After months of waiting, investors now have one less uncertainty to deal with. The election is over, and voters decided to give President Obama another four years to lead the country.
In addition to winning, the Democratic Party retained a majority in the Senate, picking up 2 seats. However, the Republican Party also maintained its majority in the House of Representatives. This means that the political leadership will not change significantly. That doesn’t mean everything will stay the same. Voters decided to retain many of the same leaders, but recent polls suggest many people want to see different legislative results.
Looking ahead, the new Congress and President Obama must now find a way to boost economic growth and create jobs. Along the way they need to avoid the fiscal cliff, foster trade with other countries and maintain the security of the United States in an increasingly threatening world. Unfortunately, avoiding the fiscal cliff and promoting economic growth are immediate problems. If Congress fails to take action, the Bush-era tax cuts and the Obama payroll tax cuts will expire at the end of this year. At the same time, mandatory federal spending cuts are scheduled to begin (as lawmakers could not agree on a compromise to reduce the deficit during last-years’ debt-ceiling negotiations). The Congressional Budget Office estimates that the economy could go into recession and contract 0.5% next year if all the tax hikes and spending cuts take place as scheduled.
We believe there are several scenarios that could unfold around the fiscal cliff. The most likely outcome would be that lawmakers would find acceptable middle ground including some tax increases and spending cuts but not the full measure scheduled to occur at the end of the year. Modest tax hikes and federal spending cuts would not severely hurt the economy but would be a drag on economic activity next year.
Recent economic news shows that the U.S. economy is slowly recovering from the 2008-2009 recession. Fortunately, the housing market has finally turned up after six years of subtracting from economic growth. The country will face some fiscal drag if Congress allows some tax increases and spending cuts to reduce the deficit next year. This fiscal drag will most likely be offset by the recovery in housing and continued increases in consumer and business spending. As a result, we believe that the economy is likely to grow in 2013.
Many investors may be concerned that the election outcome will lead to continued political gridlock that has existed during the past two years. However, both parties recognize the risk to the economy if lawmakers do not address the fiscal cliff. Therefore, during the next few weeks we are likely to see both parties talk about a willingness to work together, but start the process by stating the pre-conditions for cooperation. We believe this would just be the first step toward addressing policy differences. Obviously, the process will not be quick and easy.
Some strategists are suggesting that Congressional Leaders could allow the country to go over the fiscal cliff as a way to force a compromise. If this happened we would expect any compromise after the first of the year would be retroactive to the start of the year and the economic impact would not necessarily be that severe. The outcome would be volatile financial markets.
So what do the elections mean for investors? We believe that the underlying U.S. economic fundamentals remain favorable. The economy is growing, and the uncertainty of the election is behind us. If Congress and the President can find some middle ground and compromise over tax hikes and spending cuts, the outlook for the economy would be better than the worst-case scenario of allowing all the tax hikes and spending cuts to be implemented as scheduled.
The economy is expected to start the year on a weak note until the fiscal cliff issue is addressed, but we expect economic momentum to build as the year progresses. In this environment, the stock market would be volatile during the next few months. The positive seasonality during November and December could support stocks if investors see Congressional Leaders trying to work together. Longer-term, we look for the stock market to have modest gains next year.
Fortunately, the Federal Reserve’s easy money policies will partially offset the fiscal drag of reducing the deficit. The government may borrow and spend a little less next year if a compromise is reached but net lending in other sectors of the economy has increased, and this increase in credit in the private sector is likely to support economic growth. In addition, the credit markets are likely to benefit if the Fed continues to provide liquidity to the economy by buying bonds until the unemployment rate declines.
My clients have been positioned with asset preservation and potential of positive returns in mind during the past year. This was in order to deal with the uncertainty of the global environment, the Eurozone debt Crisis, slowdown in China’s GDP, the US election outcome and the pending fiscal cliff (to name just a few). Finally, businesses appear to have delayed capital spending and hiring until the direction of governments policies becomes clearer. After waiting much of this year, next year could potentially be a year of action and less worsening situations (possibly even improving situations). Investors may take a less defensive position, assuming investor sentiment improves (on a relative basis, this is anticipated) and this could lead to stocks outperforming bonds in 2013. If this scenario ends out being true then cyclical sectors of the stock market are likely to perform better than defensive sectors. Although this is only an “if”.
