On the Radar: Let's Get Fiscal

This is the second in a three-part series on longer-term issues that could either sustain or stall the current equity rally once stock prices fully capture their current, still-attractive values. The first in this series took up the prospective policy change by the Federal Reserve. This discussion considers future fiscal developments.

For the past few years, the fiscal situation has offered financial markets little joy. Deficits have soared into the trillions of dollars a year, at their worst climbing above 10% of the economy's gross domestic product (GDP). The country's public debt outstanding has, accordingly, grown to almost equal its GDP, a relative burden not seen in more than 60 years. In summer 2011, the government almost shut down because Washington failed to reach a compromise on the debt ceiling. That failure led to the country's first ever credit-rating downgrade. The jury-rigged "solution" of that time led to this year's across-the-board sequester of government spending, hardly a considered solution. The whole picture has, in fact, been one of short-term fixes and muddled maneuvers to delay decisions. It has hardly been the model of reliability from which investors and businesspeople could do their planning.

Of late, the economic recovery has begun to raise revenues enough to reduce the deficit figures and so also the pace at which total debt outstanding is expanding. But this modest, if welcome improvement does little to answer the well-known need for concerted action to control spending and reduce the government's uncomfortable reliance on debt. President Obama's healthcare reform, it has become increasingly clear, will impose further budget strains as it is implemented. The retirement of the baby-boom generation will burden both Social Security and Medicare beyond their resources, while the general aging of the population will impose huge healthcare burdens on the economy above and beyond those placed on Washington's programs. Meanwhile, all acknowledge that the tax code is needlessly complex and counterproductive. The equity rally has proceeded, despite Washington's seeming inability to cope, almost surely because attractive valuations so favor equities and the Fed has so flooded markets with liquidity that prices can rise even in the face of this fiscal muddle. But investors are well aware that in time, after equities fully capture current values and the Fed begins to change its policy, fiscal failings will weigh heavier and could even stall the rally.

If, in the fullness of time, future failure in Washington has the power to shut down this rally, even modest fiscal successes have the power to sustain it. In this respect, the easiest thing for Washington to do would be to let the passage of time clarify legislative specifics that today remain ambiguous. Even years after the passage of the Patient Protection and Affordable Care Act and the massive Dodd-Frank financial reform legislation,1 the rules and provisions that govern the future remain obscure, leaving corporations and investors unsure of future costs or the nature of tomorrow's regulatory environment. If Washington can refrain from tinkering further and work diligently to clarify these rules and costs, American commerce and industry would take encouragement from a better ability to plan than in years. Though such a prospect is far from the desired comprehensive budget reform, it could nonetheless improve matters on the fiscal front enough to invite extended market gains.

The biggest assist Washington could give, of course, would be a grand budget compromise. By giving investors reason to expect spending controls, adequate revenue growth, and a reduced reliance on debt, it would allow more aggressive valuations of stocks and bonds and so add to the rally's upward momentum, even after stocks fully realize today's evident valuations. But if such a grand compromise looks improbable—and it does—there is a greater chance of good news from tax reform.

Even in today's highly partisan environment, pro-growth tax reform is not so improbable as it might seem. After all, similar proposals have emerged on both sides of the aisle, in the Senate, the House of Representatives, and the White House. All in various ways would lower statutory tax rates, and make up the revenue shortfall by eliminating various breaks and credits. The Bowles-Simpson bipartisan budget reform proposals2 of 2010 included these elements. Both Republican budgets written by Representative Paul Ryan (R-WI) included them, too, as have a number of bills in the House and the Senate from Republicans, Democrats, and bipartisan groups. Even President Obama included such elements in his plan for the corporate tax code. Firm legislation has eluded Washington because Republicans would look for revenue neutrality or include an overall tax reduction in the reform while the Democrats would look to increase revenues. Still, there is much common ground on which to base a compromise. Even if reform included a modest tax hike, the simplification and improved transparency offered by these changes would make business decision making more economically efficient, improve growth prospects, and allow more aggressive equity valuations, extending the rally even after prices caught up to existing values.

Though all bears close watching, investors would do well to wait before positioning themselves for good or bad on this fiscal front. Given still-attractive stock valuations, the rally could go quite a way further, even with continued muddle in Washington, before realizing current values. Only then, say 18-24 months from now, would investors need to adjust for the prospects of fiscal failure or success. At that time, ongoing bungling in Washington would call for a more defensive posture, as it could very possibly stall the rally. Some fiscal progress, however, even of a minor sort, could allow that rally to continue and warrant still aggressive portfolio postures.

1 Officially the Dodd-Frank Wall Street Reform and Consumer Protection Act. The legislation's principal sponsors were Senator Chris Dodd (D-CT) and Representative Barney Frank (D-MA).

2 This is in reference to the National Commission on Fiscal Responsibility and Reform, often called Bowles-Simpson, taken from the names of co-chairs Erskine Bowles (former Clinton chief of staff) and Senator Alan Simpson (R-WY).

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

© Lord Abbett


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