Focus on fiscal fundamentals
As I spend time researching the economy and markets, I find more and more information related to politics and the fiscal cliff, both of which are important variables that influence markets. In 2012 the presidential election held investors at bay, and immediately following, the focus was on the looming fiscal cliff. Unfortunately, the fiscal cliff, or ruminates of it, will be dealt with throughout 2013.
We now know that the revenue side of the fiscal cliff equation will result in a tax increase for 77 percent of U.S. households. The spending side of the equation was kicked down the road, only to be dealt with at the end of February. Now, as Congress wrestles with spending cuts, they must consider raising the debt ceiling or perhaps face a government shutdown or even a default on U.S. debt.
These issues are important, but they are not the drivers of long-term asset prices. Over time, they become market noise — a distraction from what is truly important: the fundamentals.
First, from an economic standpoint, presidential elections don’t really matter that much. The elections themselves create some uncertainty which cause market volatility and opportunity. But, in general, the markets are bipartisan in nature and don’t “care” who wins or which party is in control. In studying past election results and market performance since 1900, the market prefers a Democratic president, and the results improve with a Democratic president and a split Congress, the current political power status.
Table 1: Market Performance, March 4, 1901 – March 4, 2013
Political power status
% of Time
Democratic President, Democratic Congress
Democratic President, Congress Split
Democratic President, Republican Congress
Republican President, Republican Congress
Republican President, Congress Split
Republican President, Democratic Congress
Second, as mentioned earlier, 77 percent of U.S. households will see an increase in taxes this year. Yet historical data tells us that taxes don’t have a major impact on market performance. When taxes go up, be it income tax rates or capital gain rates or taxes on dividends, markets can still produce attractive returns. For example, in 1993 income taxes and taxes on dividends increased substantially; however, using the S&P 500 as a market proxy, the market posted a return of 10 percent.
Table 2: S&P 500 Total Return Index, January 1, 1928 – December 31, 2012
Top Federal Income Tax Rate is …
% of Time
Third, the consternation over the debt ceiling, in absolute terms, is exaggerated because the overall amount of debt will (and should) continue to increase as our economy grows. The debt ceiling has been raised 79 times since it was established in 1917, and it will continue to be expanded when needed. As our economy grows we should naturally take on additional debt, as long as it is manageable and fiscally effective.
While it is debatable whether the current situation is manageable, we can all agree that the debt ceiling should be constrained to a rational level in terms of debt as a percentage of GDP. An example would be for the U.S. to constrain the debt-to-GDP ratio at 80 percent. So in simplistic terms, as the economy grows to $20 trillion, the debt would increase; however, it would be constrained to $16 trillion or 80 percent of GDP.
It’s unfortunate that the decision to extend the debt ceiling, which should be a simple function within our normal management of the balance sheet, has become an explosive instrument of political leverage because of previous fiscal recklessness and ongoing divisiveness in Washington. Perhaps the way it’s being handled will force Congress to come up with a rational, long-term solution. Then we can move forward knowing there will be some required discipline guiding the future extensions of the ceiling.
What really matters?
I grew up in Wisconsin, so naturally I am a Green Bay Packers football fan. In 1959, Vince Lombardi became the head coach of the Packers; unfortunately he inherited a dysfunctional team. After assessing the team, he stood before them holding out the ball and spoke arguably the most famous quote in football history: “Gentlemen,
this is a football!” He made the decision to start with the basics and fundamentals as he rebuilt the team. In 1960 the Packers played in the NFL Championship game, and even though they lost, Lombardi went on to be a great coach with an impressive track record. The stock market isn’t much different— fundamentals matter.
Sooner or later, the market looks at the underlying fundamentals to determine asset prices. Since 2009, the fundamentals of the U.S. economy have been improving. Some of the important, positive aspects of the economy often neglected by the media include corporate health, residential investment and motor vehicle sales. All of these factors are improving.
First, corporate fundamentals are strong. Companies are lean, productivity is high and margins are near record levels. Corporate earnings also are at all-time highs and
businesses, while still uncertain about the economic environment, are looking to invest the cash they have sitting on the sidelines. Additionally, corporate balance sheets have never been stronger, and because of this, earnings have outpaced the stock market performance since 2009, growing by 96 percent, while the S&P 500 has increased by 68 percent.
Clearly, monetary policy and liquidity have played a role in driving stock prices higher, but this year we anticipate earnings growth to be in the six to eight percent range. That should support high single-digit equity returns. Noise aside, sooner or later corporate earnings will be a major catalyst in moving stock prices higher.
Additionally, one of the most encouraging signs in the economy is that some of the most cyclical elements of the U.S. economy - housing and motor vehicles - are finally recovering from the recession. In fact, we forecast that both housing and automobiles will once again be major contributors to U.S. economic growth over the next few years. Historically, it has been common for residential investment and motor vehicles to comprise nearly 10 percent of real GDP. Today, that number stands at just under six percent due to the depressed nature of these markets, which means there is a significant runway for growth ahead.
The housing market peaked in 2006 as we were building 2.2 million homes a year, which created a supply problem. Today the pendulum has swung the other direction and now we have a demand problem as excess supply has dissipated. This will support increasing home prices and climbing consumer confidence.
With respect to the motor vehicle sector, during the last recession many individuals made the rational decision to delay a major capital expenditure, purchasing a new automobile, by running their current vehicles for longer. This has resulted in an all-time average age high, with vehicle stock at nearly 1 1 years, creating a significant amount of pent up demand for new and used cars. As financial and labor market conditions have improved, and as credit conditions ease, we are seeing strength in automobile demand. We believe the auto sector could be a positive contributor to real GDP for at least the next three years.
Lastly, we see global fundamentals improving. Since June 2011, there have been 345 stimulative initiatives worldwide, interest rate cuts, quantitative easing, lower tax rates and loan programs.
I believe that banks and credit are the life blood of the economy. When examining the performance of commercial bank stocks in the U.S., they returned 24 percent in 2012, yet banks in Europe were up 32 percent. The performance of bank stocks gives us some insight into the health of the banking industry. Clearly it is improving, and global banks are currently in better shape to lend money, which will support economic growth.
Additionally, as the global environment improves, U.S. corporations will ship their goods and services around the world, continuing the improvement of corporate earnings.
The fundamentals of our economy are improving, albeit slower than most expected. It’s still important to note that the fundamentals are headed in the right direction. And fundamentals matter.