Market Roundup - December 2012
December: Will U.S. politicians agree to agree?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Despite the negative moves in the stock market after the presidential election, stocks at the end of November were actually up—but barely. Although it may be tempting to ascribe a lot of the market moves to the ongoing debate about the fiscal cliff, that would be ignoring many other factors driving the markets, for example: developments in Europe, China’s manufacturing beginning to accelerate, the impending elections in Japan, and the ongoing problems in the Middle East. By comparison, the fiscal cliff is more of a divot than a major driver.
The economyBy Brian Jacobsen
Third quarter gross domestic product (GDP) for the U.S. was revised up from 2% to 2.7%. Export growth ended up, adding to rather than subtracting from growth. Consumption spending grew more slowly than originally estimated, but inventory accumulation drove the bulk of the revisions. While 2.7% is a good growth number, the quality of growth wasn’t outstanding. Growth from inventory accumulation can be transitory, especially if sales don’t pick up.
Growth for the fourth quarter of 2012 is likely to slow, due to not only the disruption of economic activity due to Hurricane Sandy but the ambiguity caused by the ongoing debate about what to do about U.S. tax policy for 2013. This type of uncertainty can make consumers and companies sit pat for a bit, waiting for clarity. Depending on how the debate in Washington is resolved, we may see a continued slowdown in the U.S. going into 2013.
When evaluating what’s likely to play out in Washington, we think it’s important to look back to December 2010—when the Bush-era tax cuts were first set to expire. It wasn’t until November 30 that politicians even began to discuss an agreement. Within seven days, a deal was struck. We suspect that if a deal isn’t done within the first week of December, investors might get impatient with politicians and try to force their hand. We’d view that as a buying opportunity, though. Most likely, policymakers will come to an agreement to extend policies temporarily and to work on a more comprehensive agreement in the future. Politicians would, effectively, be agreeing to agree some other time.
We’d only become concerned if politicians agree to disagree and get nothing done. That would signal a type of political paralysis that would likely persist until the 2014 mid-term elections. While the actual economic effects of the tax increases and spending cuts that are part of the fiscal cliff would likely shave growth from 3% in 2013 to 0%, that’s hardly a devastating outcome. It’s not good, and it could keep market valuations from improving, but we don’t think it’s a reason to panic. Be concerned? Yes. Panic? No. The real effect the fiscal cliff negotiations will have will be on expectations about future policy changes and how the actual deal that is struck will change this outlook. In other words, the tax increases and spending cuts might not be as important as what the agreement says about future tax increases and spending cuts.
Housing is beginning to make contributions to economic growth. That will likely continue, if not accelerate. The Federal Reserve (Fed) is meeting on December 11 and is likely to announce that it will convert its current policy of selling short-term Treasury securities in exchange for longer-dated Treasury securities into a flat-out purchase program. While the Fed is buying $40 billion per month in mortgage-backed securities, it could increase that amount to help keep mortgage rates at record low levels. Keeping financing cheap is pretty much all the Fed can do to actually spur the economy on.
One place where monetary policy may abruptly change is Japan. A new election has been called, to take place on December 16. After rising to power in 2009, the Democratic Party of Japan (DPJ) is likely to lose power to the Liberal Democratic Party (LDP). The DPJ has not done much to help Japan get out of its deflationary trap, and the LDP has been very vocal in saying that the Bank of Japan (BOJ) should target a 2% rate of inflation. If the LDP takes power, as expected, investors should watch whether legislation is proposed that would effectively strip the BOJ of its independence. While a little inflation would probably help Japan, getting that inflation by compromising the independence of the country’s central bank could turn a little inflation into a lot over time.
While the European Central Bank (ECB), the International Monetary Fund (IMF), and the European Commission (EC) agreed to ease the debt reduction targets for Greece in order to release the next tranche of financing due to the Greek government, the decision was not made without acrimony. The IMF wants Greece to reduce its debt-to-GDP ratio more aggressively than either the EC or ECB wants. To realistically reduce Greece’s debt ratio would likely require official sector lenders to write down the amount owed, to lower the interest rate charged on loans, and to extend the maturity of the loans. The write-downs are the most controversial dimension of this debt debate. A write-down likely wouldn’t sit well with the German public, and 2013 is an election year in Germany, with Prime Minister Angela Merkel going up for reelection in September or October.What would give investors even more relief than a reprieve in the Greek debt drama would be a bailout for Spanish banks. However, Prime Minister Rajoy is still reluctant to ask for aid. The markets may need to force up the interest cost of Spanish debt to prod him into action.
EquitiesBy John Manley
November was supposed to bring us change and certainty. Instead, little changed, and the uncertainty became more ingrained in our political system. After the expenditure of billions of dollars and trillions of unkind words, we are back to the same political leaders we had six months ago. We have the same president and the same leadership in the House and Senate; and now we know that we will have them for some time. We will have to get used to them, and they to each other.
While the potential economic damage of pre-ordained tax increases and spending cuts have brought both sides to the negotiating table, we expect these talks to be bitter and contentious. The concessions that each side expects of the other are contrary to hardened philosophies and will require the repudiation of promises and the tarnishing of ideals. They cannot appear to be lightly undertaken.
Each side must posture and challenge the other. At first, intransigence must appear a virtue and the willingness to compromise a sign of weakness or even panic.
The market’s reaction to the election gave us a preview of what is in store for the fiscal cliff debateSince the election, the fiscal cliff has been the topic of discussion. In our opinion, the equity markets’ sharp sell-off in the first two trading days after the votes were counted gave us a preview of what is in store if Christmas approaches with no real deal in sight. Investors may give politicians the benefit of the doubt at first, but they will punish both sides if positions harden before common ground is reached. While we believe that a sharp equity pullback is possible, we suspect its very speed and sting will make it shallow. We gauge the risk in the short run to be about five percent.
More importantly, we believe that an equity pullback would force the issue. No one wins in a stalemate, and both sides can hope to claim credit if a budget-shrinking compromise is achieved. We advise you to buckle your seat belts for December, but keep your eyes fixed on 2013.
Overall, November was not a bad month for U.S. equitiesAs it was, November was not a bad month for equities in the U.S. The S&P 500 Index gained a modest 0.6%, but the Nasdaq Composite Index, with its heavy technology weighting, added a very respectable 1.4%. Smaller stocks outperformed, and the market’s advance appeared to be fairly broad. The Dow Jones Industrial Average lost -0.1%, while the Value Line Composite gained 1.6% (arithmetic) and 1.2% (geometric). The Russell 3000® Growth Index gained 1.6% in November, while the Russell 3000 Value Index was flat. We suspect the latter was adversely affected by the increased potential for an unfavorable regulatory environment for the financial industry.
Among the sectors, the consumer was king. Despite the potential for higher income taxes in 2013, the consumer discretionary sector led the pack with a solid 3.2% return. Cyclicals, in general, tended to outperform. Both the materials and industrial sectors gained 1.7% in the month. Even the depressed information technology sector managed to advance 1.1% in November and get back a bit more of the 5% it had dropped in the prior two months.
Big dividend payers were at a disadvantage. The utilities sector proved to be a large drag on the market, with a 4.3% decline. The telecommunication services sector (which is dominated by a few large-capitalization, high-dividend-yielding stocks) fell back 0.9%. Also on the defensive were energy (down 1.4%) and financials (down 0.8%). We see value in the energy sector, with a chance for long-term appreciation. In financials, we do not see exceptional value, but we do sense the real risk of a substantially more challenging regulatory environment.
In summary, the U.S. equity market rose and seemed to shrug off the prospects of higher taxes and more stringent regulation. However, those fears did seem to show up within the sector and group performance.
A number of foreign equity markets also did well in NovemberThe most interesting equity market developments occurred outside of the U.S. The stock markets of almost all of the developed economies outperformed the S&P 500 in U.S. dollar terms. Japan rose 5.8% to lead the way. Despite talk of growing economic weakness, the performance of the European stock markets was almost entirely positive. France led with a 3.9% gain, followed by Switzerland with a 3.4% advance. The UK, the Netherlands, and Italy all rose about 2%, and even Greece beat the U.S. with a 1.0% gain.
We believe that these markets are looking beyond current economic weakness to the “less austere austerity” that they believe will come. Since the beginning of September, we have encouraged long-term investors build positions in these markets. We continue to do so.
Among the emerging markets, China was the weakest, falling 4.1% in U.S. dollar terms. Although downward pressure continues in China, we would invest in the industrial sectors while avoiding the financial sector. Other areas of strength were (all in U.S. dollar terms): India (up 3.4%) and Argentina (up 2.6%). Mexico and Hong Kong both added 1.8% in the month.
Resource-dominated markets lagged. Norway was up only 0.8% (all of it due to currency), and Russia eked out a 0.2% gain.
BondsBy James Kochan
The municipal market easily outperformed the rest of the bond market in November, as investors apparently decided that higher marginal tax rates are inevitable and will increase the demand for tax-exempt income. The strong November returns pushed the year-to-date return for the municipal market index to an astounding 630 basis points (bps; 100 bps equals 1.00%) above the return from the Treasury market. Moreover, in a month in which the taxable markets experienced a modest flight to safety, the A/BBB segments of the municipal market continued to outperform the AAA/AA segments. Last month, that outperformance was approximately 50 bps. Over the past 11 months, the A/BBB credits have outperformed the AAA/AA credits by approximately 400 bps.
Treasuries were the second-best performers in the taxable markets, ending a three-month string of negative returns from the 10- and 30-year maturities. Yields remained within relatively narrow ranges during the month, but even small declines in the longer maturities were sufficient to produce total returns above 1% for the 10-year notes and the bonds. The year-to-date return from Treasuries remains one of the weakest of any taxable sector.
Table 1: Year-to-date bond market total returns (%)
The power of incremental coupon income was apparent in the corporate market in November. Yields were flat to slightly higher in both the investment-grade and high-yield markets, due to a combination of profit taking and some resistance to what had become record low yields. Substantially greater coupon income from the high-yield bond market allowed it to post a positive return, while the investment-grade index recorded a negative return for the first time since March. The weakest credits within those markets, the BBB and CCC segments, recorded somewhat weaker returns than the stronger credits. That has been the typical pattern for months in which the corporate markets struggle somewhat.
The mortgage market performed poorly for the second consecutive month. After plummeting to near zero in September in response to the Fed’s decision to buy $40 billion mortgage-backed securities per month, mortgage spreads increased in October and most of November, to around 50 bps. While still about one-half what would be regarded as the typical spreads, the current spreads might be sustainable in a market where net issuance is extremely weak and the Fed is a big net buyer.
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 non-bank equities, to the point where we think they represent compelling long-term investment opportunities. In Japan, there is the risk that a rapidly depreciating yen could offset any gains in securities in local-currency terms, so the outlook for monetary policy in Japan will need to be closely monitored. 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.
Value versus growthWe think the U.S. and global economies 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 information technology. 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 media is obsessed with the fiscal cliff debate, but the coverage of this issue ignores a lot of other market drivers. The upcoming election in Japan and the ongoing problems in the Middle East (Egypt, Iran, Syria, and the Gaza Strip) all merit monitoring. As hard as it may be to believe, the markets aren’t just all about the fiscal cliff. In the end, we think politicians in Washington, D.C., will agree to agree, meaning that they’ll effectively punt the problem into the next session of Congress. This would create a relief rally in the markets.