Whether a corporate CEO, professional sports coach, or even just a parent, much of the time spent in private tends to focus on “what could go wrong” and identifying preventive measures. Investors are no different. In the past thirteen years, two historic market declines of greater than 45% blindsided investors. Investors are justified to consider whether a third secular decline is pending. Certainly much of the media coverage of the capital markets focuses on that scenario.
So while prudent to ask “what could go wrong,” the evidence does not suggest an imminent secular top. Perhaps as the calendar advances into 2013, a grand compromise regarding the fiscal cliff, oddly enough might be “what could go right”.
On Thursday, October 11, CNBC TV interviewed together Lloyd Blankfein, CEO of Goldman Sachs, and Alan Simpson and Erskine Bowles, champions of the now famous Simpson-Bowles debt reduction plan. When asked to comment on the looming fiscal cliff, and what could be next, Blankfein offered the following: “What if we came up with a situation tomorrow? You opened up a newspaper and there was some conciliation, there was some agreement. It may not be everything that one side would want, somewhere in the middle, maybe even closer to the extreme that you didn’t like. But there was some compromise that was laid out. What kind of stimulus do you think that would provide?” The questioner asked Blankfein for an answer to his own question and his reply was “Huge!”
The Goldman CEO’s comment captures much of what has been at work in the stock market over recent months and could be the prospect for months and years ahead. The economy and the equity markets are poised for something big if (and it’s a big if) our government leaders can begin dealing with the spending, deficit, tax, jobs and other key impediments to our economic growth.
Investors got a taste of this prospect for better times during the third quarter when the S&P 500 climbed 6.35%. Driven by ample liquidity from Federal Reserve monetary policy – including the launch of a QE3 program to buy mortgages – stock prices reacted positively to a slow but growing economy, continued high level of corporate earnings, reduced threat from slowdowns from European and Asian economies, and the expectation that US fiscal policy has nowhere to go but get better. Most pundits believe that after the election, Congress will postpone the tax and spending changes known as the fiscal cliff and the stock market seems to presume no economic damage is imminent. Then, during 2013, regardless of who’s elected President, the next Administration and Congress have no choice but to attack these difficult issues. If reasonable solutions are found, the impact could be “huge”, using Blankfein’s word. Let’s remember, Goldman Sachs is the leading investment bank in the world, with a footprint providing financial services to the largest corporations and institutional investors worldwide. Their read of the upside possibilities to our economies, businesses and capital markets has been historically among the best.
The road to a better economy will of course be bumpy. Reaching “conciliation” or “compromise” will be difficult given the polarization of the political parties. The outcome of the election will certainly define the approach that the next Administration takes. Spending cuts and tax reform will be severely impacted by the effort of lobbyists. There is certainly the possibility that stalemates result and the economy turns down. However, all the polling indications this election season – on top of fiscal conservative inroads made over the last two years in all levels of government – do suggest that the public is sending the message to our legislators to get the job done. Again, if they do, it could be “huge” for the years ahead.
So how do you fix this mess? Fiscal policy. Our legislators are elected to enact bills and set policy to guide the economy. Legislation is an act of bipartisanship led by Congress and spearheaded by the President. Whenever new policies are passed into law – markets respond and adapt. If the policy is received positively, then markets and consumer sentiment respond accordingly. If on the other hand, policy is poorly received then the reaction is negative. So, we are in need of pro-growth fiscal policy that is well received by the population at large.
Free markets are a reflection of our society. Every nuance is factored into the equation – from actions of multinational conglomerates to the simple hand shake among two friends. It is these events that represent the mood and ethos of the free markets. Investors’ actions are a sign of the times. Difficult periods promote caution and savings. When things are perceived well, morale is high and displayed by confidence in spending and risk taking. The mood of the moment shows up one way or another in purchases, expenditures, and investments.
All these points, and others that could be cited, suggest that the US economy has a tailwind that awaits a stronger thrust. Different policies about taxes, spending, regulation, energy and so forth do not mean that the wind will pick up immediately. Rather, there are likely to be some disruptions and dislocations as federal spending cuts and tighter monetary steps are implemented. Yet stronger business and consumer confidence, the rolling off of past problems such as excess housing supply and more accommodative regulations such as energy expansion, all are benefits that can offset fiscal drag. Perhaps we are in a period much like the first 2 years of both the Reagan and Clinton presidencies: years 1 and 2 for Reagan dealing with 1970’s inflation and for Clinton ending the S&L crisis and recession, then in both cases followed by 6 years of robust growth.
The right conditions set the stage for much better times ahead once we first deal with our problems. Acceleration in economic growth to the 3-4% range and unemployment moving towards 5% would give a “huge” boost to corporate profits and stock prices.
I am carefully watching the next few months to ascertain if movement in the right direction actually happens. The election will be determined, the efforts to deal with the fiscal cliff (most likely on a temporary basis) will be evident in the lame duck Congress, and new pronouncements from the next Administration should cast light on plans and policies to deal long term with the structural issues. Pending clarity around these issues, I do not believe any change in investment strategy relative to what each client currently has in place should be made. In our security selections, I still advocate short duration in fixed income holdings to mitigate the risk of rising interest rates. Among our equities, I have always maintained diversified portfolios across the economic sectors, with our current weighting tilted towards the industries and companies that benefit from strong emerging market growth and steadily improving US prospects.
As always, I thank you for your business and your trust in me.