The delay in resolution of the Fiscal Cliff certainly had a negative impact on consumer spending in the fourth quarter and will likely have an adverse effect on Q1 2013 GDP growth as many corporations postponed initiatives awaiting the outcome. Even though the first leg of the Fiscal Cliff resolution preserved the Bush-era tax cuts for all but the wealthiest Americans, everyone will be paying higher taxes than a year ago as the temporary payroll tax holiday expired. The next leg of the Fiscal Cliff debate could be even uglier and more dysfunctional than the first as spending cuts and an extension of the debt ceiling will be on the table. While we are confident a compromise will eventually be reached between Republicans and Democrats, we suspect the bickering and haggling between now and then could further erode consumer and corporate confidence. In short, we see a politician-induced difficult economic environment over the first half of 2013; but, once the politics are behind us we expect an improving economy over the second half of the year.
At its last Federal Open Market Committee meeting of 2012 the Federal Reserve tied its accommodative monetary policy to the unemployment rate. Specifically, the committee agreed to maintain its asset purchase programs and 0% Federal Funds rate policies until such time as the unemployment rate falls below 6.5%. The Fed wants higher inflation. For those of us who were raised in this business on the adage “don’t fight the Fed”, we believe the Fed will eventually get its way—lower unemployment but higher inflation.
As noted above, short-term interest rates will remain low for some time. Prior to this last FOMC meeting, the Federal Reserve had committed to keeping them low until at least 2015. Longer term interest rates will benefit from the Fed’s asset purchase programs but will face more upward pressure from the aforementioned inflation outlook. Moreover, bond investors are not comforted by fiscal irresponsibility—an extension of the Bush-era tax cuts for all but the wealthiest without an accompanying expense reduction plan will not be well received by bondholders.
Domestic Equity Markets
Ultimately stock prices track corporate earnings—we believe the corporate earnings environment remains positive even as the overall economic environment remains fragile. That, coupled with an accommodative monetary policy, makes domestic equities attractive. Dividend and long-term capital gains tax rates were bumped modestly for the wealthiest Americans, but not as much as many feared (back to the ordinary income tax rate). On an after-tax basis, even for those paying the highest rates, the 2.2% dividend yield of the S&P 500 is much higher than the 1.75% yield on the investment grade corporate bond market or the 1.25% yield on the intermediate municipal bond market.
Domestic Bond Market
We expect short-term interest rates to remain low for some time; but, as we noted above, we do expect the Fed to ultimately win its fight to reduce the unemployment rate and increase the inflation rate—that isn’t a good scenario for longer-term bonds. Corporate bond yield spreads relative to US Treasury debt remain attractive particularly when one considers the increasing supply of US Treasury debt relative to corporate debt. In our tax-exempt portfolios we continue to emphasize higher quality issuers as declining property values and tax bases are having an adverse effect on many state and local municipalities. Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics.
Europe is in a recession, but there are signs of little green shoots popping up—we believe the worst may be behind the European Union. Likewise, the newly elected Japanese Premier Shinzo Abe is putting pressure on the Bank of Japan to pursue the same accommodative policies as our own Federal Reserve Bank to stimulate growth in that country. The emerging market economies are showing signs of renewed strength, as evidenced by the fact Macau saw gambling revenues balloon 20% this past December. Longer term we still expect the emerging economies and the emerging middle classes within those economies to fuel significant growth over the coming decades.
Since most of the world’s major central banks are pursuing inflationary policies similar to our own Federal Reserve Bank we would expect inflationary pressures to increase in most major economies. Europe could be an exception to this as the austerity measures pursued there probably pose a greater risk for deflation than inflation.
As with the domestic market, we expect global short-term interest rates to remain low; but, due to inflationary pressures we would expect some upward pressure on longer-term interest rates. Again, the exception is probably the European rate environment where longer-term rates probably still have room to fall, particularly in some of the periphery states.
The dollar remains the unquestioned global reserve currency but oddly enough, since last summer the Euro has been the world’s strongest currency. This is largely due to Europe’s austerity measures as opposed to our inflationary monetary stimulus policies. Japan is now also pursuing those same policies, which has led to a10% devaluation in the yen versus the US dollar. We would expect the dollar/euro relationship to stabilize, but we expect further declines in the yen.
Global central banks’ inflationary policies will be positive for natural resource prices. Renewed economic growth in the emerging markets will be a huge positive for natural resource prices. Longer-term, increased global demand without a comparable increase in supply will keep natural resource prices on their upward sloping trajectory.
Global Equity Markets
We’ve become much more constructive with regard to developed and emerging international markets. At present we have a neutral weighting but the next move is likely to be an overweight. Valuations in developed international markets remain attractive; and, emerging and frontier market valuations are attractive relative to their high growth rates.
Global Bond Markets
While we remain concerned about the seemingly never-ending sovereign debt crisis in Europe, we believe current yield levels offered by some of the periphery states compensate investors for those risks. Longer term we believe developed foreign government bonds will outperform U.S. Treasury bonds due to their higher yields and less inflationary central bank policies. We would underweight emerging market debt as we believe those yields no longer compensate investors for the inherent inflation and credit risks.