So far, a strange year where US stocks have surged or fallen violently daily for reasons having nothing to do with fundamentals in the US and everything to do with the daily pronouncement out of CNBC of whether the "risk trade is off or on." Luckily, we pay no attention to CNBC whatsoever.
In the latest iteration, investors have flooded back to European and US stocks on the surprise announcement that a single Eurozone wide agency, somewhat akin to the Federal Deposit Insurance Corporation (FDIC), will be established to backstop European banks directly, rather than lending through the respective governments of troubled banks. This will prevent the current spiral of high debt relative to GDP, which drives up sovereign interest rates, which stifles economic output, from getting worse.
Through mid-morning July 6th, the S&P 500 is up 8.6% YTD.
US Economic growth forecast coming down
Our biggest worry right now is the rate of growth in US GDP. Unemployment levels in Europe are at record levels, and the Eurozone may be slipping back into recession (typically defined as two quarters of negative growth.) Exports from the United States to Europe are falling, which negatively affected the latest manufacturing report. Reduced industrial output in turn puts pressure on employment and eventually shows up in the reduction of services output. The US will grow at about a 2% annual rate this year. Not a recession, but not growth sufficient to drop unemployment in the US below 8% before year end. There are some signs of increasing consumer and business expectations for 2013. However, corporate revenue and earnings projections are flattening relative to last year.
US Presidential Election Politics
The Obama reelection campaign got an unexpected boost from the Supreme Court 5-4 decision to leave ObamaCare essentially untouched. Obama maintains a small but growing lead over Romney at both the national level and in 10 of 12 "battle ground states," including Florida. If the election were held today based on state level polls, Obama would beat Romney 332-206 in the Electoral College. Note: we're not advocating one candidate over the other; we're simply trying to figure out who will be the winner, which will have major policy implications for 2013. The Republican controlled Congress will block any Obama initiatives for the rest of 2012 regardless of harm done to the rest of the country as a result.
Supreme Court Chief Justice John Roberts shocked observers by ruling that ObamaCare was a "tax" that Congress is well within its rights to impose. The tax falls primarily on high net worth families as follows:
- An additional Medicare payroll tax of 0.9% will be applied to individuals with AGI exceeding $200K, married couples with AGI exceeding $250K
- An additional 3.8% surtax will be applied to the lesser of investment income or AGI exceeding $200K for individuals and $250K for married couples.
- A penalty of 1-2.5% of income up a maximum of $2,085 annually will be applied to individuals and families who refuse to get health insurance.
- Companies that don't provide insurance for their employees will pay $2000/employee starting with the 51st employee.
- Low income families may receive a tax credit to make health insurance affordable.
We're not going to engage in rhetoric about whether ObamaCare is "fair" or "socialist" or any number of overblown adjectives. There is much in the US tax code that is regressive; this tax actually balances the tax load somewhat. We don't like the fact the Tax Code just made another lurch towards the incomprehensible. Average Americans have no idea what they get to keep from an incremental dollar of income. We do know that unexpected health care costs are the single determinant most likely to drive a family into bankruptcy or foreclosure, so the current regime is not tenable. Romney may want to repeal ObamaCare on Day One of his presidency but if so, then he'll have to come up with an alternative that provides coverage for all Americans (like RomneyCare in Massachusetts, for example.)
Taxmageddon - January 1st 2013
The income tax, capital gains and dividend rates that have prevailed since 2004 are due to expire at the end of 2013, leading to an immediate increase averaging 3.5% for middle income families taxed primarily on income, and steeper increases on families with income derived primarily from investments. We expect no legislation to address this prior to the seating of a new Congress on January 3rd, 2013, which means that all Americans will face a (recession inducing) reduction of income on the first week of the New Year. If Romney is the new president, expect further delay until the new administration is inaugurated January 20th.
We expect that something will be worked to compromise new tax rates going forward. However, businesses and investors hate uncertainty, so the faster this is resolved, the better. What we would like to see is a flat tax code averaging, let's say, 25% after exempting the first $20K income with no distinction between income earned from labor versus capital (income tax, capital gains tax, dividend tax rates all the same.) We believe this could be revenue neutral if most deductions including sacred cows such as mortgage interest and charitable deductions were phased out over 5 years. We would also like to see business subsidies such as ethanol support phased out over the same 5 years. We'd also like to see the creation of a corporate Alternative Minimum Tax that allows companies like General Electric to record billions in profits but pay millions in taxes. The probability of such a rational, easy to understand code being implemented? Zero! The political structure of the United States depends on handing out favors by manipulating the tax code.
Significance of the Barclays LIBOR settlement and ouster of CEO Bob Diamond
LIBOR stands for London Inter-Bank Offer Rate and is the interest rate that banks charge each other for short term loans, primarily in dollars and primarily for overnight settlement (though potentially up to 5 years.) The rate is posted once/day, though the actual value fluctuates through the day. So what? LIBOR is the key reference rate for hundreds of other financial products including corporate loans, credit cards, mortgages and derivatives. During the 2008-9 financial crisis, executives at Barclays Bank in the UK became concerned that the rate they posted was significantly higher than peer firms, which would indicate credit concerns by counterparties. The rate posted by Barclays was artificially lowered, as documented by e-mails among the traders. Posting an incorrect rate helps borrowers, but harms lenders, thus attracting attention of regulators at the British Financial Services Authority, and the United States Commodities Futures Trading Commission and US Justice department.
It is probable that Barclays was not the only bank of 16 rate setters engaged in this practice. UBS, JP Morgan, Goldman Sachs and other key banks are probably under investigation. What is remarkable is that, not only did Barclays pay a $450 million fine, but Barclay's CEO Robert Diamond and COO Jerry del Missier were obliged to resign (and probably give up their 2012 bonuses and golden parachute packages.) Wow! That's the first instance we can recall in a decade where a bank executive personally suffered for misdeeds committed on their watch. When a bank settles, but bank executives keep their jobs, it's the bank shareholders who suffer. Now we have to wonder if Jamie Dimon's job at JP Morgan is at risk for the $5-9 billion lost in the "London whale" credit default swap fiasco. We're also really, really, really rooting for Jon Corzine to go to jail for his role in the collapse of MF Global, for which $1.2 billion in customer funds are still unaccounted.
The banking system can only recover credibility if people who take reckless risks with other people's money suffer dire consequences when things go wrong.
June Employment report
The latest employment report disappointed for the third month in a row, dropping 1.3% off the S&P 500 this morning. The unemployment rate remained unchanged at 8.2%. The trailing three month average of 75K jobs doesn't even match growth in the work force. Retail, education and healthcare sectors added virtually no jobs, while hiring in construction, business services and manufacturing picked up. Gains in temporary work indicate better numbers later this year. As we mentioned above, business and investors hate uncertainty, so may be postponing full-time hiring.
Our clients are exhausted by the market whipsaws and terrified that their retirement dreams are all a mirage. But those clients who remain committed to our strategy are showing reasonable gains for the year. Among our clients who are depending on their portfolios, we continue to distribute their monthly "allowance" as we did through the entire financial crisis. We expect a "soft patch" in the US economy over the next 6-9 months. However, we recently saw a forecast for US GDP to grow 50% over the next decade - and that's seems totally reasonable to us!
With interest rates likely to remain at post-war lows through 2014 and stock valuations still remarkably cheap, we remain cautiously optimistic on the outlook for US stocks and maintain our expectation that the S&P 500 will grow 12% by year end. With US stocks up already up 8.6% YTD, our forecast implies limited upside for the rest of this year (unless we get a buying panic.) However, we now forecast 2013 to be another year of 8-12% gains and we encourage prospective clients to get invested in anticipation.