Politics & Policy - Be Prepared to Go Over the Fiscal Cliff

Be prepared to go over the Fiscal Cliff

Once again we are in full crisis mode in Washington as our elected “crisis managers” set out to resolve the pending fiscal cliff. We have written in the past that, given the history of Washington over the past four years, we expect an eleventh hour deal that only extends the hard decisions further out in time. Recall the debt limit increase of last year. And the magnificently named super committee that failed. The last minute negotiations to avoid the shutdown of non-essential governmental agencies are always amusing.

To reiterate the pending economic challenge, on January 2, 2013 this country faces a slew of new taxes and spending cuts that economist are sure will send this country into another recession. The impact of which will drain over $600 billion from the U.S economy. The nation is facing a $127 billion tax increase on Americans when the payroll tax cuts expire; $295 billion tax increase from the expiration of the Bush tax cuts; $24 billion in new taxes from ObamaCare; $87 billion tax increase in other tax provisions. The nation also faced $87 billion in defense and discretionary spending cuts and $35 billion in cuts from the end of extended unemployment benefits.

The Left

Even now, both sides are jockeying to position themselves to obtain the greatest negotiating leverage. This past weekend during his weekly radio address President Obama warned Republicans that there are only two possible outcomes for the coming negotiations, allow tax breaks to expire for the top two percent of American earners, or taxes will go up for EVERYONE.

Democratic allies in the labor movement are campaigning aggressively to lock in the lefts objectives. According to The Hill, “The American Federation of State, County and Municipal Employees (AFSCME), the National Education Association (NEA) and the Service Employees International Union (SEIU) will launch a series of radio and television ads on Tuesday that urges lawmakers to let the Bush tax rates for the wealthy expire while preserving entitlement benefits.”

Jim Messina, the president’s campaign manager is using social networking and email to get the message out to supporters regarding the president’s position in the negotiations. By using its “re-election machine”, there are hopes that the Obama administration will garner the appropriate support they need to take a hard-line stance. 

The Right

The right is also gearing up for battle. Speaker of the House John Boehner wrote an op-ed piece in the Cincinnati Enquirer simply stating that ObamaCare must be put on the negotiating table for cuts in order to proceed making the case that the country cannot afford the added costs. We are almost certain this will be a non-starter for democrats and further exemplifies the gap the two parties must bridge to come to a final settlement. 

Speaker Boehner is gathering the appropriate allies in Congress to counter the Presidents claims of an election mandate by stating his retention of the Speaker of the House position offers his own election mandate.

The Wall Street Journal opinion section this weekend conducted an interview with Grover Norquist, head of the Americans for Tax Reform group. Mr. Norquist has been an extremely influential advocate against the raising of taxes and has every Republican leader sign a pact with the American people that they will vote against such action. When asked if he thinks Republicans will yield to tax increases if the appropriate spending cuts are initiated the Journal wrote, “Mr. Norquist insists that this won't happen because Republicans who think Mr. Obama or Senate Majority Leader Harry Reid are ever going to agree to cut domestic spending or reform entitlements are "chasing imaginary unicorns."”

He goes on to state, “"I feel very comfortable with where the Republican leaders are right now," he says. "We are infinitely stronger than we were two and four and 10 years ago as a Republican Party. We should be much more confident. We should emphasize growth and do a better job spreading the message to all voters. Explaining to people why tax increases are bad for the economy—that should be child's play."”

Based on the weekend banter back and forth, an investor needs to understand that, in light of the pleasantries and thin market rally last week, the issue of the fiscal cliff is far from over.  

What this means for the Stock Market

Obviously the market is sensitive to the issue of the fiscal cliff and despite the holiday shortened market rally that ensued on meager volume, we are of the opinion, based of the preliminary readings that businesses and investors will continue to scale back as it becomes ever more likely that we actually may be going over the cliff. 

Former Chairman of the Federal Reserve Alan Greenspan said this past week that “the markets will crater if we run into any evidence that we can’t solve this problem.” Credit Suisse produced a survey that 38% of businesses surveyed have stated that they have cancelled or postponed planned investment and spending decisions based on the pending fiscal issues. This is currently being picked up the durable goods figures that have been declining. The next release will be on Tuesday.

Any prolonged exposure to uncertainty will have negative effects on the stock market thus we are staying in cash and quite possibly, as per our behavioral model, increasing our short exposure. We take this stance after further insight that we actually think we will go over the fiscal cliff, albeit for a brief period. If that were to happen, we anticipate further market downside from these levels.

Be prepared to go over the Fiscal Cliff

In our opinion, it appears the disagreement between the left and right is too vast to solve in the next five weeks. In addition, we believe we are wrong in our original assessment of an eleventh hour deal that only extends the hard decisions further out in time.

After contemplating each sides strategy over Thanksgiving turkey, we have come to the conclusion that both sides must WANT to go over the cliff temporarily. It will change the entire dynamic of the debate.

Ponder this: On December 31, 2012 the debate revolves around INCREASING taxes on the top 2%, DECREASING defense spending, INCREASING payroll taxes and DECREASING unemployment benefits.

On January 2, 2013, after we go over the fiscal cliff, the debate will resolve around DECREASING taxes for the bottom 98%, INCREASING defense spending, DECREASING payroll taxes and INCREASING unemployment benefits.

How much easier will it be for politicians to vote to reverse the damage than to make tough decisions before the crisis. What a difference a day makes. With this outcome, Democrats get everything they want, thus President Obama’s hard-line stance and Republicans will save face by not having to vote for tax increases on America’s wealthy.

It’s basically a complicated way of simply kicking the can down the road. Of course this is a controversial view and  we have been wrong many times in the past, but given the current conditions and what our models are saying, we will stay the course and believe this stock market correction has NOT come to an end.

 - Joseph S. Kalinowski, CFA

Twitter: @jskalinowski

References

http://www.businessinsider.com/durable-goods-orders-fiscal-cliff-2012-11

http://thehill.com/homenews/house/269133-tax-fight-has-feeling-of-deja-vu

http://online.wsj.com/article/SB10001424127887324352004578137112355225342.html

http://thehill.com/blogs/on-the-money/domestic-taxes/269147-tax-policy-center-adds-fuel-to-rate-debate

http://www.forbes.com/sites/steveforbes/2012/11/20/president-obama-clinton-prosperity-requires-clinton-sized-government/

http://www.americanthinker.com/blog/2012/11/senator_chambliss_to_vote_for_tax_increases.html

http://www.americanthinker.com/2012/11/whither_the_republicans.html

http://thehill.com/blogs/on-the-money/domestic-taxes/269181-chambliss-i-care-more-about-my-country-than-for-norquist-tax-pledge

http://thehill.com/homenews/house/268815-boehner-tightens-grip-on-gop-rank-and-file

http://thehill.com/business-a-lobbying/268807-unions-work-to-pull-talks-on-fiscal-cliff-to-the-left

http://thehill.com/homenews/administration/268587-obama-only-two-paths-available-in-fiscal-cliff-talks

http://thehill.com/blogs/on-the-money/budget/269103-business-leaders-seek-debt-ceiling-hike-with-fiscal-cliff-deal

http://www.americanthinker.com/2012/11/the_balanced_approach_is_an_unbalanced_lie.html

http://www.newsmax.com/Markets/Greenspan-markets-Fiscal-Cliff/2012/11/16/id/464513

http://thehill.com/homenews/senate/268977-bennet-and-alexander-give-leaders-emergency-backup-plan-to-avoid-fiscal-cliff

http://finance.townhall.com/columnists/larrykudlow/2012/11/21/obama_wants_higher_revenues_and_rates/page/full/

http://thehill.com/blogs/healthwatch/health-reform-implementation/269059-boehner-obamacare-must-be-on-table-in-debt-talks

http://thehill.com/video/house/269151-mcmorris-rodgers-clock-is-ticking-on-looming-fiscal-cliff

http://thehill.com/blogs/blog-briefing-room/news/269081-obama-campaign-uses-e-mail-list-to-rally-supporters-on-fiscal-cliff

http://www.businessinsider.com/another-week-gone-and-no-fix-for-the-fiscal-cliff-2012-11

 

JSK Partners of New York, LLC
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No part of this report may be reproduced in any manner without the expressed written permission of JSK Partners of New York, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  JSK Partners of New York, LLC have proprietary accounts and funds under management. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report.  The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of JSK Partners of New York, LLC and its affiliated companies may also be conducting trades based on the firm's  research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant. 

Politics & Policy - Equity Risk Premium Points to Trouble Ahead.

In our Money and Finance note today, we expressed our skepticism towards the current market bounce in large part due to our overall skepticism regarding a smooth formulation of the proper fiscal policy stemming from Washington.

One should expect a looming battle of the right and left on how best to proceed forward regarding the handling of the national economy with the final solution coming in the eleventh hour. That mounting uncertainty as negotiations roll on will create a level volatility in the market that investors will view negatively.

 That said, the most likely the solution out of Washington will be counterproductive as an economic growth policy and short-term in nature. It will be, in essence another kick the can session.

What is concerning is the state of our fiscal affairs in this country and how it will affect our economy. After reading an article by Robert Jenkins in the Financial Times last week entitled, “It’s time to think the unthinkable on America’s debt”, We wanted to revisit a model that was created many years ago addressing equity risk premium.

Figure 1 compares the twelve-month forward earning yield (this is the inverse of the P/E ratio using forward forecasts) to the ten year U.S. Treasury bond yield. The latest readings are derived from the following figures. Currently Wall Street analysts are projecting S&P 500 earnings to settle in around $111.42 in the coming twelve months indicating an earnings yield of 8.1%. When compared to the 1.6% offered on the ten year, the differential is completely misaligned with where history states it should be. In order to produce a more normalized comparison, stock prices will need to rise dramatically, OR corporate earnings will need to be cut drastically OR treasury yields need to rise aggressively. 

 Perhaps a combination of all three will happen, but given the uniquely easy monetary policy that has been initiated by the Fed, one needs to assume that treasuries are largely over-valued at this point.

Taken further, the Fed has control of monetary decisions for the time being allowing fiscal policy a runway towards restructuring. Let’s hope that politicians in Washington do not squander this window of opportunity while they have it. If the control of the situation transitions from our policy leaders to the bond market, a financial crisis will arise dwarfing the economic meltdown of 2008.

Debt Crisis

The Cato Institute wrote an ominous report about our fiscal dilemma. The report is written by Doug Bandow and is entitled “Heading toward National Insolvency”. A must read for those concerned about our economic future, we wanted to highlight some of the key points from this report. http://www.cato.org/publications/commentary/heading-toward-national-insolvency

Bear in mind that for the past four years, the federal government is running a deficit of over $1 trillion per year, which is the largest budget deficits since 1945 in both dollar terms and as a percent of GDP according to the Congressional Budget Office.

The CBO, under its more optimistic projections warn that debt as a percent of GDP has the ability to decrease to 53% by 2037. Thus under optimistic assumptions, our debt will still be 40% higher than average even after 25 years of restructuring. 

The CBO goes on to state how the growing debt load would increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to borrow at affordable rates.  

Bandow goes on to write, “Unfortunately, rising outlays and debt threaten to create an economic death spiral. Obviously, more borrowing means higher interest payments, that is, more government spending. At the same time, more debt is likely to increase interest rates, since lenders will become ever more worried about Uncle Sam's ability to pay back the loans. Last year Standard & Poors downgraded Washington's credit rating and in early June threatened to do so again if Congress fails to control spending. The result would be even higher interest payments.

Moreover, warned CBO, rising red ink "would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment — which in turn would lower the growth of incomes in the United States." That is, because of excessive government outlays Americans will earn less even as they have to pay the government more. And there's no logical stopping point. As expenditures rise, the cycle will accelerate.”

The Fed’s Balance Sheet

Our view holds that Chairman Bernanke has been forced to go above and beyond traditional monetary policy stimulus measures because Washington is in such a funk. Both parties have engaged in ideological sparring and have completely rendered traditional fiscal policy measures inept. The last decade of abusive spending in Washington has drained our resources at a time when we could use them.

Chairman Bernanke and the Federal Reserve have increased the Fed's balance sheet using unorthodox monetary measures such as Quantitative Easing and Operation Twist. The Fed, whose balance sheet was less than $1 trillion prior to the Great Recession now stands at roughly $2.8 trillion. Increasingly worrisome is the “twist” from shorter-term maturities to longer-term instruments that are more sensitive to changes in interest rates. With their latest “QE Infinity” announcement, many economists are projecting an increase of the Fed’s balance sheet to $4 to $6 trillion, or an increase of 40% to 115% by the end of 2013.

At some point, the Federal Reserve would be forced to stop purchasing or risk higher inflation. Should the situation arise requiring the Fed to sell securities, then treasuries will fall and rates will rise.

Rising rates

Given the current level of interest rates and borrowing, some economists are projecting that the nations interest payments servicing outstanding debt will exceed our national defense budget within ten years. This assumes current rates below the two percent level. But if rates were to rise above 5% on the ten year (a concept not that strange) then we could see that time frame shorten dramatically.

Equity Risk Premium

Looking back at figure 1, the model has pointed to financial outliers as coming crises. In September of 1987, the model spiked indicating a breakdown within the normal trend. The market went on to crash two months later. More recently, in January 2000 the model once again went off-kilter inducing me to write a piece entitled “Reality Check.com”. In it we wrote of a coming day of reckoning for the dot.com age. This call proved correct in that the corporate landscape as it related to the internet changed forever.

Completely turned around, this model looks awful for holders of U.S. Treasuries.

 

Joseph S. Kalinowski, CFA

Twitter: @jskalinowski

References

http://www.ft.com/intl/cms/s/0/63ffec6e-2a6a-11e2-a137-00144feabdc0.html#axzz2Cggf33dc

http://www.cato.org/publications/commentary/heading-toward-national-insolvency

http://www.thenewamerican.com/economy/commentary/item/12898-federal-reserve-balance-sheet-set-to-explode

http://www.federalbudget.com/

http://www.investmentu.com/2012/August/treasury-bond-apocalypse.html

http://mobile.reuters.com/article/idUSBRE89H1I020121018?irpc=932

http://www.cbo.gov/publication/43539

http://www.cbo.gov/publication/43288

http://cnsnews.com/news/article/interest-federal-debt-hit-104b-first-half-fy2012-despite-low-interest-rates

 

JSK Partners of New York, LLC
40 Wall Street, 28th Floor
New York, NY 10005

T (212) 537-0462
T (800) 618-1120
F (800) 618-1120

www.jsk-partners.com

 

No part of this report may be reproduced in any manner without the expressed written permission of JSK Partners of New York, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  JSK Partners of New York, LLC have proprietary accounts and funds under management. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report.  The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of JSK Partners of New York, LLC and its affiliated companies may also be conducting trades based on the firm's  research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant.