Whether you followed Mayan calendars, Hopi legends, Chinese ancient texts, the mysterious Planet X, or simply wondered about interesting number combinations on the calendar, the fact that you are reading this indicates that you have made it past most popular myths about the end of the world. I wish we could state the same for the Fiscal Cliff negotiations, though the US Government appear to be following the Greek calendar (modern, not ancient). The main battle areas have been taxes and entitlements, with some unusual proposals thrown into the mix. One of the those is an idea called Chained CPI (Consumer Price Index), which attempts to find an inflation rate that could account for changes in spending habits, rather than the currently used fixed basket of goods method of calculating CPI. The original deadline for Fiscal Cliff negotiations was 21 December 2012, based upon a planned recess of Congress until early January. Some form of a compromise was expected by that time, though Speaker of the House John Boehner choose to put forward a "Plan B" limiting tax increases to those with incomes over $400k annually. After an all-too-common procedural vote, Plan B was brought to the floor of the House of Representatives for discussion, despite that it was unlikely to pass a vote in the Senate. The measure failed to go forward to a vote, as Representative Boehner realized that a large group of Republican House members opposed any tax increases. In the absence of some form of compromise, provisions already in place from late 2011 will allow taxes to increase for everyone. The fall-out of this failure may cause a change in leadership in the House of Representatives, with Representative Eric Cantor a likely successor. There remains a slight possibility some form of compromise, and a quick vote, will happen prior to the end of 2012, though with a comprehensive deal unlikely, we may see a bit more can kicking with temporary measures passing to force negotiations into the middle of 2013. There are two major problems with pushing negotiations further into 2013. The first issue is that immediate spending cuts may cause a decline in funding that negates the slight recent improvement in the US economy, possibly tipping the country into another recession. The second risk is that Moody's and Fitch Ratings may downgrade the credit worthiness of the United States by the end of 2013, followed by ratings decreases of major corporations, which would increase borrowing costs across the United States.
There is a much bigger issue in Fiscal Cliff negotiations, and economist Michael Feroli of JPMorgan points out that whether short term measures, or ten year planning, current efforts do almost nothing to address the longer term debt trajectory of the United States. Fixation on a ten (10) year budget misses the chance to create lasting improvements in national debt under a 20 or 30 year time period. Perhaps a little controversial, though the implication is that politicians are attempting more to boost their reputations amongst the electorate, rather than creating lasting solutions. In mid December it appeared that Fiscal Cliff negotiations were much closer in concept and proposals than politicians led the public to believe, so the idea that discussions become more politicized is not too far off the mark. Since the United States is still the world's largest economy, failure to resolve differences could lead to a 0.5% contraction in the US economy, and impact many countries in Europe already in recession. The automatic spending cuts will affect the majority of small businesses and most individual tax payers, though larger corporations are unlikely to increase capital expenditures until a clear direction is decided amongst politicians. The late night failure of Plan B led to a steep sell-off in stock markets, though the S&P 500 did end up 1.17% on the week. The last trading week of December is likely to see much shorter volumes due to Christmas holiday, so greater intra-day volatility is likely, though any further sell-off may not happen until early January 2013, if at all. Oddly enough, a Reuters poll of market analysts found that most expected global stock markets to gain towards the end of 2013, even if a European recession and Fiscal Cliff impasse rattle markets early in 2013.
There is some room for optimism, with China moving to alter the exchange rate of the Yuan to allow for more flexibility. This is a necessary move to enable the Yuan to be used more often in global trade, since currency pegand trading restrictions create an artificial value to China's currency. There have been numerous news articles about unusual transaction and collateral moves in China, such as hording raw materials, so the Chinese government may be reaching a point where looser exchange policies are inevitable. Combined with potentially lower US Dollar (USD), Japanese Yen (JPY), and Euro (EUR) values in 2013 due to additional stimulus measures, the timing Yuan (CNY) flexibility may result in very little volatility. Russell Emerging Markets Funds estimatesChinese corporate earnings may increase at least 10% in 2013. Goldman Sachs also projected increased economic growth through 2013 in China. After recent elections in Japan brought Prime Minister Shinzo Abe back to power in a landslide victory, there was little surprise that the Bank of Japan increased their inflation target for 2013, on the back of further asset purchases and stimulus measures. We may see some pressure on the currently high JPY valuation, which could bolster the export market for Japan, though it has been decades since the Japanese economy influenced world markets in a major way. Targeting higher inflation will push Japanese consumers to spend more sooner, in anticipation of higher future prices of goods and services, though this will create demand upon the Bank of Japan to increase the amount of currency in circulation. While this money printing serves to devalue the Yen in the near term, potentially helping exports, few investors are willing to bet against Japan, especially with European economies still showing little sign of improvement. The more immediate worry of Shinzo Abe returning to power in Japan is that he may push the government to take a more hard-line stance against a Chinese territorial claim over disputed islands. The main issue is not the uninhabited islands, but instead the right to pursue offshore drilling for oil and natural gas. In the latest move in this dispute, China attempted to use geological characteristics of the continental shelf to bolster their claim to these disputed islands. So far the dispute has been peaceful, though Chinese consumers have greatly curtailed spending on Japanese branded products, and there have been some protests near Japanese owned factories in China. There are some economic incentives for Japan and China to work together to solve this dispute, though a break-down in discussions could impact markets in 2013.
Fitch Ratings has warned that a failure to resolve Fiscal Cliff differences could derail the recovery in US housing markets. While the Fiscal Cliff is discouraging investment, corporate spending, and hiring, in the near term the impact is more psychological than damaging. As we saw with the JPMorgan analysis above, real improvements in the US economy are being overlooked as the news focuses on Fiscal Cliff discussions. When we compare unsold housing inventory to GDP growth, we find some correlation in the downturn to the US economy with a growth in unsold housing inventories beyond one year. While much of the current economic crisis has been driven by banking sector troubles, the growth of unemployment has been fuelled by a decline in construction workers. This is a slightly loose correlation, though house building and increased demand for properties can drive the economy upwards in 2013. Housing has been the bright spot in the economy this year, so this idea is one theme investors may want to exploit further into 2013.It would be tough to write an article without mentioning Greece, which has been the country to follow this year for potential negative market impact. Greece is finally moving to tackle tax evasion, possibly due to a great shortfall in expected tax revenues. There remains a need for Greek leadersto draw a plan to move Greece forward, though A move by the European Central Bank (ECB) to once again allow Greek bonds to be used as collateral will stabilize the credit sector in Greece. One final hurdle that Greece overcame was a court challenge in Germany over the legality of Greek bond purchases by the ECB and usage of Greek bonds as collateral. A lower European Court threw out the case as manifestly inadmissible, clearing the way for the action by the ECB; this case also affects ECB purchases of Portuguese, Spanish, and Italian bonds. Greece still has a long way to any real recovery, and the economies of Spain and Portugal are still lagging behind. Progress is definitely being made in Europe, even if it is slow and there remain hurdles ahead. As independent investors we should be careful to watch for speculative moves in stock markets, and instead focus on areas where markets have improved. Negative events in 2012 are now behind us, and even those Argentine sailors stalled in Ghana (on moves by a hedge fund to collect on unpaid Argentine bonds) are once again sailing across the Atlantic Ocean. So with some positive prospects for 2013 ahead of us, we'll be seeing again in 2013 in our next article. We wish you all a Merry Christmas and a Happy New Year.
G. Moat
