Market Memo: Short-term bearish, long-term bullish

As we announced in our Nov. 8 Market Memo, “This isn’t what the markets wanted,” we’ve turned near-term bearish since the election. Although we remain optimistic on the longer-term outlook, particularly by the end of next year, we see a number of headwinds for the market in the weeks ahead:

• First and foremost, the outcome of the fiscal cliff negotiations is uncertain, and the post-election dynamics could result in a fall off the cliff. This could immediately suck 2 to 3 points off GDP and spark a recession. Even if there is a deal, uncertainty is always bad, and the timing couldn’t be worse, with this high-stakes game of political poker coming during 2013 corporate budget season. This could magnify the near-term impact as companies hold off hiring and spending as they stare down the precipice.
• Whatever the outcome of the cliff talks, clearly taxes will be going up. This includes some that will hit the economy broadly (the likely expiration of the 2% payroll tax relief on all wage-earners, for example) and some that will home in on high wage-earners/small businesses (increases in the marginal federal income tax rates on higher brackets, an additional 3.8% Medicare tax on higher-income households, and the potential for both extending the Medicare tax to investment income and uncapping Social Security taxes that currently apply to incomes only up to $110,000).
• It’s now all but certain that Obamacare won’t be repealed, meaning many businesses and individuals are about to get hit with higher bills since the big cost increases were put off until after the 2012 election. Aetna, for example, said this week it expects individual insurance premiums to rise 20% to 40% in 2014. These added costs will represent a further drag on consumption and small-business investment.
• Other areas of the economy likely will be squeezed by the continued anti-business oversight of the Obama administration, including financials, shale energy development, health care, etc.  Many business leaders suspect that a backlog of pent-up, economy-slowing regulatory edicts, held in abeyance for the elections, may be about to be unleashed upon us.
• Compounding all this are the simultaneous slowdown in China, the recession in the eurozone and the drag of Hurricane Sandy, which clobbered heavily populated areas in the East.

We expect the sum of these aforementioned headwinds will slow growth in the current quarter and spill over into the New Year.

Pause mode
We don’t expect the worst case, however—the market already is off 5% from its pre-election peak.  But if the cliff negotiations appear to break down at some point (and we think they may), the S&P 500 could drop another 5% to 10% before it’s over.  And the longer it takes to resolve the cliff, the longer business managers across the country remain in “pause mode.”  “Pause mode” means lower spending and increased risk of sliding into recession.

We advised our investors to shift their equity overweights to neutral post the election, and would remain there for now. Within the equity portfolio, we’d recommend defense over offense, particularly emphasizing dividend-producing stocks in telecom and consumer staples.

The bullish long-term case
Our full-year 2013 view, however, is more bullish. We continue to think we are in the early stages of a long-term secular bull market.  Presuming the fiscal-cliff negotiations finally end with a reasonable compromise of higher taxes and entitlement cuts—and a federal tax structure that is viewed as semi-permanent around which businesses and individuals can plan beyond next week—next year’s second half could see an economic rebound on the back of the release of pent-up demand. If by then Europe moves into recovery mode (we expect it will) and China begins reaccelerating as its leadership transition is complete, global economic growth would become a tailwind for equities.

Given this view, here’s what is on our buy list during the coming weeks as the current stock market correction runs its course:

• U.S. over international. Better economic growth, manufacturing renaissance driven by more competitive labor market and lower-cost energy, release of pent-up demand from fiscal cliff, housing recovery off a six-year bear market in starts and reacceleration of household formations, and very attractive valuations versus bonds. The S&P target remains 1,660 by year-end 2013.
• Within the U.S., we would be buying the pro-cyclical sectors:  banking (particularly those exposed to housing/mortgage sector), consumer cyclical/autos, industrials, and technology.
• Outside the U.S., we would remain selective. In Europe, our strategy continues to be “Germany and points north.” In Latin America, we like Mexico still as a higher-growth but U.S.-linked investment theme. In Asia, we are buying China as it emerges from two years of underperformance through its economic deceleration.