In the final hours of the 2012 trading year, the financial markets showed their relief that Congress and the White House had reached an agreement and the “Fiscal Cliff” would be averted. The collective attention of the markets is now turning to the Debt Ceiling talks which involve Congress signing off on yet another increase in the borrowing limits of the US. Given that the US debt limit has been raised at regular intervals, some Congressional members are not willing to rubber stamp yet another debt limit increase.
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Turning the Page on the Fiscal Cliff
In the final hours of the 2012 trading year, the financial markets showed their relief that Congress and the White House had reached an agreement and the “Fiscal Cliff” would be averted. The collective attention of the markets is now turning to the Debt Ceiling talks which involve Congress signing off on yet another increase in the borrowing limits of the US. Given that the US debt limit has been raised at regular intervals, some Congressional members are not willing to rubber stamp yet another debt limit increase. This sets the table for the next potential fight between Congress and the President and is one that could upset investor portfolios. Essentially, the “national credit card” of the US could be maxed out against the debt ceiling. Without an agreement that would allow the US to borrow more, the US could begin to default on its $16.4 trillion debt. The markets would not take kindly to such an event.
Fortunately, this is not a high probability event – though it could still provide the markets a bumpy ride. Currently, the markets are pricing in a scenario of yet another 11th hour deal.
Investors here find themselves at polar opposites. The pessimistic side believes that the national debt is too high a hurdle for the economy to overcome and the deleveraging process will continue for some time yet. The bullish argument is that the economy is on the mend with a rebounding housing and auto sector leading the way. Add in low inflation, a Federal Reserve willing to hold interest rates lower for longer, and rising corporate earnings and we have an attractive environment. Globally, central banks are continuing their bold efforts to seemingly do whatever it takes to ensure their respective economies are strengthened. Nearly 40 central banks around the world are engaged in aggressive monetary easing in order to stimulate their economies.
Putting Money to Work
Investors have been so cheered by this backdrop that for the week ending January 9th, they have put more capital to work into equity mutual funds in the US than any other single week since October 2007. A similar occurrence took place when US markets were peaking before the financial crisis. This is a marked turnaround from the trend that has prevailed for the last five years as investors withdrew close to $500 billion from US equity mutual funds while adding $1.2 trillion to bond funds according to the Investment Company Institute (see chart above).
This trend has also caught on in emerging markets (China, India, Brazil, Russia, etc.). According to Morgan Stanley, emerging market stock funds have seen cash inflows for 18 consecutive weeks. In comparison the previous record was 29 weeks of money inflows ending December 2010.
As we have highlighted over the years, such data points are not comforting. In fact, extremes in investor fund flows tend to be a contrarian indicator as mutual fund investors often invest by piling into fads or assets that have already been bid up. It should be noted that the last time we observed this much of an increase in investor risk appetite, US equities tumbled 57 percent in almost 18 months after the S&P 500 stock market index reached its peak in October 2007. However, no one indicator can be used in isolation and there is currently a modest undercurrent of strength to the global economy.
Officially called the American Taxpayer Relief Act of 2012, the fiscal cliff deal will raise revenue of $617 billion over the next ten years as compared to the option of allowing the Bush tax cuts to carry on. Over $540 billion will come from households making over $1 million per year. While the budget deal provides markets with temporary relief from anxiety, critics believe that the tax impact will actually raise taxes on almost 80% of US taxpayers through higher income taxes, payroll taxes or both. They state that the impact of the higher taxes will hurt the economy while the US federal deficit will likely remain in the frightening $1 trillion range and the debt-to-GDP ratio for 2013 will still climb to about 107% of GDP from the current 100% level. The budgetary challenge for the US will lie in whether or not the increase in tax revenues outweighs the drag on the economy that those same tax increases will create. Looking at the US budgetary numbers, this much is clear: the budget will continue to be a headwind until the tough decisions on spending controls on entitlement programs and defense budgets are made.
Canada is going to be impacted by whatever route the US economy takes. Domestic challenges to the Canadian economy are only now starting to make the front pages. For some time, our commentaries and newsletters have tried to make the point that Canadian consumer debt, elevated house prices and accelerating government spending at the federal, provincial and municipal levels could combine to hinder future economic growth.
The Bank of Canada has kicked off 2013 with some candid comments suggesting the economy is going to take longer to recover and rates will stay low for sometime. One of the objectives of the fiscal and monetary authorities in Canada has been to slow the increase in household credit. To this end, the data are moving in the right direction as the increase in household credit has been moderating from a 5.5% growth rate to a little more than 3% in the most recent quarter. This is the lowest rate of growth since 1999 and is being led by slowing mortgage credit. However, the troubling fact is that this slower increase in credit is still above the growth of disposable income which means that consumer debt is still rising faster than incomes.
Amazingly, in a few short years Canadian consumers have managed to increase their debt levels to beyond the levels that US consumers had at the beginning of the collapse in the US real estate market. The latest data from the Bank of Canada shows that the ratio of household debt to income is at 165%.
Therein lies the challenge for Canada’s economy. Canadian consumer spending accounts for 58% of GDP but debt levels are already at record highs. Thus, consumer spending will not be able to lead in any significant way a potential rebound in economic growth. As the chart above shows, Canada’s leading economic indicators point to a Canadian economy that will lag the United States and the rest of the G7.
While Canadians have been accustomed to tax cuts over the last fifteen years, it is highly unlikely that Canadian taxes will be able to fall any further. The deterioration in the budgetary picture at all levels of government will likely mean higher taxes – further restraining the economy and disposable income.
Profits and Expectations
For several quarters, most analysts have been lowering their expectations for profit growth. This is due to the fact that GDP numbers for much of the world are coming in lower than expected. However, as the bar has been lowered successively, most companies have been able to jump over the bar to the relief of investors. The bearish argument around corporate earnings is that earnings growth has slowed and revenue growth has all but stalled. According to data from Thompson Reuters, current expectations are for US corporate earnings to rise 1.9% year over year. Three months ago, expectations were for a 9.9% annual increase and six months ago it was for a 13.7% increase. Clearly, expectations have come down.
This is significant because revenue growth is tied to growth of the economy (GDP growth). If GDP growth rates stall or come in under expectations, corporate revenue is likely to come in under expectations. Therefore, corporations would not be able to meet the expectations that are built into stock prices. Thus far, fourth quarter 2012 earnings announcements are beating expectations by more than 2 to 1 – albeit on lowered expectations. Currently, the S&P 500 is trading at a level of approximately 13.2 times 2013 earnings estimates which makes the market cheaper than the longer term average of closer to 15 times. While the US stock market is not cheap, it is fairly valued. In order for the market to continue to be fairly valued, global GDP will have to continue to strengthen and corporate profit margins must hold steady. As a percentage of US GDP, corporate profit margins in the US are at record highs as wages have been restrained, interest rates are low and corporate balance sheets are pristine.
These characteristics have allowed S&P 500 corporations to buy back over 8 billion shares (net) over the last twenty-one months, thereby providing support to stock prices. As of 3Q 2012, the S&P 500 companies had about 300 billion shares outstanding – which was the lowest number of shares since mid 2009.
While the markets have somewhat elevated expectations, an improving economy and a calmer macro- economic environment will help to support the markets. The key outcome to monitor will be to see whether revenue growth, corporate profit margins, and earnings continue to make stocks an attractive asset class.
Pacifica Partners – Capital Management Navigating a Sea of Opportunity
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