reduced government spending. Now let's take this in the context of the expenditure approach to GDP, which is the following:

GDP = C+I+G+Xn

where "C" is consumer spending, "I" is business spending, "G" is government spending and "Xn" is net exports. With higher taxes, money is being taken away from consumers and businesses. This implies both the "C" and "I" components of GDP will go down on net as a result of higher taxes. And cuts in government spending will directly reduce on net the "G" component of GDP. Lastly, any sustained increase in the already negative "Xn" net exports component is unlikely given the relatively worse state of the global economy including many of our largest trading partners. All of these forces suggest a heavy drag is about to commence on U.S. economic growth, which is typically negative for the stock market and other cyclical risk assets.

Stocks have the power to continue rising in the coming year despite decelerating economic growth. And this is almost exclusively due to the U.S. Federal Reserve, which is steadfast and unyielding in its objective to employ monetary stimulus at all costs in an attempt to save the U.S. economy. The Fed launched QE3 in mid-September as its latest attempt to further flood a marketplace already awash in more than a trillion dollars of liquidity. This included the purchase of $40 billion in mortgage-backed securities (MBS) each month until the Fed is satisfied with the employment situation in the U.S. While some investors are heralding this latest monetary stimulus effort as a failure since the stock market has responded by plunging lower, it is critically important to note that the liquidity from QE3 has yet to find its way into the financial system in a sustainable way. This is due to the fact that the settlement of MBS purchases by the Fed is delayed by two to three months on average due to how MBS securities are traded. So Fed liquidity is coming soon, and just like a flash flood, once it does it will build quickly from a trickle to an increasingly raging torrent.

While an agreement on the fiscal cliff will likely go down in history as the reason the U.S. stock market and other risk assets begin to sustainably rally in the coming weeks, the real reason will almost certainly be the fact that Fed liquidity is starting to fully work its way through the financial system by then. And just as this liquidity starts to flow, the Fed will likely double down on its QE commitment by announcing after its next FOMC meeting on December 12 that it intends to also make outright purchases of up to $45 billion or more in U.S. Treasuries each month upon the conclusion of Operation Twist at the end of the year. In sum, the addition of Treasury securities to the program would bring QE3 to roughly in line with the monthly outright asset purchases of $80 billion per month under QE2. And unlike QE1 and QE2, since the current program is open ended, this implies that the Fed is set to expand its balance sheet by injecting roughly $1 trillion of liquidity into financial markets in calendar year 2013 alone.

The profound impact of balance sheet expanding monetary stimulus from the U.S. Federal Reserve on financial markets cannot be understated. Over the last few years, the world could literally be coming to an end at a given moment, yet markets would find a way to inexplicably melt higher on an almost daily basis when the Fed was fully engaged in balance sheet expanding QE1 and QE2. Good news is outstanding news, bad news is good news and really bad news is somehow even better news for markets under the influence of QE. And such forces of balance sheet expanding monetary stimulus are not limited to the U.S., for if the European Central Bank (ECB) is undergoing a rapid balance sheet expansion, this can also float risk markets higher. This was on full display from mid-December 2011 through the end of February 2012 when the stock market drifted higher almost daily while the ECB carried out its balance sheet expanding Long-Term Refinancing Operation (LTRO).

Interestingly, the worsening of the ongoing crisis in Europe could provide an added boost higher to stocks and other risk assets in the coming year. The debt problems on the continent started with Greece back in the summer of 2010. They have since spread to Portugal and Ireland and now to the much larger Spain and Italy. Not only is Europe already mired in recession, it is increasingly suffering from a debt contagion, and policy makers across the region are attempting to rescue these economies by providing even more debt under the condition that countries accept growth-crushing austerity in return. Please see the GDP equation above to see why the math just does not work on this solution. At present, the ECB is prepared to rapidly expand their balance sheet to buy the debt of Spain and Italy as soon as the leaders of either of these countries ask for the help and enter into the Faustian deal. Both have resisted to this point, but their hands are likely to be forced in the next six months starting with Spain. And once they relent, this will represent an added torrent of liquidity being pumped into the global financial system by the ECB. Not that the problems will be fixed. To the contrary, they will only get worse. But financial markets will be provided with added fuel to thrust higher in the meantime.

China also stands to join the expansionary monetary policy game in the near future. The China economy has been recently languishing. And while a +6% economic growth rate may seem robust for a developed economy like the U.S., it must remain at this level or above to accommodate the massive shift of labor from the countryside into the labor force. And with a population that is the largest in the world and is becoming increasingly restless about their current circumstances and the corruption that they perceive in the political system, the government is in a position where it will need to act decisively to improve the economy and the welfare of its citizens. Given that growth improvement is unlikely to come from exporting to its global customers, many of which are fading toward recession if not already there, the Chinese leadership will be forced to engage in efforts to spark growth for itself. Thus, another round of monetary stimulus from China would not come as a surprise in the near-term. And this stimulus may come very soon given the transfer of leadership is now underway, as a major monetary stimulus program would provide a welcome tailwind of support to help this new leadership firmly establish its footing with the Chinese people.

So for the coming year, we are likely to see the convergence of two forces. One is the slowing of the global economy toward recession. The other is the increasingly massive flow of balance sheet monetary stimulus from major central banks from around the world.

To date for financial markets, the euphoric forces of monetary stimulus have won out over the reality of deteriorating economic fundamentals. And over the near-term and perhaps for much of 2013, it is likely that the steady flood of liquidity into the global financial system will cause cyclical risk assets such as stocks (NYSEARCA:SPY) and high yield bonds (NYSEARCA:HYG) and commodities as well as hard assets such as gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) to enter into another sustained melt higher, particularly given the magnitude of monetary stimulus that is potentially set to be injected along the way.

But this does not at all mean that things will end well. To the contrary, the more global policy makers try to print their way out of their current predicament, the messier the final outcome is likely to be. It is worth noting that balance sheet expanding monetary stimulus has had a diminishing marginal effect on risk assets including stocks over the last few years. At some point over the next 12-18 months we will likely arrive at the threshold where monetary stimulus can no longer support higher stock prices. And this will mark the moment that we begin to enter the final stages of the secular bear market that started back in 2000.

Two potential endgames appear most probable from where we stand today.

The first is a relatively more stable circumstance that is bound to arrive by late 2013 to mid 2014. Under this scenario, problems in the global economy continue to fester and grow. The financial crisis in Europe spreads from Spain and Italy to France and even begins chipping at Germany. The United States economy falls back into recession and Chinese growth remains uneven. At this point, the forces of deteriorating global economic fundamentals begin to overwhelm the stimulative influences of monetary policy. Risk assets including stocks cease drifting higher and begin to grind steadily lower under the weight of the underlying economic reality. At this point, global monetary policy makers finally capitulate and withdraw any further balance sheet expanding monetary stimulus in favor of trying to instead guide an orderly unwind of the debt super cycle. This would be a fairly painful but gradual process that would take time to complete and would likely result in the gradual deflation of the stock market back to levels well below where it is trading today. Current fair value of 950 on the S&P 500 or below would be reasonable under such a scenario.

The second is a more violent scenario that is also likely to erupt by late 2013 to mid 2014. As above, the global economy continues to deteriorate. But instead of monetary policy makers opting to withdrawal stimulus, under this second scenario the markets riot in advance due to mounting concerns over global debt and the ongoing viability of selected fiat currencies such as the euro. This response causes global interest rates to spike sharply higher even in the safe haven markets while economic growth decelerates to the downside, resulting in a major stagflationary outcome as investors flock to hard assets such as gold, silver and other selected commodities that provide a store of value. In contrast to the first scenario, this would likely be an extremely sharp and painful process that would likely play out fairly quickly including the swift decline in the prices of risk assets such as stocks to below fair value levels.

A third still possible outcome is that everything works out and policy makers are able to steer the global economy back toward a sustainable growth path over the next few years. I genuinely hope that they are able to pull it off and that we can arrive at a painless end to the challenges we currently face. But most indications suggest this is a low probability outcome at this point.

The good news associated with either challenging scenario listed above is that once policy makers either chose or are forced to finally lean into the problem and the cleansing process is completed, the secular bear market that began in 2000 will finally be over and the foundation will be set for the beginning of the next secular bull market. And just as in past instances including 1949 and 1982, this will be a most positive development for investors looking out over the coming decades.

In the meantime, the bottom line question remains as to how to best navigate this outlook from an investment standpoint. Given the deluge of liquidity that is likely to be injected into the global financial system in the coming months, an allocation to precious metals such as gold and silver through the Central GoldTrust (NYSEMKT:GTU) and the Central Fund of Canada (NYSEARCA:CEF) is recommended. Maintaining a decent allocation to risk assets such as stocks and high yield bonds is also suitable strategy at least for the next three to twelve months. But given the still high levels of uncertainty and event risk, any such allocation should be held in proportion to other asset classes and should be managed carefully and with a watchful eye along the way. As for specific stock allocations, controlling risk through diversified products such as the S&P 500 Low Volatility (NYSE:SPLV) and the S&P Mid-Cap 400 (NYSEARCA:MDY) is a reasonable approach. As for specific allocations, focusing on stock names that stand to benefit most from global central bank money printing including Occidental Petroleum (NYSE:OXY) in energy, BHP Billiton (NYSE:BHP) in mining and Potash Corporation (POT) in agriculture as well as country specific themes such as China (NYSEARCA:FXI) and Brazil (NYSEARCA:EWZ) stand to be rewarded.

What about when the tide finally turns and we begin our decent toward the secular bear market endgame? We likely have some time before we arrive at this inflection point, but it is looming on the horizon most likely by late 2013 to mid 2014. But even if such a turning point finally comes to pass, it does not mean that investment markets will be without strong returns opportunities along the way. Continuing to hold gold and silver through such an unwinding process through the Central GoldTrust and the Central Fund of Canada would likely still be rewarded. Maintaining exposures to the variety of other more stable asset classes that have demonstrated the ability to perform well regardless of how dire circumstances seem at any given point in time is recommended. This includes but is not limited to depending on the circumstances, Agency MBS (NYSEARCA:MBB), U.S. TIPS (NYSEARCA:TIP), National Municipal Bonds (NYSEARCA:MUB) and Build America Bonds (NYSE:BAB). The ultimate stock market hedge in negatively correlated Long-Term U.S. Treasuries (NYSEARCA:TLT) may also merit consideration depending on how events unfold. And for those seeking protection from a sharply rising interest rate environment, floating rate Senior Loans (NYSE:BKLN) may also represent an attractive choice. And while evacuating most stock and high yield bond positions would be prudent under any unwind scenario, selected names will likely still be suitable depending on the pace of the decline. Even under a crisis circumstance, inferior goods providers such as Wal-Mart (NYSE:WMT), McDonald's (NYSE:MCD), Family Dollar (NYSE:FDO) and Dollar Tree (NASDAQ:DLTR) have shown the ability to rise in the face of extreme stock market stress.

In summary, I anticipate one final period of market ebullience in the face of deteriorating economic conditions into 2013 and perhaps as long as early 2014. But this will likely represent the final run higher for risk assets in the post crisis period, as we are quickly approaching the point where the cleansing process will finally be forced to take place. And once it does and is completed, perhaps by 2016 as a rough projection but maybe earlier, we will bring to a close the current secular bear market and will finally begin the next secular bull market.

Thank you for taking the time to read my article on Seeking Alpha. Recognizing that mine is just one voice in a crowd of many, I look forward to hearing your thoughts and perspectives on how you expect events to unfold over the next few years, as I know a wide divergence of views exist on this point.

Disclosure: I am long FXI, EWZ, MCD, BHP, OXY, POT, BAB, BKLN, CEF, GTU, HYG, MBB, MDY, MUB, SPLV, TIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.