Quarterly Market Update
Chief Investment Officer John Sawyer remains optimistic about the overall economic recovery and expansion despite the political theater in Washington. In this edition of Market Outlook, Mr. Sawyer contends that fiscal and monetary policy may not be operating at cross purposes to the extent that some pundits have argued and indeed may result in legislative discipline that could ultimately benefit the economy further down the road.
1. What economic impact do you expect from the political theater in Washington over the budget and debt ceiling crisis?
Generally the expectations are that third-quarter earnings will be in line or above consensus and that the year-over-year comparisons will be pretty easy as third quarter 2012 was not so great. We will beat estimates this quarter, but only because of the lower guidance provided by analysts prior to the end of the quarter. This, combined with the economic impact of the government shutdown, could set a real challenge for fourth-quarter earnings and put some pressure on the market as we approach year end. The market will key in on the guidance going forward in 2014 as companies may lower guidance even further depending on the length of the shutdown and the resulting impact on consumer and business confidence.
2. What is the anticipated economic impact for the remainder of 2013 of the Affordable Care Act?
The reality of the situation is that the money has already been distributed and spent, and while the insurance program may not stay around in its current form, it is not going away. As the situation stands at the end of third quarter and this publication’s reporting period, given political machinations on Capitol Hill, we could very well end up with a clean, two-week or six-week budget resolution instead of a comprehensive long-term solution which will unfortunately continue the discussion through the fall. The financial markets are expecting a quick resolution and therefore have not reacted in any appreciable way to what is going on. However, if the situation does not resolve itself soon, at some point fatigue will set in and we will see a reaction from a price perspective.
If Congress fails to reach a budget agreement, we anticipate a damper to economic activity from the government shutdown which some predict, should the impasse continue through the end of the year, could be a drag on GDP. Certainly a drop in the already moderate GDP growth rate would affect financial markets from a fundamental standpoint.
3. After the Federal Reserve (the Fed) decided in September to continue quantitative easing for the time being, what might we expect in fourth quarter?
We were as surprised as most that the Fed did not formally announce the wind down of Quantitative Easing 3 (QE3), but in hindsight it makes a great deal of sense given that we were only two weeks away from the federal budget and debt ceiling discussions. Combined, those topics may have very well represented too many variables for the market to swallow at once. In the interest of not overloading investor sentiment, the Fed decided to delay September’s widely anticipated taper activity.
Obviously, this isn’t a can that can be kicked down the road forever. We are simply waiting for stronger economic numbers and to move past issues other than tapering that are affecting the economy. If we can get through the Congressional situation with some sort of reasonable budget resolution and a further extension of the debt limit, and unless there is some depressive effect on the economy from these issues, we will probably see the Fed make the anticipated announcement at the next Federal Open Market Committee meeting or two.
4. Fiscal and monetary policies continue to be at odds. Do the two offset each other?
Monetary and fiscal policies are not necessarily at cross purposes. Although it does not look like it right now, the Fed and the Treasury are potentially allowing Congress to put some discipline into the process. Once the economy is on a firmer standing and the Fed starts to back out, at that point we will have more legislative discipline in place. So it could be that the Fed and the Treasury are effectively trying to give Congress enough room to put some real changes into place without immediately impacting the overall economy.
5. Do you agree with those that are calling for a change in the monetary policy targets?
While this is clearly a more challenging recovery than what we have seen for nearly a century, I do not see a benefit to changing the Fed’s mandate of stable prices and full employment at this time. The Fed’s dual mandate can be at cross purposes at times, and even potentially somewhat ambiguous, but it has served us well through many business cycles.
6. September was the five-year anniversary of the Lehman Brothers bankruptcy and the beginning of the great recession. Please comment on the regulation that has subsequently been enacted to prevent such future events?
There has been an inordinate amount of regulation enacted to try and prevent a recast of the event. Within the housing industry we are certainly seeing much higher quality underwriting. Mortgage companies are no longer making unjustified loans on houses. In my opinion, regulation within that area has been very successful.
One thing that does somewhat concern me is that the new regulations do not necessarily address the more open-ended potential problems that we may face in the future, but rather focus on stopping what we did before. But in fact, credit default swap securitization issuance has now surpassed that of 2008. While the market may be better structured and a little more diversified from a counterparty perspective, the activities that to some degree led to Lehman’s bankruptcy are still ongoing.
Why is that you might ask? While the fallout affected everyone worldwide, the securities at the heart of the problem were sold only within an institutional marketplace, never to retail investors. Therefore it has remained primarily a market issue with only an indirect impact on consumers. If you think back to the savings and loan crisis, everyone owned certificates of deposit from the institutions that failed. But investors did not directly own credit default swaps and so people still do not really understand what happened, or the instruments that allowed it to happen, which means there is not going to be a groundswell of advocacy against the instruments.
There continues to be some depressing fallout from credit default swaps, but these are risk-based markets and you are never going to completely regulate safety. Overall the situation reinforces the notion that when investing, despite the big push for transparency and disclosure, investors must ultimately bear responsibility for their own decisions. There will continue to be problems and if investors buy into the hype or do not have their expectations properly aligned with what can happen, they can find themselves in situations such as these. At the end of the day, investors simply cannot abdicate their homework to someone else.
7. Would you comment on the bifurcation of the economic recovery which has recently received increased press?
Obviously economic recovery must go to some extent hand-in-hand with a housing recovery. We have seen pockets of very strong recovery, particularly the overall national appreciation of housing prices off the bottom, with the exception of a few areas like Florida and Nevada. New home construction is a big driver of employment, and so recovery in that area certainly helps to reduce the unemployment rate. We need fresh housing stock every year and to a large degree the inventory is being absorbed and new buildings are coming on line which will continue to boost the economy. Much like we have seen with GDP and employment, it has been a very slow, but steady recovery and we believe this will continue to be the case.
Unfortunately, while we have seen improvements in the jobs market, the employment recovery has not come as far as that of the financial markets or housing sector. We had a real shock to the system which is why the Fed has led with such aggressive quantitative easing programs, and unfortunately there is no quick fix. It takes time for the engine of recovery to roll through the full economy. The recovery started at the top where the biggest beneficiaries were obviously the financial markets, but then it benefited housing and it will continue to roll through the full economy.
8. What is your outlook for financial markets as 2013 comes to a close?
From a fundamental perspective we should keep a close eye on earnings. With the issues in the Middle East and at home in Washington, there is every potential for a somewhat volatile fourth quarter. We would do well to hold the current market gains through the remainder of the year, but much will depend on cooler heads in Washington.
Despite some volatility, the financial markets have not moved substantially in the last few weeks. We could very well experience much of the same for the balance of the year – some intermediate volatility within a narrow range without an appreciable move in the markets.
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