Recently I wrote to alert you to our defensive positioning and significant sale of equities. Today I want to expand on my thoughts and give you an insight on how others view the landscape.
First the good. Slow growth has continued. Low rates have finally helped the housing market to begin to recover. The weaker dollar has helped our manufacturing sector strengthen. It is even possible that the United States can become energy independent. At the State level, reform of public benefits has begun. Of course they have no choice. The States must balance their budget every year – no deficits allowed.
So what’s bad? How about a potential expiration of massive tax breaks (the fiscal cliff), the largest increase in taxes in the country’s history (Obama Care), mandatory across the board spending cuts (required to raise the debt ceiling last year), the debt ceiling fast approaching again (as early as January depending upon tax receipts), and it being a question of when, not if, Israel attacks Iran’s nuclear facilities (we saw what the Spring Arab Revolt did to oil prices in 2011). Oh, and I didn’t mention Europe. Clearly the bad things seemingly threaten to derail the good things. It could get ugly.
So what are others thinking? The day after the election I attended an advanced wealth management conference in Denver hosted by LPL Financial. Burt White, their Chief Investment Officer, looked at five reasons why the markets are struggling. First, he identified Greece and the European social protests over fiscal austerity. Second, he said it looks like German banks are becoming stressed by the European fiscal crisis. Next, he mentioned the once in a decade change in the Chinese Ruling Party. Fourth, corporate earnings aren’t great (they are actually negative), and finally he said – the election outcome. And by that he meant, as I did when I called it the worst possible outcome, there is no change in the political power structure in Washington. And, of course, the inability to forge compromise is why we have all of the looming issues I just mentioned.
So what is his take on the fiscal cliff? When all the tax breaks expire and the spending cuts are enacted, we will have “fiscal tightening” of about 3.5% of 2013 estimated GDP. Typically a tightening of 1.5% results in a recession. Interestingly, Burt suggested 3 possible outcomes to the fiscal cliff and handicapped them as to their probability. He put the bear case – going over the cliff – at 30%. The base case – compromise – at 55%, and the bull case – a long-term solution – at 15%.
So what is the bear case expected to look like? Gridlock, recession, credit downgrades, technical default on US debt, at least a 25% drop in stock prices. By the way, he mentioned that in 1969, we had a 3% fiscal tightening and stocks dropped 36%, ouch!
How about the base case? Republicans will compromise. They have more to lose. Going over the cliff means tax increases on the middle class and wealthy and cuts to defense spending with no required cuts in entitlements. Instead of 3.5% tightening, we will end up with 1.5%. The compromise. Payroll tax cuts expire, most of the required spending cuts happen, middle class tax cuts are extended, maybe a new “wealthy” tax bracket, unemployment benefits are extended and another AMT patch is applied. To me it also sounds most probable but it is just another bandaid. Wasn’t a 1.5% tightening recessionary anyway?
The bull case. That requires reforming the tax code and entitlement programs. That requires political courage. So what was the political strategist’s take on the election and these issues? Since Burt was downright depressing, you’d figure that someone who covers politics would sugarcoat it, right? Wrong.
Greg Valliere, Chief Political Strategist of the Potomac Research Group, began by suggesting Republicans got their butt kicked because there is a demographic tsunami going on. The Hispanic vote is growing and the Democrats got 73% of it. He wondered if the Republican party, as we know it, would ever win another Presidency. He predicted the near term to be extremely volatile and projected two scenarios on the fiscal cliff. One, we don’t fall off in January – cuts will probably be extended until the 1st or 2nd quarter of 2013 (sounds like kick the can to me). Or two, we get total acrimony on the 22nd of December when Congress adjourns. He said President Obama is not a good politician – not engaging and pragmatic like President Reagan and President Clinton, but rather aloof. He thought a grand deal on the deficit was probably not on the table because there was not enough political leadership in the current administration. As you can probably guess by now, they were taking away the sharp objects in the room. Greg concluded by saying we overlook geopolitics at our own peril. Israel and Iran. When will Netanyahu move? Three months? After the presentation we all promptly reconvened at the local pub for therapy.
So now you know why I am a little defensive. In fact, more so than at any time in my more than three decades of advising. But we do have a plan – even multiple plans. Policy has implications and there will be winners and losers. It is our job to identify them and with the help of our vast resources develop strategies to make prudent investments. Even while we are waiting for the dust to settle a little, we are updating our own bear, base, and bull case allocations. By the way, our current actions reflect the pre-planning decisions we made last year. We are constantly looking to manage downside risks and identify opportunities. This time will be no different. There will always be good and bad. It doesn’t have to get ugly!
Sincerely,
Donald Miller
CEO/Principal
Greater Midwest Financial Group, LLC.
102 N Karlov Ave
Chicago, IL 60624-3047
Securities Offered Through LPL Financial
Member FINRA/SIPC
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
