Market Commentary
by Byron Wien
 
11/02/2012

Four Major Problems

The pace of the United States economy is improving from the disappointing performance of the first three quarters.  Initial jobless claims have declined and both the manufacturing and the service sector purchasing manager indexes are above 50, indicating the economy is expanding.  Automobile production is strong, housing is bottoming, and retailers are gearing up for a robust Christmas season.  In Europe every effort is being made to hold the European Union together and keep the euro as the continent’s basic currency.  Central banks in Europe and the United States are expanding money supply vigorously, but in spite of that, inflation is tame in the developed world and interest rates are low in the U.S., the U.K. and Germany.  China is applying both fiscal and monetary stimulus to ensure a “soft landing.”  In spite of the recent correction, the equity market in the United States is up in double digits, so why should I be worried?

Hovering out there are four serious threats to the investment environment.  The first is the prospect of earnings disappointments in 2013.  The second is the potential impact of the so-called “fiscal cliff” which could result in tax increases big enough to throw the U.S. economy into a recession.  The third is the possibility of political problems causing a break-up of the European Union in spite of the best efforts of the leaders of the various countries to avoid that outcome.  The result of this would be widespread defaults on the sovereign debt of some of the weaker countries, creating havoc in parts of the world banking system.  And the fourth is the risk of an air strike by Israel on Iran’s nuclear development facilities.

Taking them in order, the prospect of a decline in Standard & Poor’s 500 operating earnings in 2013 from 2012 levels is very real.  Profit margins as a percentage of sales are peaking at about 9% and corporate profits as a percentage of Gross Domestic Product (GDP) have risen from the long-term average of 7% to more than 10% today.  During the first three quarters of 2012, the United States economy grew at a real rate of less than 2%.  Growth should pick up in the fourth quarter to something better than that, but hardly to a level that could be described as a strong economy.  At the current rate of growth the U.S. doesn’t do much better than absorb the new people coming into the workforce.

Almost all strategists are forecasting an increase in Standard & Poor’s 500 earnings next year.  From this year’s probable level of $100 or more, most believe 2013 will come in at $105–$110 (and there are some bottom-up estimates above $120). The world is a very competitive place today and few believe that GDP in the U.S. will grow as much as 3% next year.  The slowdown in Europe will have some impact on U.S. exports.  Moreover, companies have limited pricing power, and inflation, while modest, is still pushing some raw materials prices and other costs higher.  So if revenues only increase by a small amount and costs rise, there is a good chance margins will be under pressure in 2013, raising the possibility of earnings disappointments.  We have already seen a hint of trouble coming:  in the second quarter more than half of all S&P 500 companies had sales realizations lower than forecast.  Some key technology companies have reported disappointing earnings for the third quarter and given negative guidance to analysts about the outlook.  So did Caterpillar and companies in other sectors. 

Going forward we expect more negative earnings guidance.  Concern about the earnings outlook is one reason so many investors have remained cautious.  This does not mean that a bear market looms immediately ahead.  If S&P 500 earnings were flat, the market at 14.5 times 2013 would still be reasonably priced.  The prospect of another year of double-digit S&P 500 appreciation, as we have enjoyed this year, would seem unlikely, however.

Both in the political arena and in investment management conference rooms, the prospect of the “fiscal cliff” is giving rise to a great deal of discussion.  These tax increases which could take effect at the beginning of next year amount to $547 billion in total on a $16 trillion economy, or more than 3% of GDP.  Since the economy is only growing at a real rate of 2% right now, we could move from modest growth to a near-recession if all of the tax increases scheduled to go into effect in January were implemented.  The $547 billion is a nominal dollar figure.  The 2% growth is “real”; it would be 4% if expressed in nominal dollars.  Most observers fail to make the distinction between the nominal tax increases and real GDP.  Both candidates for the presidency say they will ask Congress to defer some of the increases until their administration has an opportunity to review the entire tax code and make recommendations. 

The largest component of the fiscal cliff is the expiration of the tax preferences enacted under George W. Bush, which amount to over $300 billion.  While President Obama would eliminate the cuts for those making over $250,000 and modify the dividend and capital gains rate, it is unlikely that even he would let all of the Bush tax cuts expire.  Other provisions like the payroll tax relief and the sequestering of funds for healthcare, defense and other items that resulted from the inability of Congress to come up with a workable plan to cut the deficit last fall are likely to be deferred temporarily.  The task facing the government in Washington is a tough one.  They want to cut spending programs and they want the economy to grow at the same time, but government expenditures contribute significantly to that growth and if Congress cuts too much, it may imperil the expansion of the economy.  There is no question that the entire tax code needs to be revised.  Many loopholes must be closed, certain deductions need to be eliminated or changed and some taxes will need to be raised.  There is no way we can bring down the enormous annual U.S. deficit without both cutting expenditures (24% of GDP) and also raising taxes (17% of GDP).  We are facing a potential crisis and Washington will have to respond to that challenge.  I think a workable compromise will be reached no matter who wins the presidential election, but there is likely to be some negative impact on growth next year even so.  An improvement in housing will offset part, but not all, of the fiscal drag.

I am encouraged by what I see in Europe.  Virtually all the policy makers there seem to be trying to work together to find a solution to the sovereign debt problem.  Mario Monti of Italy, Mariano Rajoy of Spain and François Hollande of France have met to discuss sensible approaches to deficit reduction.  Angela Merkel of Germany has met with Antonis Samaras of Greece to show her support.  There is a growing realization that if any major current member of the European Union were to default on its sovereign obligations, Europe’s fragile banking system would be in trouble.  Most Europeans agree that the common currency had a definite positive impact across the continent in the twelve years it has been in use.  The problem is that unit labor costs have risen in the weaker countries while they have been kept under control in Germany.  As a result, countries like Italy and Spain have become uncompetitive.  This is not an issue that can be solved overnight, but it is also not clear that any current member of the European Union would be better off if it left and went back to its national currency and devalued it.

The solution, if there is one, is for the European Central Bank to continue to provide liquidity to the banks and, as is now starting to happen, to the governments themselves and to require those countries receiving funds to meet certain financial conditions in exchange.  The next step is for the various countries to move toward some form of fiscal convergence.  The first phase would be a banking union with a deposit insurance program.  Next would be the establishment of some central authority to assess the ability of each country receiving aid to meet its deficit targets.  Everyone agrees that a political union in Europe is probably impossible, but a greater degree of fiscal cooperation is probably achievable, and it looks like that is where Europe is heading. 

There are still many obstacles, and many critics who believe structural changes in Europe are not likely, but progress is being made and that is why the euro has been strong against the dollar and the stock markets there are rallying.  There are sure to be setbacks, and the possibility of failure continues to be a risk, but the last few months have provided some reason for hope.  Europe’s dilemma was summed up clearly by David Miliband, former U.K. Foreign Secretary, who said, “The tragedy of the left is that it is against reform and the tragedy of the right is that it sees reform and austerity as the same thing.  The proper position is to encourage structural and institutional reform but without harping too much on austerity, which is worsening the disease and making the tunnel longer.”  The same might be said for the United States. 

Finally there is concern around the world that Israel will strike against the nuclear development facilities in Iran, with or without the help of the United States.  This could result in the closing of the Strait of Hormuz, through which much of the oil imported by Western countries from the Middle East flows.  Iran would undoubtedly retaliate heavily against Israel with its missile capability although it is not clear how much destruction and loss of life would result if the missiles were intercepted.  The entire region would be destabilized, however, and the price of Brent oil would probably rise to $150 to $200.  As a result, both Europe and the United States could move into recession in 2013.

With so much to lose by everyone involved, I believe a strike by Israel is unlikely, and over the last month some developments have taken place that have given me encouragement that Iran may come to the table and negotiate a pullback from its nuclear weapons development effort.  The most important change is evidence that the sanctions imposed on Iran by Western countries are starting to hurt the Iranian economy seriously.  The currency has depreciated by 40%, inflation is becoming virulent and social unrest is erupting into a major problem.  I have always believed that any major change in power in Iran would come from pressure from the people and not from a change in policy among the leaders.  We saw a sign of this in the last election there three years ago, but now the economic problems have escalated to the point where some political change is more likely.  There is a report, unconfirmed by both sides, that the Iranian government is willing to engage in one-on-one talks with the United States and others on its nuclear program.  This would be good news if it is true although a favorable resolution of this situation is likely to be slow in coming.

There are other factors at play as well.  Sabotage and assassinations have slowed the nuclear program down, and some intelligence sources say Iran is not close to having a bomb.  Syria, an important political ally of Iran, is under siege and the regime of Bashar al-Assad could fall at any time.  Only severe use of force is keeping Syria’s present leadership in place.  Assad is supported by China and Russia and these countries are under pressure from many others in the world community to withdraw aid for humanitarian reasons.  As Iran becomes increasingly isolated and social unrest becomes a continuing problem, its leaders may be more willing to negotiate a redirection of its nuclear project away from weapons production.  Iran has always said it has a peaceful purpose for its nuclear program, and now may be the time to make that statement true.  We are likely to see more attention given to this issue by the United States after the election, no matter who is the winner.

So these are my worries.  Any one of these issues could seriously darken the prospects for 2013 if it developed unfavorably.  It will be important to monitor each carefully as we move into next year.  I have had an optimistic view of the United States in 2012 and the market has appreciated more than most observers expected; the events I have described make me believe that 2013 will be a more difficult year.

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