Orlando's Outlook: Third time a charm?
Bottom Line The S&P 500 has rallied by 5% to start the New Year—breaking the vaunted 1,500 level on an intraday basis for the first time in five years—as investors are discounting better-than-expected corporate results for the fourth quarter thus far and expectations for stronger economic growth as calendar 2013 proceeds. While stocks are pricing in better fundamentals, however, they’re also choosing to ignore the ongoing fiscal-policy uncertainty in Washington. To be sure, President Obama and Congress did manage to partially resolve the tax portion of their fiscal-cliff discussion with their last-second New Year’s compromise. But with the president’s inauguration now behind us and his State of the Union speech coming up on Feb. 12, they’ll need to reconvene in less than a month to negotiate the March 1 automatic sequester, the March 27 expiration of the federal government’s continuing spending resolution and the $16.4 trillion debt ceiling, which was just this week pushed back to May 19. We continue to believe that the S&P will break an all-time record high this year, rallying by 15-20% on a total-return basis up to 1,660 by year end. But we certainly don’t expect stocks to achieve our target price without a pause. While we see no evidence of an overbought market at present, we remain vigilant for a healthy 5-10% near-term correction, perhaps sparked by a dose of Washington intransigence in the coming weeks and months.
Strike one We remember less than fondly the second half of calendar 2011, during which time the so-called Grand Bargain between President Obama and House Speaker John Boehner fell apart, the debt ceiling was triggered, the three rating agencies (Moody’s, S&P, and Fitch’s) downgraded the U.S. government’s credit for the first time, and the Congressional Super Committee failed to reach a compromise agreement between Labor Day and Thanksgiving. So from July 7 to Oct. 4, 2011, stocks plunged by nearly 21%; from that trough, however, stocks rallied by more than 32% over the next seven months.
Strike two Against that backdrop, we as a nation then executed a status-quo election on Nov. 6, re-electing the exact same senior people and sending them back to Washington to have the exact same discussion. So from Sept. 14 to Nov. 16, 2012, stocks fell by almost 9%, as investors priced in ongoing fiscal-policy intransigence. But from that trough to today, stocks have rebounded by almost 12%.
We’ve seen this movie before, we know how it ends So investors may very well be looking at the current dysfunction in Washington and concluding that however much they hate this legislative three-ring circus, it’s really just an elaborate kabuki dance. By the end of the year, they reason, Washington will have figured out a way to compromise on the spending issues, and stocks may be 15% higher. So why should we get suckered into selling stocks now, and potentially miss the big recovery rally, like we saw the last two times this happened in 2011 and 2012? So we’re simply going to ignore Washington this time, they conclude, and focus exclusively on the economic and corporate fundamentals, which frankly don’t look all that bad.
House extends debt ceiling This past Wednesday, the Republican-controlled House of Representatives (by a vote of 285-144) authorized the temporary suspension of the current $16.4 trillion debt ceiling until May 19. The new statutory borrowing limit would then be retroactively reset to account for whatever federal debt the Treasury Department had issued to cover spending in the interim, which is estimated to be about $450 billion. True, this action does represent a reversal of the so-called “Boehner Rule,” which held that increases in the debt limit needed to be matched with dollar-for-dollar spending cuts. But there were two very interesting quid pro quos attached to this bill: the Democratically controlled Senate is required to produce a federal budget by April 15 for the first time since 2009, and failing that, their congressional pay will be suspended. Senate Majority Leader Harry Reid (D-Nev.) and Budget Committee Chairman Patty Murray (D-Wash.) have both said that the Senate will pass this bill and comply with its terms, and President Obama has also said that he will sign it. Importantly, this will provide the American people for the first time in the last four years with the opportunity to see formal budgets from the White House, the Senate and the House of Representatives simultaneously, and thus judge whose fiscal priorities they prefer.
But isn’t it Congress’ job to raise the debt ceiling? President Obama has been very frustrated with Congress’ unwillingness to raise the debt ceiling on a timely basis, explaining that they are required to do so simply to pay for the spending that they’ve already authorized. But some members of Congress don’t share that point of view, as no Congress can pass laws that obligate a future Congress to act. In fact, 18% of the new 113th Congress just arrived in Washington for the first time a few weeks ago (13 of 100 senators, 84 of 435 representatives), and they don’t believe that they had anything to do with authorizing the $5.8 trillion increase in federal debt over the past four years. Many of them, in fact, were elected in their states or districts to help balance the budget and start to work down the deficit.
Plenty of blame to go around A recent Wall Street Journal/NBC News poll spread the blame pretty evenly. Despite a 52% approval rating for President Obama, a 58% majority felt that the U.S. economy was on the wrong track and headed downhill. Yet, a plurality (45% to 33%) said that they would blame the Republicans if the federal government couldn’t meet its financial obligations due to a standoff between Congress and the administration. So why can’t we all just compromise in a bipartisan fashion to grow the economy faster, create more jobs, balance the budget and repay the deficit, all in a socially responsible manner that does not harm the least among us?
Inauguration speech a progressive wish list To that point, President Obama’s soaring inauguration speech this past Monday was praised by liberals, but it left conservatives apoplectic. His second-term fiscal priorities appear centered around issues such as climate change, gay marriage, equal pay for women, gun control and immigration reform, while Republicans were hoping to hear more about entitlement reform, balanced budgets, deficit reduction, stronger economic growth, and job creation. So there’s a very clear political dichotomy between the parties’ legislative priorities.
It’s all about growth Due largely to what we believe are sub-optimal fiscal policies in Washington, we’re carrying a below-consensus Gross Domestic Product (GDP) estimate of only 1.7% for 2013. That said, the Blue Chip consensus at 2% growth is not much higher, also well below trend-line economic growth of 3%, which is also well below the 4 % rate of GDP growth that many of us think possible at this point in the economic cycle, coming out of the depths of the Great Recession. That may not seem like much, but according to the Congressional Budget Office (CBO), the difference between 2% and 4% GDP growth in a $16 trillion economy over the course of a decade translates into $6 trillion less revenue for the federal government. In short, all of these contentious spending negotiations that we’ve been having in Washington over the past four years would disappear instantaneously, if we were growing the economy at something closer to its underlying potential.
Fool me once, shame on you Fool me twice, shame on me. Fool me a third time, and I’m looking for a new profession. With the imminent threat of a debt-ceiling default and a credit-rating agency downgrade now off the table for at least the next four months, investors are breathing easier. Moreover, with President Obama’s post-election popularity still relatively high and the polls running against them, Republicans are unlikely to force a government shutdown. So equity investors are certainly feeling better. Witness the VIX, which is now trading at a five-year cycle low of 12. If investors were truly worried about Washington, then the volatility index would have already spiked back towards 50, as it did during the fated summer of 2011, or at least back towards 30, as it did in mid 2012. For investors, the third time may indeed be the charm, as they’ve vowed not to make that same mistake again.