Market Commentary
by Byron Wien

Yearning for Clarity


Almost everything happening these days seems to be adding to the uncertainty of the outlook.  The consensus had been that once the election was over, investors would have a better sense of what the United States economy would be like in 2013 and how the tax structure might change.  Once the ballot boxes had been stored, we had to deal with the aftermath of Hurricane Sandy, which had caused enormous personal and economic hardship.  As power resumed in the region, Washington focused on the so-called fiscal cliff.  Both parties showed a willingness to take steps to reduce the impact on the economy of the expenditure cuts and tax increases by January 1, but as yet no specific agreement has been reached.  In the Near East conditions deteriorated.  The violence in Syria continued and the conflict between Israel and Hamas in Gaza intensified, with missile attacks on both sides.  A cease-fire has now been negotiated.  Let’s hope it lasts.  In Europe Greece asked for a two-year extension in meeting its debt to Gross Domestic Product (GDP) targets, and finance ministers and other officials attended various meetings on structural change, but they still have not come up with a plan for greater fiscal convergence.  In China the leadership transition has taken place and more fiscal and monetary stimulus is planned, so at least there is some good news coming out of the world’s second largest economy.  Recent data shows the economy is improving.  

Against this backdrop it is hard to make serious investment decisions.  The Wall Street Journal reported that corporations are curtailing capital spending plans but with all that’s going on, that should not be front page headline news.  Revenues are only increasing modestly and operating rates are at 78%, so there is little need for building new plants and equipping them.  Since the end of the recession, companies have used their capital spending budgets to increase productivity.  Profits as a percentage of sales are peaking and corporate profits as a percentage of GDP are at a recent record.  Companies are functioning at maximum efficiency and unless managers see important sales increases, they have little reason to make capital investment decisions.

The uncertainties surrounding the fiscal cliff are also hardly reassuring to corporate managers.  The opening position of the Democrats is that the top tax bracket rate has to move from 35% to 39.6%, but the Republicans, while recognizing the need to raise revenues, would rather do this by eliminating some loopholes and limiting deductions.  Clearly more negotiation has to take place.  In my view we are likely to see a combination of tax increases and expenditure cuts amounting to 1.5% on a nominal GDP growth rate of 4%.  With inflation at 2% this would put real GDP growth just above the zero line.  Housing, however, is bottoming this year and should be contributing to growth next year, but it is unlikely that we will see real GDP much above 2%.  I am still worried that modest corporate revenue increases resulting from slow overall economic growth will make earnings improvement in 2013 difficult.  Companies have limited pricing power and some costs are increasing.  While most strategists and analysts are forecasting earnings progress next year, I believe that may prove too optimistic.

Every effort will be made for the parties to come to some conceptual agreement on the framework for dealing with the fiscal cliff before the end of the year, but the right approach would be to take a comprehensive look at the entire tax code rather than tinkering with a few provisions so a deal can be signed before 2013 begins.  If I were to handicap the probabilities I would put the likelihood of the top bracket tax rate being raised to close to 40% very high, but there might be some flexibility by the Democrats on where the top bracket begins in order to bring the Republicans on board.  Raising the break-point to $1 million, as had been discussed, is out of the question in my view, but $500,000 is a possibility.  While the Republicans are committed to not raising tax rates, Obama is determined to have the wealthy pay “their fair share,” so this is an issue that will not be easily resolved.  Those of us in the financial services industry, especially in New York, may have a distorted sense of the definition of “wealthy.”  Remember, in Washington very few elected or appointed officials make more than $200,000 and the President may be influenced by that.  

I also think that the tax rate on dividends and capital gains is sure to go up.  I would put both at 20% plus the 3.8% surcharge to help pay for the Affordable Care Act.  The expectation that these taxes will increase has caused heavy selling of appreciated holdings by individuals wanting to reap their profits before year-end.  Fear that a cap will be placed on charitable contributions has also caused many to give securities with large capital gains to institutions who then sell them in the open market, putting additional pressure on prices.  These factors help explain the poor market performance since the election.  It is unclear when this will end, but it should create some buying opportunities in recent winners along the way.  There has been selling of high-dividend-paying stocks as a result of the anticipated changes in the tax code.  Ned Davis Research has pointed out that for the last 60 years the Standard & Poor’s 500 dividend yield has been 1.4% points below the 10-year Treasury yield on an after tax basis.  As of October 31, it was .64% above the 10-year Treasury.  The differential would still be above the Treasury if taxes on dividends were raised.  As long as the Federal Reserve remains accommodative, dividend payers should remain attractive relative to non-payers.

The payroll tax cut which was extended last year affects most working people but there is limited support for continuing it in its present form for another year.  It is unlikely to end abruptly; a gradual roll-off would be less disruptive.  There are a number of other items such as jobless benefits, physician payments, the sequestering of funds for defense and healthcare, and adjustments in the Alternative Minimum tax that are on the table and both parties will attempt to defer some of these.  If the whole fiscal cliff of $600 billion–plus were to hit in 2013, the economy would almost certainly slip back into recession or something very close to it and neither political party wants to be responsible for that.

I also think that we are going to see some government programs cut.  The big items are healthcare, Social Security and defense.  Of the three, the defense budget is most likely to be substantially reduced. I think a commission will be formed to take a thorough look at defense expenditures because it would be hard to make serious progress in reducing defense programs in Congress without an impartial body making recommendations.  Almost every state has a defense contractor or military base or both and no member of Congress is going to vote for trimming back a program or facility in his or her district with the resultant elimination of jobs.  In healthcare we have to move away from pay-for-service to a more results-oriented system.  Healthcare costs in the United States are in the high teens as a percentage of GDP, substantially above the level of Europe, which has a comparable level of care.  There is much waste and fraud in the system and this has to be addressed.  Social Security is somewhat sacrosanct, but while the present retirement structure might be maintained for those 55 and over, perhaps changes could be implemented for younger people in the work force not yet approaching retirement.

The idea of eliminating tax preferences for certain industries like oil and gas and real estate is surely going to be considered.  So will limitations on deductions for charitable contributions, mortgage interest and state and local taxes.  There are special interest groups that will be fighting hard to preserve these preferences and deductions and that is why I think the whole process of dealing with the fiscal cliff will spill into next year.  It will take some time to deal thoughtfully with all of these issues.  Those who worry that higher tax rates will discourage entrepreneurs are countered by economic historians who point out that during the 1960s the top earners were paying a marginal rate of 70% and the economy continued to grow.  The United States was in a different competitive position relative to the rest of the world back then, however.  Europe and Asia were still recovering after the war.

Another issue is the debt ceiling, and we may be approaching this faster than is widely believed.  There is general agreement that Washington will have to deal with it before March, but I have seen data indicating that we could hit the $16.394 trillion limit as early as December 8.  We were at $16.242 trillion on November 14.  When the current limit was established there was agreement that the increase from $15.25 trillion to the current level would be matched by spending cuts, but I don’t believe Washington has taken that trade-off seriously.  What will probably happen is that the whole debt ceiling issue will be folded into the fiscal cliff negotiation.  It cannot be ignored.

Perhaps the most distressing aspect of America’s current financial predicament is that we are weighing the merits of various expenditure cuts and tax increases that will surely slow an economy with a record number of people out of work 27 weeks or more and more people on food stamps than ever before.  And because we are so focused on cutting government programs we cannot consider any major program to improve our decaying infrastructure or deal with the fact that we, the largest economy in the world in terms of GDP, are a country whose 15-year-olds rank 22nd in the world in reading, 21st in science and 29th in math.  We are considered the leader of the free world, but will that be true several decades from now?

There is not much new to report on Europe.  The continent is in a shallow recession now and the leaders of the key countries continue to work towards some form of fiscal integration.  The key risk continues to be that social unrest related to the implementation of austerity programs in the various countries impedes the ability of their governments to agree to the formation of a banking union, to provide deposit insurance and to agree to supervision of the budgetary process by the European Commission.  Much of what needs to be done requires giving up some sovereignty by the various countries, but that is going to be necessary if the European Union is going to endure in the long term.  So far the burden has fallen on the European Central Bank to provide the liquidity to enable the countries in trouble to meet their obligations, but this cannot go on forever.  We need to see structural changes begin soon. 

If the cease-fire were to break down and Israel were to send troops into Gaza, its fragile relationship with Jordan and Egypt would be threatened and the tenuous stability in the Middle East would be endangered.  The prospect of continued uncertainty on its western border might influence Israel’s willingness to mount an attack against Iran’s nuclear facilities.  Missiles manufactured in Iran and capable of reaching Tel Aviv and Jerusalem have come out of Gaza.  With its population experiencing injuries, loss of life and fear as people seek refuge in bomb shelters, it is unlikely that Israel would want to escalate its military commitment in a conflict with Iran which would be even larger in scale.  Last week the International Atomic Energy Agency reported that Iran had completed equipping an underground facility capable of producing weapons-grade uranium.  I had hoped that the decline in Iran’s currency and the hardships endured by its population as a result of the international sanctions would increase the likelihood of negotiations leading to a scale-back of the nuclear weapons program.  That seems less likely now.  Continued unsettled conditions and strife in the region means higher oil prices.

With the resolution of many issues in doubt it is not surprising that the markets are wavering.  Hopefully we will have greater clarity on some of these before 2013 begins, but we have to plan for continued uncertainty.  The markets are fairly valued so a major decline is unlikely, but a significant move higher is improbable also.

Finally a brief post-mortem on the election.  Considering the weak state of the economy and his low approval rating it is surprising that Obama and the Democrats did so well.  As the conservative commentator David Frum pointed out, he took all the swing states he targeted and had a 55-45 margin of victory beyond the southern Republican stronghold.  Superior technology helped Obama, but it probably didn’t play a role in the Congressional races and the Democrats picked up eight seats.  Romney moved to the center too late (during the first debate).  He needed to appeal to the die-hard social conservatives and the Tea Party during the primaries, but should have expressed his inherent moderate thinking right after that.  The Republican Party failed to recognize the importance of the changing demographics in America.  Its policies were not embraced by Hispanics, African-Americans, younger women and youth generally.  The Democrats seized on these weaknesses.  While Romney was campaigning for the nomination, they registered likely voters sympathetic to their policies and worked hard to make sure these people got to the polls on election day.  I think the voters were also confused about where Romney really stood on many issues and whether his economic plan would really work.  He might have fared better if he had picked Rob Portman of Ohio rather than Paul Ryan as his running mate.  In any case the Republicans will have to rethink their strategy, focusing on the social issues and population breakdown of the America that now exists, or they will have trouble in 2016 as well.

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