Fiscal Pothole

Welcome to the start of a new year. Hopefully all of you had an enjoyable New Years, and are starting off 2013 with a fresh outlook. The same might not be said for politicians in Washington, D.C. who staged a very late night vote to make deals to avoid the Fiscal Cliff. Most stock markets around the globe reacted positively on news that a deal passed the Senate and House of Representatives, though considering the build-up to the vote, the gains in markets appear to be more of a relief rally. The Legislative Branch is empowered to pass spending bills prior to the start of each fiscal year, yet since 1996 it has repeatedly failed to accomplish that task. The previous temporary measures were agreed to in August of 2011, at a time when a failure to negotiate led to sharp market declines. When the first measures passed the Senate early on New Year's Day, the Congressional Budget Office estimated that the deal would add $4 trillion to US debt. The House of Representatives voted on the measures prior to the opening of US stock markets, though the measures that passed should be of continuing concern. President Obama signed the bill into law on 3 January 2013. Of some benefit is extension of Bush era tax cuts, though over the next decade taxes will increase on Americans earning over $400K per year. Capital gains taxes, and taxes on dividends, return to the old rate of 20% instead of the more recent 15%. The deal means taxes increasing for 77% of Americans. What we will need to watch is that previously agreed automatic spending cuts are only extended for two months, which sets the stage for more tough negotiations in March 2013. The deal made on the Fiscal Cliff does nothing to address long term tax reform, nor long term entitlements. Even the IMF suggest that the United States could do more to address long term debt levels. We are likely to see more battles as the debt ceiling approaches, since the US Treasury have indicated that they can only avoid hitting the debt ceiling for about two months. When measured under normal circumstances, the United States already hit the debt ceiling on 31 December 2012. After that the only options beyond defaulting on US Treasuries would be withholding payments to Federal workers, soldiers, or recipients of Social Security. Uncertainty over the outcome held back financial markets in late 2012, so it should not be surprising that we are seeing solid buying volume on stock markets, but this is unlikely to last. On Thursday 3 January 2013 Representative Boehner was reconfirmed as Speaker of the House in a narrow vote, which sets up the next battle over the debt ceiling and further spending cuts.
The latest private sector payrolls report from ADP and Moody's Analytics indicated 215000 jobs were added by private employers, up from 148k in November, and much higher than an expected gain of 133k. There is some criticism of the latest ADP figures that occurs each December, usually blamed upon an accounting quirk, so we might actually see these figures restated next month. The November APD Jobs Report was revised from 118k to 143000. The Department of Labor released unemployment claims data that was estimated due to a lack of information from nine states, including California and Virginia. Initial unemployment claims appear to have increased to 372000 (seasonally adjusted). While I expect some restatement of figures, the trend through 2012 was a slight improvement in employment. Some analysts at Goldman Sachs (GS) and Credit Suisse (CS) are expecting continued employment improvements in early 2013. CME Group project unemployment in the US will decline below 7% by the end of 2013. We can see some of the affects of this trend through increased retail sales. However, the holiday shopping season retails sales indications indicate some retailers doing far better than others. We still do not have figures from retail giants Walmart (WMT) and Best Buy (BBY), though discount stores appear to have seen increased retail sales. The impacts of Hurricane Sandy, headlines about the Fiscal Cliff, and sombre mood following the Connecticut school shooting were thought to have held back holiday spending. Mastercard affiliated research firm SpendingPulse indicated retail sales that they track grew 2% more than in the 2011 holiday shopping season. This holiday shopping season could prove to be the weakest for retailers since 2008.When we consider the long drought conditions across much of the United States in 2012, we expect higher food prices will limit retail sales in early 2013. Guns sales and applications for gun permits increased to historically high levels through 2012. Auto sales slightly increased in December for some domestic auto companies, though not enough to offset large gains through 2012 for Japanese rivals. The biggest gains were posted by Volkswagen Group in 2012 with a 31% increase in sales. Upcoming debt ceiling negotiations may cause some slowing of auto sales in the first quarter of 2013, mostly over uncertainty about the direction of the economy in the United States.
Ratings agency S&P commented that they did not feel the Fiscal Cliff deal changed the outlook on the United States for 2013, though they did state that the risk of a recession had been reduced. S&P Ratings project 2013 US GDP growth at 2.2%. Moody's Rating is taking a wait-and-seeapproach to the United States, based upon the expectation of more fiscal negotiations. Moody's has indicated that more actions may be needed to maintain a AAA rating. So far Fitch Ratings have yet to comment about the outlook for the United States, but we have found several other market analysts and gurus weighing in with predictions for 2013 market conditions. Steen Jakobsen, Chief Economist of Saxo Bank, identifies some potentially negative market moving events of which we should be watchful. He points out that the debt burdens and fiscal deficits now in place are the highest since World War II, largely on the back of continual extend-and-pretend policies. He rightly points out that many investors now watch changes in central bank policies and liquidity operations in order to judge market direction. It is like markets are addicted to stimulus, and real levels are unreachable without central bank intervention. In some ways we can expect that the bottom of the markets in 2009 will not be seen again, all due to central bank activity to avoid a repeat of that huge sell-off. If you follow that link from Saxo Bank, there is a PDF with 10 predictions for 2013. Of that list, one of the more interesting items is 30 year US Treasury yields, which Saxo Bank expect to see increase. Currently global bond markets hold three times the invested funds of stock markets, mostly with little to no yield. Despite announcements that the Federal Reserve and the European Central Bank will continue buying sovereign debt to keep interest rates low, there is no guarantee that investors will stick with bonds. Total bond issuance in 2013 is expected to decline in most countries. This may temper demand somewhat, though issuance is expected to increase from the United States, Canada, Russia, India, and China. If we see a correction in bond yields, then it may signal a good time for investors to move some funds back into bonds. Some corporate bonds proved to be better investments in fixed income in 2012 than highly rated sovereign bonds. In a diversified portfolio, it is almost always a good idea to have a portion of investments in fixed income funds. M&G Investments highlights some of the bright spots in fixed income in 2012. While M&G Investments do not expect fixed income markets to perform as well in 2013, they do point out that taking some risk is a necessary part of generating investment gains. Byron Wein of private equity giant Blackstone Partners recently released his ten predictions for 2013. Of note are the S&P falling to near 1300, financial company stocks struggling, further drought impacting food prices, and gold reaching $1900 per ounce on continued Central Bank stimulus and currency debasement.
Argus Market Research points out that economies in Europe appear to have stabilized, as purchasing managers indexes showed slight improvements in December 2012. On a global basis, the International Monetary Fund (IMF) is expecting 3.6% growth in 2013, led by China and India. Many countries in Europe are expecting to be in recession throughout 2013. In France, one of the largest economies in Europe, the number of unemployed reached 3.132 million people, the highest level since 1998. Tough austerity measures are also beginning to have a negative real affect in Portugal, who are now asking the IMF and European Union to give some form of relief on continued demands. Investors may want to watch European markets, and shares of European companies with listings in the United States, to see if some buying opportunities appear. It is important to keep in mind that while Europe may be at a bottom, there is a long way to go until meaningful economic recovery and growth return. Despite the high growth rate projections for China, Argus Research point out that South Africa still has a higher GDP per capita and Brazil is even higher in GDP per capita. Investors may find several opportunities in companies headquartered in South Africa and Brazil, though the political climate aspect of risk is different than that found with US and European companies. South America may prove to be a good investment choice in 2013, as indicated by the recent upgrade by S&P Ratings for Chile from AA- to AA+. We can also expect to read more about problems in Greece, as highlighted in a report released on Christmas Eve. The report highlights the difficulties of Greece in collecting an estimated €53 billion (Euros) of outstanding taxes. In that report, the European Union and the IMF suggest that only about 20% of that amount might be collectable, and that Greece needs more people to investigate the largest debtors in Greece. We might reasonably expect more write-downs of Greek debt, new bailouts, or further missed targets in 2013. Despite numerous predictions of a Euro collapse, or an exit of Greece from the Eurozone (called a Grexit), 2012 proved that Europe can bounce back, though the road to full economic recovery will be slow. However, problems do remain to be solved in Greece, perhaps best highlighted by the discovery that the former Prime Minister Papaconstantinou was directly connected to four names removed from a list of possible tax evaders provided by the IMF to the Greek Minister of Justice. Given the revelations of corruption in Greece, it should not be too surprising that someone in the Greek government altered the IMF list (also called the Lagarde List) to remove names of politicians and their family members who have large Swiss bank accounts outside of Greece.
Overseas investments always present different risks, as highlighted by an unusual incident in China where Citic Trust Company delayed an interest payment to investors due to one of it's debtors missing a major payment. Researchers at the Federal Reserve note that the rebound in China's economy is uneven, and that demand for loans in China have decreased, which puts into question the IMF's projection of 8% growth in 2013. Also of note in that report, due out in full this month, is that inventories of raw materials have risen to very high levels. We may see a sharp decline in commodity prices in early 2013, considering that China is a very large purchaser of raw materials from around the world. Official Chinese government figures on the state of their economy are always open to scepticism, though global bank HSBC have a fairly reliable research team looking into the Chinese economy. The December HSBC survey of purchasing managers index, in China, indicates an improvement in economic conditions, with a 51.5 PMI reading being the highest since early 2011. There is a great set of data available at this link for the latest HSBC figures on China's economy, and it is notable that growth has stagnated for most of 2012. It remains to be seen if new leadership in China can usher in a new era of renewed growth. Global mining giants BHP Billiton (BHP), Rio Tinto (RIO) and Vale (VALE) may experience reduced revenues due to price declines on iron ore and other raw materials due to slowing demand. Investment bank Barclays Capital encourage buying gold on dipsthroughout 2013, and they project a decline in the Japanese Yen (JPY). Upcoming Basel III bank regulations, with 2013 target capital ratios ahead of 2018 compliance, may affect gold markets through the year. The Japanese Yen has been falling against the Dollar (USD) and Euro (EUR) recently, partially on the promise by newly elected Prime Minister Shinzo Abe to push the Bank of Japan to directly purchase Japanese government bonds in order to stimulate the economy. Such a policy shift is active currency devaluation. When combined with gains in the Euro and an improved US economy, it is not surprising to see the recent moves in the Yen.
In our watch of global macro events that could affect economic conditions, our first surprise of 2013 comes from a rare speech by North Korean leader Kim Jong-un. In that speech he called for an end to the conflict with South Korea, possibly in an appeal for further aid and assistance. It's too early to tell how genuine the intentions were in that speech, though obviously an end to conflict with North Korea could boost economies in northeast Asia, especially the economy of South Korea. The other possible reason behind the move by North Korea may be the success of continued tough economic sanctions against Iran. As Europe and the United States moved to isolate Iran economically, Iran damaged their internal affairs by attempting to enact currency control and a new currency exchange. Some analysts feel it is only a matter of time for Iran's nuclear ambitions to be successful, but it is not clear that the people of Iran will continue supporting the current ruling group. The continued decline of Syria, and changes in North Africa due to Arab Spring events, may prompt more changes in the Middle East and Near East. During research and compilation of this article, some news is arriving that Venezuelan President Hugo Chavez may be in his last days, or perhaps is already dead. If Chavez fails to appear for 10 January 2013 inauguration, Venezuela would stage another round of new elections. Hugo Chavez has been fighting an unspecified form of cancer, and has been seeking treatment in Cuba throughout much of the last year. Venezuela is one of the largest oil producing countries in the world, though production has declined as Chavez moved to nationalize much of the oil industry, ceasing assets from private companies. Obviously expanded conflict zones or collapses of ruling parties could affect the price of oil, international shipping, or increase military expenses in Western nations going through economic recovery. Hopefully the current conflicts find some resolution this year, and we see a decline in conflicts, rather than an escalation. Most of these would be potential Black Swan events, and they would rarely create a lasting negative economic impact.
This is a slow time of year for housing news, though the New York Times reports that a possible settlement may be near between 14 large banks and the government over housing loan abuses. The amount suggested is near $10 billion, with about $3.75 billion going to compensate people who have already lost their homes, and an additional $1.5 billion in unspecified relief. Negotiations continue through the Office of the Comptroller of the Currency and the 14 banks, though a settlement would relieve banks of the task of reviewing many loans already at some phase of the foreclosure process. Housing has been one of the few bright spots in the US economy in 2012, so this would help continue that progress. Housing research firm CoreLogic released the latest figures on the Shadow Inventory of properties as of October 2012. In that report, CoreLogic notes Shadow Inventory declined by 12% to an estimated 2.3 million units, or about seven months of supply. The Federal Reserve will be continuing the program to purchase Mortgage Backed Securities (MBS) on the open market, though it appears they are somewhat frustrated with mortgage rates that remain higher than they expected. The Federal Reserve challenges the notion of increased costs, and suggest that a 2.6% thirty year fixed mortgage should be possible under current market conditions. While the Federal Reserve do not expect mortgage rates to drop under 3%, they do think mortgage rates could fall a bit further this year. The Dallas Federal Reserve released new studies on Service Sector Activity in Texas, indicating longer working week and stronger labor demand growth. That Dallas Fed note some optimism amongst businesses in Texas, which bodes well for the region in early 2013. In a strange twist on the ongoing economic crisis we have faced since 2008, bailed out insurance company AIG (AIG) is rolling out a two week long ad campaign basically thanking the government for saving the company. AIG received about $182 billion in bailout funding as the government took over the failed insurer, though the US Treasury managed to sell all holdings in AIG with a profit of $22.7 billion in 2012. The Federal Open Markets Committee (FOMC) released mid December 2012meeting minutes, indicating a desire to discontinue some stimulus measures by the end of 2013. So with some positive developments, and our overview of events to watch for in 2013, we wish you a prosperous year of investing.
G. Moat
Dislosure: I hold a long positions in Credit Suisse (CS) and Vale (VALE). This article is not a recommendation for investors to either buy, nor to sell, shares in Credit Suisse nor Vale. Investors are advised to perform their own research prior to making investment decisions.