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International Investing

Bumpy End To The Year
Sentinel Investments
By Christian Thwaites
November 20, 2012

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Europe would like to have America's problems. Here we have declining public spending, increasing receipts, falling debt to GDP ratios and unemployment 3% below the European average. This puts the Fiscal Cliff (and I was so hoping to avoid that cliché) debate somewhat in context. It's serious enough to draw the attention of corporate CEOs, put a heavy dampener on business confidence, which we saw in the recent NFIB report, and postpone hiring plans and capital investment, which showed up in last week's Empire and Philly Fed surveys. This is how the cliff breaks down:


  Budget Item $bn Hit to 2013 GDP Hit to 2013 Employment
1. Defense cuts $24 0.4% 0.4%
2. Medicare cuts $40 0.4% 0.4%
3. Tax increases for lower incomes $288 1.4% 1.8%
4. Tax increases for higher incomes $42 0.1% 0.2%
5. Payroll Tax $108 0.7% 0.8%

  Total $502 2.9% 3.5%


So five points come out of this: one, the big, unadulterated number clearly slams the economy straight into recession; two, the tax increase for the top brackets (line 4) , which gets most of the press, counts for very little; three, the payroll tax cut number (line 5) includes $26bn of extended Unemployment Insurance (UI) benefits and both payroll and UI have a very big multiplier, meaning, especially in the case of UI, spending decreases by exactly the amount of the cut, which is not the case for the income tax (lines 3 and 4); four, there's little support for an extension of the payroll tax deduction; and five, there's less talk of a cliff and more of a slow burn economy as the changes take effect in early 2013 and consumers and businesses adapt. This last point is surely right. If nothing changes and all current legislation lapses, the full impact won't occur immediately. Any decline in the economy could accelerate if left untended and the deficit would improve almost immediately. But the full-off/remain-off scenario is highly unlikely.

So...what will happen? 
The issue is attracting deserved attention. There's marginally less polarity than a few weeks ago and that's because the stakes are arguably higher. The election was always going to delight half the population and annoy the other half. With that out of the way, legislators can turn their resolve to something which affects everyone and where the pressure to "just do something" is as high as it was back in 1995-1996 when the Clinton Administration and a Republican Congress faced a similar stand-off that shut the government down for 21 days. So the pressure to reach an agreement quickly will be high. One cynical view is that the changes would take effect, which of course results in an across the board tax increase, that paves the way for a deal where all parties can point to siding with tax decreases. Which is a bit like starting a fire and then claiming hero status for rescuing the children. Hopefully, the scenario is more like:
  • extend the tax cuts for the low and moderate income households;
  • let the top taxpayer rates expire but point out that they benefit anyway because a portion of their tax falls into the lower bands;
  • drop the estate tax limit and increase dividend taxes;
  • index the AMT; and
  • eliminate the automatic defense and Medicare payment rate cuts.

All of which would lead to only minor changes in the budget deficit. The recent Treasury statement for October, the beginning of the fiscal year, is distorted somewhat by the timing of the number of business days and government invoicing, so the adjusted headline number was little changed from FY2012. But in the year to September, revenues increased 6.4%, outlays fell 1.7%, net interest on the debt fell 2% and the deficit to GDP came in at around 7%. These are not great numbers but the deficit is on a downward track and that makes it easier for everyone to do a deal. So put this all together and the risks of the cliff seem manageable. We just need patience. Clearly the bond market seems far more worried about growth slippage than runaway deficits and inflation.

Minutes and Yellen 
Not to pick historic landmarks but the speech from Janet Yellen, Vice-Chair of the Federal Reserve, ex president of the San Francisco Federal Reserve and possible successor to Bernanke, was a game changer. The Fed minutes from the October 24th meeting saw the participants wrestling with how the employment and inflation indicators combined with the target dates. At the moment, an unspecified unemployment target and a 2% inflation target sit with a commitment not to touch rates until 2015. But as we have mentioned before, the Fed is i) nowhere near convinced that unemployment is at a full, non-accelerating rate of inflation (or NAIRU) and ii) well below its inflation target. Here's the latest on the core PCE which hasn't been anywhere near 2% for years.


Source: Federal Reserve Bank of St. Louis, Economic Research


So the minutes acknowledge this and the Fed positioned itself for more asset purchases in the New Year once Operation Twist ends. So at that point, many expect the announcement of a renewed Treasury purchase program. The trouble with that is the composition of the Fed's balance sheet. It's at $2.8 trillion of which 57% is in treasuries and 30% in MBS. Let's call those marketable securities. The rest is mostly FX reserves and some TALF assets which are not useable open market instruments for the Fed's immediate purposes. And of the marketable securities, all of them are of maturities of over one year and 83% are in maturities over five years. So this presents a bit of a problem as the Fed is now the de facto market in many individual market the Treasury bond sector, Fed monthly purchase volumes are about 150% of supply. And that means the Fed doesn't have much more short-term paper to sell. This chart shows the YOY growth change in Fed buying. The question of what and how to buy next clearly looms:


Source: Federal Reserve Bank of St. Louis, Economic Research


This is where Janet Yellen comes in. Her basic thesis is to jump in where two Fed presidents have already spoken, namely to start tying monetary policy to specific employment levels about 2% below the current 7.9% and let inflation at least catch up to its other words to exceed 2% until it reaches the compounded 2% level. That would mean rates would stay low even though the primary indicators had met targets. The crux of the proposal is that the committee would:

"Eliminate the calendar date and replace it with guidance on the economic conditions...liftoff [of rates] would not be automatic once a threshold is reached."

This would provide more confidence to the market that policy would remain in place until the recovery is fully underway. This makes sense because most of the September impetus to the markets has already given way. The five year forward inflation expectations are back where they started and the five year TIPS break-even rate climbed and promptly corrected 40bps. It's back to where it was a year ago. Stocks, gold and the dollar have all seen the same trajectory.

What we think is going on is a probe by the Fed to try new policy tools and recommit to growth by reshaping future expectations. Or anything to up-change the gears on this very weak recovery.

Europe looks over the edge and takes one step forward. 
In the last few weeks, ECB President Mario Draghi has made frequent comments about the risk of deflation. Much of this went over the heads of the audiences because eurozone inflation is at 2.5%. But a lot of this is VAT driven. Demand is in terrible shape. The latest spat in Europe is about Greece's next aid package. Draghi said he's "done" with Greece and the IMF and EU are not even on the same page as to what the debt targets are. So it seems like the deflation fears are about to be self-fulfilling with the entire zone now officially in recession and business surveys pointing for more to come. Yields would normally come down with that kind of news but in Spain they rose about 30bp and in Germany they fell.

The only thing that keeps us from throwing in the towel on Europe is that banks are getting stronger, the ECB has done a great deal to diminish the risk of a break-up and that the bad news is pretty well discounted.

Other US Stats 
Claims and industrial production saw post-Sandy distortions. That drop in the blue line is claims jumping by nearly 100,000 from the October low. Stocks took their immediate cue.


Source: Federal Reserve Bank of St. Louis, Economic Research


Industrial production also fell 0.4% along with capacity utilization. The annual growth rate fell from 2.8% to 1.7%. The Sandy hit was very localized with the Philly Fed business report falling substantially (down 15 points) but the Empire broadly unchanged. There may be some pick up in November but broad activity was already weak from Europe and China and there has not been much change to either's outlook.

Familiar story of a i) robust new issuance market with quick take-downs ii) treasuries seeing weaker economic growth and dropping yields to 1.58% from a pre-election high of 1.80% but iii) credit spreads under short-term pressure as dealers adjust inventories and reduce liquidity. This could mean slightly wider spreads for the next few weeks but we expect the IG space to outperform other risk assets, especially equities, CMBS and high yield.

We have seen a 7% correction in the SPX[1]. More could come as analysts adjust down earnings expectations. The biggest hit in equities has been in small cap land where the correction has been even larger. Investors are looking for relative safety and we have seen a substantial outperformance of large cap this year and for most of the last 18 months. This is the longest period of sustained large cap outperformance over small cap in over six years.

Bottom Line: 
Risk assets could be under a lot of pressure between now and year-end. There's very little reason for a year-end rally what with the gains already in the market and the tax overhang. Any rally from the 1350 levels would be short-lived given the slow economy.

Sources: Pantheon MacroEconomic Advisors, Center on Budget & Policy Priorities, Congressional Budget Office, Tim Duy's Fed Watch, US Census Bureau, US Dept of Commerce, US Treasury Department, Federal Reserve Bank of San Francisco, Federal Reserve, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of St. Louis, Bloomberg, Economist Free Exchange, European Central Bank, ISI, FT Alphaville, Capital Economics, High Frequency Economics, CRT Ader, J.P. Morgan Market Intelligence, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.


(c) Sentinel Investments


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