Orlando's Outlook: Is that all there is?

Bottom line With apologies in advance to Peggy Lee, we’re clearly wondering whether this midweek 2.2% correction for the S&P 500—the largest and sharpest such pullback since last November—is all that there is. For a while there, it appeared as if the equity market had somehow managed to successfully repeal Sir Isaac Newton’s previously irrefutable law of gravity, that what goes up must come down. The S&P had surged by nearly 10% from New Year’s Eve to Tuesday’s latest in a series of rolling five-year highs at 1,530.94; if we start the clock in mid-November, this powerful three-month rally measures 14%. 

But this was all the more puzzling, in our view, because of the ongoing fiscal-policy dysfunction out of Washington and the sluggish pace of consumer spending, which we believe are related issues, and which investors were clearly choosing to ignore. To be sure, our year-end price objective of 1,660 for the S&P remains firmly in place, which implies a total return of about 15-20% for calendar 2013. But we didn’t think we’d hit our target right out of the gate. In fact, our forecast for a healthy 3-8% first-quarter correction from these somewhat lofty near-term levels left us feeling—until recent days—much like the proverbial boy who cried, “Wolf!” But if the equity market does manage to sustain a broader cleansing pullback in the coming weeks and months, we’d view that as an attractive longer-term buying opportunity. 

We believe that there were three principal catalysts for this week’s correction:

Fed’s January minutes suggest end to accommodation? Some market observers viewed the Federal Reserve’s January minutes as proof that the Fed may begin to withdraw its aggressive monetary policy accommodation as early as June 2013. We disagree, and believe that the Fed will likely keep its zero interest-rate policy (ZIRP) and its indefinite monthly $85 billion purchases of Treasuries and mortgages (QE to Infinity) in place into at least 2014, unless economic growth suddenly begins to re-accelerate. We would point to the Fed’s own stated targets, for when they have previously said they will begin to remove policy accommodation: 

• Core inflation exceeds 2.5% or higher The core year-over-year Personal Consumption Expenditure (PCE) index, the Fed’s preferred measure of inflation, sat at a benign 1.4% in December 2012. Even the core year-over-year wholesale Producer Price Index (PPI) and retail Consumer Price Index (CPI) are relatively well behaved at 1.8% and 1.9%, respectively, through January 2013. So the inflation trigger is currently well below target.
• Unemployment rate falls to below 6.5% The rate of unemployment ticked up to 7.9% in January 2013, and given what we view as the sub-optimal tone of fiscal policy in Washington at present, the labor market is unlikely to strengthen materially in coming months and quarters. So the unemployment trigger is currently well above the Fed’s target.  

Consumer spending slows In our Market Commentary last week (Christmas was mediocre—will consumers remain weak?), we discussed in detail the so-so tone of overall Christmas 2012 spending for November, December and January compared with the two previous years. But we paid particular attention to how retail sales in January 2013 were significantly softer than relatively robust November and December levels.  Retail monolith Wal-Mart—an important proxy of low-end consumer sales trends in the United States—shed additional light on this negative trend earlier this week when releasing fourth-quarter results, stating a weak January has continued into February. We believe that there are several reasons for this weakness among low-end consumers: 

• Social Security taxes rise President Obama recently allowed the Social Security payroll tax holiday to expire after two years, which increased the tax rate back to 6.2% from 4.2% on earned income up to the Social Security wage base of $113,700 in 2013. For an average American worker earning $50,000 per year, that amounts to $1,000 less consumer spending over the course of the full year. 
• IRS behind schedule Because of the late date of the fiscal-cliff deal on New Year’s Day, the Internal Revenue Service (IRS) did not begin accepting and processing 2012 tax returns until Jan. 30, which is slowing refunds and consumer spending. 
• Gasoline prices moving higher The national average price for a gallon of unleaded regular gasoline has soared by almost 18% to $3.78 per gallon from $3.22 over the past two months. Prices in New York, California, and Washington, for example, are pushing $4.50 per gallon. Every $1-per-gallon increase in the price of gas at the pumps withdraws $140 billion in discretionary spending from the economy. 

In addition, we believe that the fiscal-cliff tax deal on New Year’s Day contributes to the dampening in consumer spending among high-end consumers, because they feel relatively poorer: 

• Reinstate a top marginal rate of 39.6% (up from 35%) on taxable income above $400,000 for individuals and $450,000 for families.
• Medicare tax rises by 0.9% to 2.35% on taxable income above $200,000 for individuals and $250,000 for families.
• Reduces up to 80% of allowable itemized deductions and phases out all personal exemptions on taxable income above $250,000 for individuals and $300,000 for families.
• Flexible spending health-care accounts cut in half to $2,500 per year.
• The top rate on long-term capital gains and dividends rises from 15% to 20% on taxable income above $400,000 for individuals and $450,000 for families, plus a 3.8% surtax for the Affordable Care Act, for a new total rate of 23.8%.

Sequester looms Exactly a week from now—unless Congress votes to change it—the $85 billion automatic spending sequester will take effect on March 1, with an additional $1.1 trillion in spending cuts coming over the next decade.  Half of these cuts will be focused on defense spending (which accounts for 18% of total federal spending), with the other half centered on non-defense discretionary spending (which accounts for about 16% of total federal spending). Importantly, entitlement spending—accounting for 60% of total federal spending—largely will be spared from this budget-cutting exercise.    

To be sure, no one likes this mindless, meat-cleaver approach to cutting spending—not President Obama, not Congress—but no one can agree on what to substitute.  Republicans would like to reform entitlement spending, while President Obama would like to raise taxes further and eliminate more deductions. The potential economic impact from the automatic sequester would be roughly a 0.5% annual reduction in Gross Domestic Product (GDP) growth and perhaps 700,000 jobs lost over the next two years. 

Plans for this automatic spending sequester were formed back in July 2011, when the promising Grand Bargain between President Obama and House Speaker John Boehner fell apart after a tentative agreement. So the financial markets have certainly known about the potentially deleterious economic impact of this sequester for some time. But they either chose to ignore it, or felt that Washington would reach some last-second compromise that would result in a better-balanced budget plan.

But with President Obama insisting on additional tax hikes rather than other spending cuts, Republicans appear willing to let the hated sequester take effect. Their reasoning is that a bad spending cut is better than no spending cut at all.