Asset Management

All eyes on fiscal cliff resolution

William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets

December 14, 2012

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U.S. equity markets complacent on fiscal cliff negotiations
U.S. equity markets traded in a tight range for the week through Dec. 13, gaining 0.1%, which continues the pattern established in the last two weeks. After gaining 0.6% in November, the S&P is up 0.23% for the month to date. It is heading into year-end with a gain of 12.9% for the year, down 3.8% from the 52-week high it reached in October.

This trend in the U.S. equity markets continues even as the fiscal cliff looms, which implies that investors expect a bipartisan deal to be worked out before the Jan. 1 deadline. Although a positive scenario is far from certain, low levels of trading volatility suggest the markets are sanguine that a worst-case scenario will be averted.

International markets outpacing U.S. stocks
International equity markets were broadly higher this week. MSCI’s All Country World Index (minus the U.S.) was up 1.23% for the week through Thursday, led by a +2.3% gain in the Nikkei. Japan has been of critical interest to investors due to speculation around parliamentary elections on Sunday and an expected win for Shinzo Abe of the Liberal Democratic Party, a former prime minister who would become the seventh prime minister of Japan since 2006. The widespread belief that a new government will push the Bank of Japan to full-blown quantitative easing and a weaker yen has triggered a sharp rise in one of the cheapest markets in the world. Since its mid-November low, the Nikkei has risen over 13% — more than double the S&P’s advance over the same period.

Article Highlights

  • U.S. equity markets show little change, indicating investors expect more of a fiscal “slope” than a fiscal cliff.
  • International equity markets continue to outpace U.S. stocks.
  • Treasury yields were up slightly based on strengthening employment numbers.
  • U.S. economic data highlighted a slight decrease in unemployment claims, little to no inflation and positive retail sales.
  • Markets showed limited reaction to the Fed announcement to tie monetary policy to specific unemployment and inflation targets.

MSCI’s emerging markets index was up 1.78% for the week, extending a 7% rally since mid-November. MSCI’s Europe index also gained 1.46% this week. Europe remains technically in a recession, but the headlines have not been as bad as they have been in recent months. Germany’s ZEW Indicator of Economic Sentiment increased by 22.6 points in December and European earnings revisions, which had been negative, are less so than they were in November. The European markets remain cheap and look set to move higher as talks of an EU breakup will likely be minimized through September 2013, awaiting the outcome of German elections.

Fixed-income markets digesting Fed goals to tie monetary policy to specific targets
Fixed-income markets saw a backup in 10-year Treasury yields by roughly 10 basis points to 1.74% and the 30-year yield increased more than 20 basis points to 2.9% from Dec. 6 levels. The increase in yields has largely been a function of the Fed’s intention, announced this week, to tie its future quantitative easing activities to an unemployment rate target of 6.5% with an inflation target of 2.5%.

The Fed sought to accomplish three things in making this announcement:

  • offer reassurance that the Fed will act carefully and prudently when tightening policy and that it will not do so anytime soon,
  • correct a past mistake of targeting a date rather than an economic condition, and
  • indicate that it will reduce the size of the balance sheet before raising rates in the future.

The Fed essentially acknowledged that it is changing its stance of committing to keeping rates low through 2014, while at the same time admitting it has let prevailing economic conditions determine appropriate monetary policy. With this announcement, Fed Chairman Ben Bernanke has signaled that the committee will take many more factors into account than just the unemployment rate, inflation and inflation expectations. The implication is that future Fed tightening will not follow a schedule that the markets currently assume. In fact, the Fed just allowed for the possibility of an upside surprise in economic growth that the market is not factoring in right now.

The second important point was the comment that interest rate increases will only resume some period of time after quantitative easing ends. In other words, look for Fed tightening to come sooner and in the form of balance sheet activity before traditional interest rate policy changes.

The market viewed this explicit goal as fairly aggressive and potentially more inflationary over time. This week’s widening in Treasury yields, however, is not very significant given the historical volatility in Treasury yields over recent years. Yield increases would likely be greater still if there had been greater progress around the fiscal cliff.

In other fixed-income news, high-yield corporate securities continued to outperform their investment-grade counterparts as investors continue to seek yield while trying to avoid the risks associated with the longer duration of corporate investment-grade securities. If the job markets were to improve significantly and the Fed were to increase interest rates accordingly, investment-grade corporates would be significantly more exposed than high-yield bonds. If 2013 proves to be a year of low volatility, it is quite likely that high-yield bonds will continue to outperform high-grade corporates, since total returns would be more dependent upon interest rate carry than the extraordinary price appreciation we have seen in 2012. Fund flows into both high yield and investment-grade corporates continue to be generally positive as fixed-income funds seek yield.

U.S. economic indicators turning positive
Economic data highlighted a number of areas of good news this week. Initial jobless claims declined by 29,000 to a seasonally adjusted 343,000 in the week ended Dec. 8. The weekly claims number, always volatile during the period between Thanksgiving and Christmas due to seasonal hiring, has been especially volatile due to the effects of Hurricane Sandy. Although we do not expect an accurate unemployment number until mid-January, the improvement is impressive considering that many firms are holding off on hiring while waiting to assess the outcome and impact of the fiscal cliff resolution.

The Producer Price Index (PPI) dropped a seasonally adjusted 0.8% last month, larger than a 0.5% expected drop and the biggest decline since May, which suggests there is little inflationary pressure on the economy. Over the past year, wholesale costs have risen a mild 1.5% overall — within the Federal Reserve’s target for inflation.

Finally, retail sales for November were mixed. Overall, retail sales rose just 0.3% over the previous month — below consensus expectations of a 0.5% increase. Gasoline sales were a drag on the month, falling 4%. Building materials, however, seemed to benefit from both Hurricane Sandy and the housing recovery, gaining 1.6%. Vehicle sales were up 1.4% after a 1.9% decline in the prior month. The bright spot in the report was the core retail sales component, which excludes autos, gasoline and building materials. It rose a better-than-expected 0.5% following a flat reading in October.

Views and observations on fiscal cliff negotiations
Headlines contain both positive and negative commentary regarding the possibility of a resolution to the fiscal cliff before year-end. The fact that we are seeing more reporting on actual events and fewer rumors is a positive sign. Although negotiations are reaching the eleventh hour, reports that negotiations are being conducted directly between President Obama and House Speaker Boehner, without committees, give hope that a weekend deal is at least possible. Markets seem encouraged by the fact that the leadership of both parties is telling their respective sides to cancel holiday plans, effectively extending the current legislative session through year-end.

Thus far, the markets seem to be unfazed by the impasse centered on the size of tax increases for the top 2% of wage earners. The markets are increasingly working from the assumption that an outcome will be announced after year-end, since both parties must reach agreement by this weekend in time for any bill to be written before the holiday recess, but at the same time markets are acknowledging that the effects of going over the “cliff” will be less dramatic than anticipated—more of a fiscal slope than a fiscal cliff.

The consensus among investment managers seems to be that the most likely resolution of the fiscal cliff would reduce U.S. GDP growth expectations to 1% or lower for 2013 — a level that the U.S. economy could absorb. Neither political side seems unwilling to compromise, since a failure to compromise would risk blame for putting the U.S. economy back into recession. However, if there were any true break in the negotiations, it would lead to a market decline. How deep that decline would be will ultimately depend on how long an agreement will take to implement.

In our opinion, any market decline is a buying opportunity for U.S. equity portfolios, given the generally improving economic trend both here and abroad. Anecdotally, several CEOs expressed their personal views this week that the economy is poised for significant growth in 2013 if only the fiscal cliff could be definitively resolved in the immediate future.