Market Roundup - November 2012
The election was the beginning, not the endBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
Before the U.S. elections, Republicans controlled the House of Representatives, the Senate was narrowly controlled by the Democrats, and Obama was President. After the election, nothing has changed. It’s tempting to think that means the next few years will be similar to the last two years. While it is possible, the strong showing by Mitt Romney in the presidential election and the prospect of further shake-ups in Congress in the 2014 mid-term election could force President Obama and congressional Republicans to inch towards compromising on budget issues.
In the 28 presidential elections since 1900 (excluding the current election), the Dow Jones Industrial Average increased 46% of the time the day after the election. When the Dow was down the day after the election, the Dow ended the year down a bit further 60% of the time. When the Dow was up the day after the election, it ended the year up further 85% of the time. In other words, the first day of trading seems to be a pretty accurate predictor of trading for the remainder of the year.
It’s really easy to say, “but it’s different!” Indeed, every election is different. This year, however, there is the eurozone debt crisis, the transition of leadership in China, and the U.S. fiscal cliff. These three issues could come to a head in the month of November, despite the conclusion of the U.S. elections.
On Wednesday, November 7, the Greek Parliament is scheduled to vote on additional austerity measures, which could determine whether the Greek government receives another round of financing from its lenders. On November 25, there is a regional election in Catalonia, Spain. If the election goes well for Spanish Prime Minister Mariano Rajoy’s party, the Spanish government could ask for a bailout or conditional line of credit, which should assuage investors’ fears about the pain in Spain. On November 8, the 18th Party Congress of China will convene and we should see whether the leadership that is scheduled to take over in China in March 2013 will continue to make important political and economic reforms, or if it will be stacked with individuals who resist change.
On balance, It’s a global market and global politics matter, not just U.S. politics. However, many investors will likely pay close attention to the status of the U.S. fiscal cliff. The combination of tax increases and government spending cuts scheduled to occur as we enter 2013 have been referred to as the “fiscal cliff.” The expiration of the 2001-2003 tax cuts, the expiration of the two percentage point reduction in payroll taxes from 2010, the expiration of emergency unemployment insurance benefits, new health care reform taxes, cuts to doctors’ reimbursements under Medicare, and the budget sequester are all part of the fiscal cliff. But what could really push politicians into action is the alternative minimum tax (AMT).
Without congressional action, the AMT—which was originally enacted in 1969 to target 155 wealthy individuals—will likely saddle 30 million Americans with an additional tax burden they have probably never heard of. The AMT exemption levels were never indexed for inflation, so Congress regularly bumps up the exemption to keep inflation from capturing more and more people in the AMT net. However, congress has failed to make this normally regular adjustment, and will probably get an earful over Thanksgiving from constituents. This could likely push Congress and the president to act on the entire fiscal cliff, punting the problem into the next session of Congress.
As part of the debt-ceiling debate of 2011, the president and Congress formed a “Super Committee” to develop budget cuts, but the Super Committee failed. Well, this time they’ll probably form a “Super-Duper Committee” to construct comprehensive tax reform. The 2014 mid-term election could be like a voter-referendum on the nature of the reform.
Considering the continued uncertainty about politics, what could move the markets in 2013? The answer is “money.“ It’s no secret that businesses worldwide are holding piles of liquid assets. The money will be put into motion; it’s just a question of where the businesses will expand and seek out opportunity. That’s where a country’s fiscal and regulatory policy will be important to follow: Companies will invest to grow, but where will they do it? They’ll invest where they find a friendly environment, which is probably also where investors should be looking for investment opportunities.
U.S. elections: Domino effectBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
The American writer and philosopher Elbert Hubbard once said, “History is just one [darn] thing after another.” (What we have put in brackets was less family-friendly than the word, “darn.”) This has been repeated a few times by such prominent people as Mark Twain and Winston Churchill. If you’ve been paying attention to the economic data and the markets over the past few years, that’s certainly what things feel like: One darn thing after another.
There is an interplay between perception and reality behind Hubbard’s quote and what we’ve seen over the past few years. When people are optimistic, that tends to breed good outcomes. When people collectively get a case of the doldrums, things turn negative pretty quickly. The markets seem to exacerbate this interplay. During the 2007–2009 period, we saw this at work: As things turned down, that triggered people to hunker down, leading to even more negative outcomes. With the November elections in the U.S.; the elections in Catalonia, Spain; and the transition of leadership in China commencing, November could be one of those domino months, when what happens then triggers a cascade of sentiment and outcomes. In such an environment, where the results are outside an investor’s control, we think it’s best to anticipate and adjust: Anticipate the outcomes but adjust to whatever happens. We’re anticipating positive changes.
The economyBy Brian Jacobsen
We have a special election feature at the front of this Market Roundup to deal with the U.S. presidential and congressional elections, but there are still three unresolved issues to watch: the fiscal cliff in the U.S., austerity in Europe, and the slowdown in China. At the end of October we also had to deal with Hurricane Sandy. The property damage likely amounted to $20 billion to $50 billion, while the lost economic output amounted to another $20 billion. Any rebuilding rebound from the hurricane will not add to the nation’s net wealth, so while it could increase employment and gross domestic product (GDP) numbers toward the end of the fiscal quarter, those should not be considered actual gains. What’s not included in GDP is the value of the things lost in the damage.
The fiscal cliff is unlikely to happenOver the course of the year, one of the big issues investors have been worried about is the fiscal cliff. That’s the well-publicized increase in taxes and cuts in government spending scheduled to happen as of January 1, 2013. The tax increases are a result of the December 2010 agreement to extend the 2001 and 2003 tax cuts for two years and add a payroll tax cut for employees. The spending cuts are a result of the August 3, 2011, Budget Control Act, which was the agreement to raise the government’s debt ceiling in exchange for spending cuts.
The economic drag from the fiscal cliff has been estimated by the Congressional Budget Office to amount to 3% of GDP in 2013. We calculate that the drag is best thought of in terms of the industries it could affect rather than the effect on GDP. Half of the spending cuts—over $50 billion—will be in the defense industry. The other half of the spending cuts are nebulously distributed across a category called discretionary nondefense. That means that the spending cuts, if they happen, will likely be concentrated in the defense industry.
More disturbing to the broad economy than the spending cuts are the tax increases: Not only are all income tax rates set to increase at the end of the year, many deductions and credits will be eliminated, capital gains and dividend tax rates are set to increase, and payroll taxes are set to revert to their prereduction levels. The economic drag could be nasty and brutish but probably short. People change their behavior in response to taxes, so the biggest effects would likely be felt in the first quarter. Thus, the pain could be acute but short-lived.
Thankfully, we think the economic drag of the fiscal cliff is also unlikely to happen. Politicians have a keen re-election instinct, and we doubt a politician of either Democrat or Republican affiliation would want to face an angry electorate in 2014 if falling off the fiscal cliff drops the U.S. economy into a recession. We think it’s more a question of when than if the U.S. avoids falling off the fiscal cliff.
The Federal Reserve (Fed) has been working hard to improve financial conditions through loose monetary policy; so, the deferral or avoidance of the fiscal cliff is estimated to put 2013 GDP growth at 3% for the U.S.
The eurozone seems to be embracing a softer form of austerityU.S. markets—whether stock or bond markets—have been more linked to the eurozone crisis than anything U.S.-related. Greece’s politicians first announced they were having budget problems in 2010, and that’s probably what caused the tizzy in the financial markets more than anything that happened in the U.S.
Since March 2010, national governments in the eurozone have been discussing austerity as though it is one pill for a debt ailment. In fact, austerity is more like a cocktail than a pill. It can take many ingredients and mixtures of increases in revenues and decreases in government spending. Some market commentators have correctly referred to the increased revenue ingredient as private-sector austerity and the decreased spending ingredient as public-sector austerity. The difference is important because increases in tax revenues or tax rates have different implications than cuts in public spending. The lack of distinction between private- and public-sector austerity has continued to confuse and complicate the eurozone crisis.
Although eurozone political leaders haven’t necessarily grasped the important distinction between private- and public-sector austerity, they have seemed to back off the demands for austerity in general. We interpret the elections in France and the Netherlands to be calls to lighten up on austerity. Fiscal adjustment is not like removing a bandage where quicker is better. Too quick and the adjustment loses its popular legitimacy. Too slow and it doesn’t get done, as backtracking becomes easier. The slowing of the pace of austerity in Europe, we think, is a positive for the economies and the markets.
China’s economy has landed softlyThe recent debates about China have seemed to center on whether the economy will have a soft landing or a hard landing. A hard landing would be one where the economic slowdown happens abruptly, giving rise to social unrest. A soft landing would be one where the economic reforms could continue, bringing the 50% of the population that is considered the rural poor up out of poverty.
In 2007, China’s GDP grew by 14.2%. In 2010, its GDP grew by 10.4%. For 2012, China will be lucky to register a growth rate of 8.2%. With the eurozone being the biggest export market for Chinese goods and services, the slowdown in Europe has tapped the brakes on China’s growth. In the third quarter of 2012, China’s GDP grew at a 7.4% year-over-year rate. Industrial production slowed, but retail sales stayed robust. That’s an important dynamic that needs to continue for China: The Chinese economy needs to refocus from exports to domestic demand. That will be the challenge for the next group of leaders in China. The once-in-a-decade change in leadership will start in November 2012 and the new leadership will be in place in March 2013, and at the top of the agenda is how to reorient the Chinese economy to a more sustainable, domestic focus.From the U.S. elections to the Catalonia elections to the transition of leadership in China, November 2012 is proving to be a domino-like month. The next year could depend critically on what is set in motion in November.
EquitiesBy John Manley
October was a negative month for most of the U.S. equity markets. There were some exceptions, like the S&P 500 financials and utilities sectors. Financials were likely driven by some stronger-than-expected earnings from big banks while utilities were likely driven by both investor thirst for dividend yields and the end-of-month hurricane that hit the East Coast.
The support the Fed has provided through its third round of quantitative easing has done little to push the equity markets higher. It has provided, we think, a floor to equity markets since Chairman Bernanke and his group at the Fed seem determined to generate a wealth effect, whereby the Fed supports equity prices to make people feel wealthier to get them to spend more. This is a controversial and questionable approach, but it’s the approach they’re taking. That’s why we upped our trading range on the S&P 500 Index for the balance of the year. The fundamentals, we think, justify a 1,250–1,450 trading range, but thanks to the liquidity the Fed is providing, we increased that to a 1,370–1,550 range. The big question is whether the liquidity rally can morph into a growth rally. We think that depends on things outside the Fed’s control, like the taxing and spending policies of various governments.
Low expectations aren’t too tough to clearBased on our reading of analysts’ forecasts for earnings for the third quarter of 2012, the consensus is that earnings will decline in the third quarter. Indeed, the early read on earnings and revenues for the S&P 500 Index is that earnings per share (EPS) are lower, as is revenue per share (RPS).
Earnings have been a bit more robust than revenues for the third quarter. That’s what we’ve been expecting since global growth has been rather tepid. Corporations have been good about containing costs and expenses to prop up earnings in light of weak revenue growth. That can only continue for so long. The bulk of the cost-cutting has been thanks to companies refinancing debt at lower interest costs being able to trim the growth of payroll expenses. From this point forward, we like companies that focus less on the bottom line (EPS) and more on the top line (RPS).
It’s about companies you’re in, not countries you’re inBecause we think it’s more important to look for top-line revenue growth than bottom-line earnings growth, we think the market going forward is going to reward investors who find the revenue growers rather than the earnings maintainers.
With the political changes afoot, we think those companies that have already stripped out their cost-bloating fluff will outperform their peers. Interestingly, that may mean looking at sectors, industries, and companies that have been in embattled areas globally. Yes, we do mean globally. With the improvements in Europe, the transition of leadership in China, and election results in places like Mexico, we think a globally diversified portfolio makes more sense than the U.S.-centric portfolio we were recommending during the past year. In this environment, we’d encourage investors to focus more on companies than countries.
BondsBy James Kochan
The Treasury market recorded a second consecutive month of negative returns in October, as markets in Europe were relatively calm and U.S. economic data were somewhat better than expected. Treasury yields have tended to drift higher whenever overseas demand has not been robust, and that appears to have been the situation this fall. After two months of relatively poor performance, the year-to-date return from Treasuries is the weakest of any domestic fixed-income sector.
Table 1: Year-to-date bond market total returns (%)
The corporate markets continued to perform well in October, led by BBB and high-yield credits. In the investment-grade market, the top credits recorded returns of only 0.2%–0.3% last month, versus a return of 1.7% from the BBB credits. Bank debt continued to outperform, with substantially better returns than industrials or utilities in October and year to date. Among the high-yield sectors, CCC and weaker credits did not outperform BB and B credits in October. Thus far this year, however, CCC credits have returned 400 basis points (bps; 100 bps equals 1.00%) more than BB and B credits.
Negative returns from the mortgage market are relatively rare. Now, with mortgage-backed securities (MBS) to Treasury yield spreads exceptionally narrow thanks to the Fed’s purchases of $40 billion per month of mortgages, any backup in Treasury yields will apparently produce an equivalent rise in MBS yields.
The key story in the municipal market continues to be the substantially better returns from A/BBB credits. In October, returns from the AAA/AA sectors were close to zero, while BBB credits returned 0.7%. Thus far in 2012, a portfolio of A/BBB credits would have outperformed a portfolio of AAA/AA credits by almost 400 bps. The revenue bond sector has outperformed the general obligation sector by 200 bps thus far this year. Even with all the news reports about fiscal problems around the nation and a limited number of bankruptcies, there are few signs of heightened risk aversion in the municipal market.
Despite a considerable degree of volatility, yields in most segments of the bond markets remained within relatively narrow ranges in September and October. That will probably not be true in November and December. A host of developments, including the elections, the attempt to avoid the fiscal cliff, the need to raise the federal debt ceiling, and the outlook for tax legislation, could keep the markets on edge through year-end. We should probably expect tests of both the upper and lower bounds of the trading ranges in the weeks ahead.
Asset allocationBy Brian Jacobsen
Investment horizonsFor investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next three months, we think investors can still be rewarded by looking at higher-yielding fixed-income investments as well as growth-oriented equities.
EquitiesWithin the equity portion of a portfolio, long-term, we think investors should look globally for opportunities. There is no one sector or country that has a monopoly on opportunities. Eurozone and Japanese equities have been battered down, as have Chinese nonbank equities, to the point where we think they represent compelling long-term investment opportunities. There is also a profound amount of pessimism built into U.S. equity prices. We think all sectors have at least a nugget of investment opportunity, but we do still favor health care, information technology (IT), and energy.
Value versus growthThe U.S. election outcome will likely determine the regulatory environment and valuation potential of financial services, which tends to skew the growth/value dichotomy, but we think the U.S. and global economy will grow more rapidly over the next few years than what is embedded in stock valuations across the value-growth spectrum. We tend to prefer mispriced growth opportunities, which are those companies whose growth potentials are underappreciated by the general market. We see a lot of these companies in global health care and technology names. Notice: When it comes to technology, we are not just referring to IT. We mean all those companies that help other companies convert their inputs into outputs in a more efficient way.
Large caps versus small capsA good company is a good company, whether large or small cap. Generally, large-cap companies have easier access to credit markets and global markets than small-cap companies, but that is not always true. There are many large-cap companies that have cash burning holes in their executives’ pockets that could lead to imprudent acquisitions. As a result, we think it’s better to focus on corporate governance than size.
Fixed incomeBased on our economic outlook, we believe that interest rates are likely to remain low for the next year. This presents an opportunity for investors to take on additional duration and credit risk. Provided the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues would.
Asset allocation summary table1The blue bar on each diagram below represents our recommended tactical positioning for investors looking to make adjustments to their portfolios based on current market conditions. The green bar represents our recommended strategic positioning for investors with a time horizon of three years or more.
The bottom lineThe U.S. presidential and congressional elections are behind us. We now have the 2014 mid-term elections to look forward to. This is simply a reminder that we are always in a state of political change. That’s why we like looking at investments that are resilient to political changes. That means paying attention to global opportunities and the corporate governance of the companies you invest in.