Posted on April 17, 2013 by David Laidlaw

For the time being, the fall off of the “fiscal cliff” has been averted. The Senate negotiated a compromise on New Year’s Eve that was ratified by the House the following day. Marginal income tax rates will rise to 39.6% for incomes above $400,000 ($450,00 for couples) and payroll taxes for employees will revert back to 6.2% from 4.2%. The capital gains and dividend tax rates will increase to 23.8% (20% Capital Gains Tax plus 3.8% Affordable Care Act Unearned Income Tax) for high income earners according to the same threshold for income tax rates. Finally, the $5.12 million estate and gift tax exemption remains in place with an increased rate of 40% for estates above that level.

The bill that passed both Houses of Congress is not the “grand bargain” that the investment community has been pining for since the Simpson Bowles Commission released its report two years ago. No material changes to Federal spending were addressed by this legislation. The government “sequester” that would have reduced spending by 10% has been delayed for two months. This date roughly coincides with the time that the government will reach its debt limit. When this occurs, we would not be surprised to see another round of political brinkmanship in March of this year since there does not appear to be any consensus between the parties on what spending to cut.

Very difficult choices must still be made to reduce the long-term imbalance between government receipts and expenditures. The Congressional Budget Office projects that this bill will increase the Federal debt by $4 trillion over the next 10 years. This projection assumes optimistically that the sequester (or similar cuts) will take full effect in March. Unless a new tax and spending framework is adopted, the markets will demand much higher levels of interest on US debt. Drastically increasing interest rates would cause a sudden economic contraction and market dislocation as has occurred in peripheral Europe.

While the equity markets have rallied about 3-4% in response to the resolution, the uncertainty surrounding the negotiations may have already had a negative impact on the economy. Consumer spending weakened as holiday expenditures only increased 0.7% over last year according to MasterCard Advisors Spending Pulse. This gain is the weakest since 2008 during the nadir of the previous recession.

Aside from the depressive impacts of the political brinkmanship and failure to address fundamental imbalances, there are quite a few positive trends developing in the domestic and global economies.

Housing prices are appreciating and new home construction and starts are accelerating. The last reading from the Case Shiller index for October indicated that housing prices have increased 4.3% compared to the prior year. Nineteen out of the twenty cities measured in the index showed increasing price levels compared to September’s reading. Housing starts increased about 22% in November over last year’s level according to statistics released by the National Association of Home Builders. Housing expenditures have a large impact on economic growth so these trends are indicative of continued expansion.

Low natural gas prices resulting from advances in drilling techniques discussed in our commentary last quarter have begun to spur increased manufacturing investment in the United States. Bloomberg’s Business Week explored this development in article on December 31st titled Shale–Gas Revolution Spurs Wave of New Steel Plants. Steel manufacturers are planning on building plants that rely on natural gas to purify iron ore. Bloomberg’s article referenced five plants which are in development. For example, an Austrian steel manufacturer, Voestalpine AG, plans to construct a $661 million dollar facility employing this technology in the US.

Finally, China’s economic growth is accelerating again after exhibiting weaker economic numbers for the past two years. Chinese PMI (Purchasing Managers Index) showed readings above 50 for the past three months which indicates expansion in the manufacturing sector. These positive statistics are welcome since the rate of growth in the overall economy has decreased for seven consecutive quarters. Even though the economy has slowed, China is still growing at 7.4% per year.

China is also not the sole engine of growth in the region. The OECD released a report predicting that the whole of Southeast Asia will grow at 5.5% per year matching the rate achieved before the financial crisis in 2007/2008. These economic growth rates are dramatically lifting standards of living throughout the region. Singapore, a poster child for rapid economic development, has experienced a four-fold increase in GDP per capita over the past 25 years. Singapore already has a GDP per capita ratio that is about 20% ahead of the United States.

Finally, the Federal Reserve continues to stimulate asset prices through quantitative easing. During December, Ben Bernanke informed the markets that the Federal Reserve planned on purchasing $85 billion per month of Treasuries and Mortgage-backed Securities until the unemployment rate dips below 6.5%. This level of buying has kept interest rates low and forced funds to flow into stocks.

Against this background, stock prices are still reasonably valued on a fundamental basis. The earnings yield for the S&P 500 remains above 6% with many high-quality companies providing higher cash flows. Stocks are the favored asset classes for investors interested in obtaining returns above the rate inflation.

While the fiscal picture is cloudy, the economic and market positives outweigh the negatives. We expect high levels of volatility, especially around the debt ceiling negotiations later this winter, but do not recommend overly conservative allocations for 2013.