At the last minute possible, many of the across-the-board automatic tax hikes set to go into effect in 2013 were avoided. But, the automatic fiscal spending cuts and a decision on the extension of the federal debt ceiling were put off until March. That means we just pushed off many important decisions. Also, the tax hikes that did go into effect at the beginning of 2013, as well as the prospect of spending cuts, are likely to hamper economic growth.
Despite this, I see some positive tailwinds for stocks. Among them: the rebounding housing sector, a reacceleration of manufacturing, and growth in China. Here’s why.
The pact on taxes
The political situation in Washington tempered growth during the final quarter of 2012. Without clarity about tax rates or looming spending cuts, many companies downshifted and postponed capital spending plans. Two-thirds of Fidelity’s U.S.-focused analysts said that the fiscal cliff affected hiring and capital expenditures among the companies they follow. So even with a resolution, we may feel the aftershocks in the first quarter.
That said, clarity on what the tax rates are going to be in 2013 and beyond helped fuel a recent rally in the market, capping a strong 2012 in which the S&P 500® gained 16%.
But there are still questions outstanding. Will Congress and the White House come up with another agreement to avoid the automatic spending cuts known as sequestration? Will the debt ceiling be raised to prevent the government from defaulting on its debt?
Drag on growth
While those two looming deadlines have gotten a lot of attention, the way government cutbacks are dragging on the economy has not. Aggregate government spending has been falling for two years now. We began to see that from state and local governments in 2009. Then in 2010, the federal government’s contribution began falling as well.
With the expiration of the 2% payroll tax holiday, we’ll see another drag on growth starting in the first quarter. While 2% doesn’t sound like a lot, it will affect many people. When combined with rising taxes on high-income wage earners, it could shave as much as 1.25% off GDP growth in 2013. If sequestration takes effect, we’ll see an additional decline of 1% in GDP, and some industries like defense could be especially hard hit.
Private sector growth to the rescue?
The big question: Can the U.S. offset this government deceleration with private sector growth? Perhaps.
Housing is coming back. It has extended its upward trend from a very deep bottom. Home builder sentiment is positive. Housing starts have picked up, rising 22% year-over-year. We’re starting to see year-over-year gains in home prices, while affordability remains exceptionally high. The housing rebound has a positive multiplier effect not only in rising construction investment and employment, but in building material sales, durable goods orders, and service sector employment—all good for the economy.
Will the consumer hold up?
I was concerned that the looming fiscal cliff would impact consumer spending in the fourth quarter, because we saw that occur in August 2011, with the debt-ceiling debate. And indeed, there was a big drop in consumer sentiment in December. But in looking closely at consumer spending, while weak, it continued to grow in the final quarter. So, while not strong, consumer spending didn’t fall off the cliff. Bank lending standards also continue to ease for consumer credit, and the growth in consumer borrowing helps support spending as well.
Manufacturing is rebounding after a notable downshift in mid-2012. Going into late summer and early fall, durable goods orders fell and the ISM manufacturing index contracted, reflecting global weakness. But just recently, there are signs of an uptick globally. Because corporate America cut back on orders during the global slowdown, their inventories fell. Now they’re rebuilding inventories, restocking their shelves and factory floors—another positive sign for the manufacturing sector. Manufacturing is important even though it only accounts for 11.5% of GDP, because it produces a lot of high-skilled, high-wage jobs as well as exports.
Capital flowing in China
Turning overseas, China is on a rebound, which has an impact globally. There was a massive reacceleration of financial liquidity into the Chinese economy in the late summer. Nearly half of this increase is coming from nontraditional sources such as corporate bonds, investment trusts, and wealth management tools. We are carefully watching this trend in “shadow banking,” which eventually may result in underwriting and lending problems.
A significant percentage of that lending is going into infrastructure spending, allowing local governments to build subways and rail lines, for example. But it’s also flowing into land purchases and property development. The property market in China looks vulnerable from extreme overvaluation and apparent overbuilding. Nevertheless, liquidity is flowing into the sector again. All of this credit growth is fueling a rebound in China.
Why is China’s renewed growth important? We think the rebound we’re starting to see in the global manufacturing indicators reflects China’s reacceleration.
Europe crisis ending in recession
I’m also seeing stabilization in the periphery of Europe, after years of bad news. The steps the European Central Bank took last year stabilized capital markets in countries like Spain, Greece, and Italy. Ironically, that’s happening just as the core European economies, France and Germany, appear weak, so overall the European picture is still recessionary, but thankfully out of acute crisis.
So I see a lot of positive elements converging: the housing cycle, China’s rebound, manufacturing growth, global financial stability—and it is constructive for this stage of the U.S. economic cycle. I think all these things may be enough to offset the fiscal drag from Washington.
What does this mean for investors?
As a result of the fiscal tightening, I expect corporate profits may be flat year-over-year. In 2012, earnings rose 6% or so—and there were double-digit gains in the stock market. But with the ongoing fiscal and debt-ceiling debates in Washington, it’s difficult to see how there will be much in the way of multiple expansion. I think the easy money may have been made.
In the midst of the global financial crisis, and even during much of 2011, markets tended to move in tandem, with little regard to fundamentals. Now, with this crisis environment ebbing, I see that fundamentals matter again. The correlation among stocks—how much they move up and down together—dropped dramatically throughout 2012. There’s much more opportunity for actual stock-picking compared to the past several years. It’s becoming more important to know whether companies represent good values or not, and how they might react to particular economic scenarios—that’s why being diversified is especially important now.
That said, stocks also remain attractive compared with the alternatives. It’s hard to see an argument for further double-digit gains in bonds, especially with interest rates at historic lows. With this kind of outlook, one of the best and safest stances is to remain widely diversified. It’s sometimes mentally painful to do that when things look really bullish or bearish. But remember, while money was pouring into bond funds last year, the stock market had a double-digit gain. Whether the market does so again in 2013 is anyone’s guess, but if you’re diversified you can benefit from any upticks and reap the protection that comes from owning a wide portfolio of stocks and bonds.