American Taxpayer Relief Act of 2012. That’s the title of the recently passed legislation to avoid the so called “fiscal cliff”. I don’t know whether to laugh or cry. It isn’t a true oxymoron since that term is generally reserved for things that are surprisingly true and paradoxical but it certainly fits the more common, modern usage of the term on par with military intelligence, business ethics and, of course, civil servant. The American Taxpayer Relief Act is nothing of the sort unless one believes that Americans have been clamoring to have their taxes raised and are now relieved that the deed is finally done.
The stock market certainly seemed to like it though and I think that says quite a bit about the current expectations regarding the political class. The bill raises taxes on just about everyone who didn’t have the foresight or budget to hire a lobbyist but still only manages to raise a paltry $60 billion per year – against a near $1 trillion deficit – over the next ten years. Spending cuts? None, nada, nil, zilch. And that tax revenue number is dependent on believing the projections of the government’s number crunchers whose calculators seem to be embedded with some kind of optimism algorithm. $60 billion is about a tenth of what would have been laid on the economy by going over the cliff so, presto chango, it’s a tax hike but one the stock market can like because it didn’t hurt as bad as it could have.
At least for now anyway. The one thing that this bill makes certain – other than that Al Gore will continue to collect green energy subsidies – is that the fiscal bickering is far from over. President Obama has already called for more tax increases in exchange for any imaginary spending cuts dreamed up by Republicans and Geithner is paying the nation’s bills through some kind of magic Turbo Tax trick since our total debt has already surpassed the alleged debt ceiling. The debate is just getting cranked up and promises to be just as spellbinding for the stock market as the fiscal cliff negotiations. The sequestration “spending cuts” – mostly in the defense department – were only delayed until next month so stock traders and businesses will spend the next six weeks rubber necking the DC car wreck we call democracy. About the only thing I feel confident in predicting is that the defense cuts won’t happen because the military industrial complex keeps the lights on at the campaign headquarters of both parties.
The DC bickering and overly bullish sentiment has us on the defensive as we enter the new year. Fourth quarter growth was not exactly scintillating and we expect earnings to reflect that. Of course, we aren’t the only ones with that opinion so it may not matter that much if the economic data continues to hold up in the first quarter. The data at the end of the year was fairly positive and if that continues in the first quarter, bad 4th quarter earnings will probably get shrugged off. It will be interesting to see if efforts to avoid the fiscal cliff – a lot of income got pushed into the 4th quarter to avoid the higher rates – has an effect on the first quarter data and markets. A few bad economic reports, some negative earnings surprises and another stalemate in DC might see the recent enthusiasm for equities dented a bit.
While I am looking for some kind of correction in the short term, I am not as concerned about the intermediate term outlook. Whatever comes out of the fiscal negotiations, I expect it to have a negative impact on long term growth as more capital is diverted from private to public uses. Higher government spending as a percentage of GDP appears permanent and irreversible at this point. However, there are some intermediate and long term trends that favor the US economy and while growth may be less than it would have been with a smaller government footprint, that doesn’t mean it has to be stuck in the “new normal” 2% we’ve seen the last two years. The housing market continues to recover and should have a more significant impact on employment this year. Construction jobs have increased two of the last three months and there is a ripple effect in real estate and related industries. Manufacturing also appears to have weathered the slowdown in Asia and Europe in good shape and I expect the insourcing trend to continue over the next few years. Lastly, energy and other commodity prices are moderating.
Of greater concern than stocks is the state of the bond and commodity markets. The yield on the 10 year Treasury Note has increased from 1.4% to 1.9% recently and technically is set up for a rise to the mid 2% range. While that doesn’t seem like much, a duration of 10 years means that a 1% rise in rates translates to a 10% loss in principal for all those folks who’ve plowed into long term bond funds over the last few years. Inflation has already happened – that was the rise of gold from $750 to $1950 from the crisis to the peak last year – and this may be the year all that money creation finally hits the real economy. Bank lending is already rising fairly rapidly – commercial and industrial loans were up 13% over the last year – and money supply (M2) is rising at annualized double digit rates.
Ironically, this is happening in the context of a fairly stable US dollar. Gold, as noted above, peaked over a year ago and the dollar index has been in a choppy rising trend over the same period. The general commodity index (CRB) has been in a downtrend since peaking in early 2011. The US Dollar bull camp is a lonely place with QE infinity in place but if US growth accelerates after the fiscal showdown it may be the surprise trade of the year. With the BOJ and ECB also in full print mode, the Fed’s efforts at devaluing the dollar may come to naught. Rising interest rates and better growth should favor the dollar and there is a virtuous circle in that environment to some degree. Capital inflows for investment in a higher growth economy beget further capital inflows as the value of the dollar increases. A rising dollar could also reduce the impact on the price indexes as it tends to push down commodity prices.
The wild card this year will be the actions of the Federal Reserve. If their efforts at reflation finally bear fruit this year, how will they react? Their exit plan after creating multi-trillions of excess bank reserves may get tested sooner than the markets expect. As we saw after the release of the latest FOMC meeting minutes Friday, any hint of taking away the punchbowl is met with howls of protest from the stock market. My guess – and it is only a guess – is that the Fed will see a rising dollar as giving them leeway to continue their money creation ways especially if their preferred measure of inflation remains tame. Personally, I think that will be a bad decision in the long term but in the short term it may well kick off another inflationary boom.
Our fiscal situation is still a mess and doesn’t look to improve any time soon. It should be obvious to everyone by now that the President has no intention of reducing spending and the fiscal cliff debacle will stiffen Republican resolve against raising taxes. Higher nominal growth created through inflationary monetary policy may improve the deficit situation somewhat in the short term but it isn’t a sustainable policy. As long as the Fed continues to print we can get a kind of non-natural growth but the minute they are forced to tighten, it will evaporate as quickly as the false prosperity of the housing bubble. If we do get another inflationary boom (and yes, that’s what the housing bubble was) the morons in DC better use it as an opportunity to get our fiscal house in order finally. If they don’t, the next crisis will make 2008 look like child’s play and oxymoronic policy won’t be an option.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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