From Myth To Reality With David Rosenberg

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From Gluskin Sheff's David Rosenberg

Myths And Realities

Markets always operate at the margin. And what just happened at the political level was an 11th-hour deal that effectively removed the risk of a severe fiscally-induced recession, supposedly beginning this quarter. Whatever odds there were of this occurring, and judging by levels of market valuation and investor sentiment surveys, there was some, but never a whole lot of "fiscal cliff being entertained as a base-case scenario, it is that "some", no matter how small, that was removed from the range of near-term possible outcomes.

So after the worst post-Christmas market performance since 1937, we had the largest surge to kick off any year in recorded history. The Dow soared 308.41 points, or 2.4%, to 13,412.55 with all 30 components in the black. The S&P 500 index climbed 36.23 points, or 2.5%, to 1,462.42, again with all ten sectors participating. The Nasdaq composite added 92.75 points, or 31%, to 3,112.26. Breadth was solid with ten stocks rising on the Big Board for every decliner. And volume reached 4.2 billion shares across the major exchanges.

The myth is that we are now seeing the clouds part to the extent that cash will be put to work. Not so fast. It is very likely that much of the market advance has been short-covering and some abatement in selling activity.

The myth is that the GOP caved in with the House vote (257-167) showing 85 Republican Congressman voting in favour of this fiscal deal. And only five GOP senators voted "no" in an 89-8 pro-deal split But keep in mind that, as was the case in the Fall of 2010, we had a lame-duck Congress on our hands, ready and willing to go the easy route. Not only that, but we also had a President this time aching to vacation in Hawaii — so the quicker a deal could be cobbled together, the longer Mr. Obama could spend surfing and sunning with his family.

The reality is that the tough choices and the tough bargaining have been left to the next Congress and are about to be sworn in.

For the time being, the markets can revel in the In the fact that the worst of the economic effects of the fiscal cliff was averted, but there are more chapters of this book to be written, and the Republicans in the House believe they were elected to cut spending as much as the White House believed it was elected to tax the rich and at least partly redress the income inequality dilemma.

The myth is that political compromise won the day. No doubt, the avoidance of the "cliff" was engineered by the Republicans abandoning a 20-year pledge to never again raise tax rates. What they now get in return after they gave the President what he wanted in terms of tax rate hikes (even if he raises his limit to $450k from $250k per couple) will be interesting to see, especially since there is only a two-month extension of the automatic spending cuts (starting with $110 billion this year) and the time they are slated to kick in is around the same time the Treasury will no longer be able to circumvent the debt ceiling issue. This time, there is no post-election wrath over the GOP overstepping its bounds by resisting hikes in top marginal rates — hikes that the Administration viewed as a mandate.

During the campaign, the President made spending curbs and deficit reduction key planks of his campaign (to the angst of his left-wing ranks). So this is the next chapter in this saga —a possible repeat of the rancor during the SLIM mer of 2011 when the prospect of the debt ceiling being pierced and the risk of default (as preposterous as that is for a country that is home to the world's reserve currency) dominated the headlines and market sentiment at the time S&P was quick off the mark to say that the 'deal' has done little to alter the rating agency's "negative credit outlook" on its already-lowered AA+ ranking on US sovereign debt.

So as equities now retest the cycle highs, it would be folly to believe that we will not experience recurring setbacks and heightened volatility along the way. This makes for a terrific backdrop for nimble trading but beyond that, long-only strategies would be well advised to hedge with calls on volatility given how cheap this insurance is right now Suffice it to say, trying to assess the situation through a "glass half full" lens, that this latest round of 'compromise' is going to lead to some thoughtful deliberation supported by the political capital that exists at the very beginning of the election cycle — in stark contrast to the heat of the last 12 months that was all about re-election. So the future now will be dealing with what was not dealt with in the latest go-around — which means tax reform, entitlement reform and fiscal belt-tightening that prevents the deficit from becoming increasingly structural in nature.

The myth is that the economy escaped a bullet here. The reality is that even with the proverbial "cliff" having been avoided, the impact of the legislation is going to extract at least a 1 1/2 percentage point bite out of GDP growth. Assuming a 2-2.5% private sector growth rate, this implies fractional growth in real economic activity for the coming year. If 1% is deemed to be the cut-off for stock market performance, 2013 is going to prove to be a very dicey call. Fractional economic growth is not constructive for profits especially with no more mom for margin expansion, and at this point it is hard to drum up a scenario where average P/E multiples can rise with the uncertainty over spending cuts and the debt ceiling issue looming at the end of the first quarter.

Again, the myth is that Washington gave its citizens a deal. The reality is that it was a desperate 11th-hour deal devoid of resolving many crucial long-term fiscal issues. And the deferral of the spending cut makes the debt ceiling issue that much more acute. And note that the 1.5 percentage point fiscal drain becomes closer to two percentage points from GDP for 2013 if/once these slated spending cuts live to see the light of day. So yes, yes, the 'deal' manages to avert the fiscal cliff, but still leaves in place a degree of policy uncertainty high enough to limit the potential for any multiple expansion, at least in my view.

There is another myth that less than 1% (0.7%) of Americans will get hit with a higher tax bill in 2013. How disingenuous. It is true that the biggest single item in the bin is the permanent extension of income tax rates originally put in place in 2001 and 2003 for all income below $400,000. The Alternative Minimum Tax (AMT) is patched permanently to avoid raising taxes on middle-income tax payers. The bill extends for another year unemployment benefits for people unemployed longer than 26 weeks (relief of about $30 billion and there were also other 'breaks that were extended, like the Earned Income Tax Credit, and the Child Tax Credit, as well as for businesses through tax credits for R&D and a one year extension of 50% bonus depreciation — allowing businesses to write off 50% of the value of new investments).

But for those individuals fortunate enough to earn above $400,000, tax rates rise to 39.6% from 35%. Tax rates on capital gains and dividends will remain at 15% for income below $400,000, but will rise to 20% for income over $400,000 plus a new 3.8% Medicare contribution tax (as specified under the Affordable Care Act) as of January 1st this year to total 23.8%. Within this income threshold, estate taxes also rise from 35% to 40% with an exemption of $5 million. Keep in mind that even though the top 1% are affected, increasing top marginal tax rates typically have the highest multiplier or 'ripple' impacts on economic activity — what makes for good politics doesn't necessarily make for good economics.

Not only that, but the Bill did not extend the payroll tax holiday as was the case in late 2010. Payroll taxes will immediately rise from 4.2% to 6.2% and represents an average tax increase of $700 on all U.S. households.

So while income tax tables stay the same for just about everyone, 77% of filers will indeed be paying a higher tax bill this year compared with 2012. As per the Tax Policy Center, households that earn between $500k and $1 million, it will see an average $15k hit to disposable incomes this year. For those above $1 million, the average bite is $170k (a couple right at the million mark will pay $37k extra 90% of the tax take occurs at $1 million and up). By the way, even those workers who make between $50k and $75k a year will face a tax hike of $822 in 2013 — oh, that's about equivalent to an iPad with 3G capabilities, just for some perspective... either that or a year's worth of daily Spam consumption.

So here are the takeaways. This is less a deal, far from the grand bargain most business executives were hoping for, and really just more in the way of patchwork policy. I'm far from impressed with how Washington works. Bring back Jefferson Smith and Frank Capra. Meanwhile, the countdown to the next crisis begins with the government's $16.4 trillion borrowing authority running
out by the end of March, and with the Republicans who control the House feeling far less pressure to acquiesce without meaningful spending, tax expenditure and entitlements reforms.

The final myth relates to the incoming economic data and that we are seeing global strength. The reality is that the macro backdrop is still quite fragile and what passes as 'strength' today would have been considered a shock to most pundits in prior up-economic cycles. The ISM is a case in point. The markets loved the headline print of 50.7 in December, higher than both expectations of 50.5 and the previous month's 49.5 reading. Meanwhile. December's modest bounce off the post-recession low of 49.5 in November was not enough to offset the 2.2 point falloff registered in November. New orders stagnant at 50.3 was tied for the lowest since August. Production dipped to 52.6 from 53.7, the first decline in four months. So the gain was led by employment, which posted a 4.3 point gain to 52.7, which doesn't say a whole lot about productivity seeing as the output component actually slowed in the ISM report. Not only that, but the share of manufacturers reporting positive momentum in December came in at just 39%, a four-year low and the exact same level prevailing in December 2007 (the same month the recession that few saw coming actually began).

Meanwhile, the euro zone PMI came in a tad worse than initial flash estimates — the final December manufacturing PMI was 46.1 versus the preliminary 46.3 print Germany in particular saw declines in both output and new orders while Spain contracted for an amazing 20th consecutive month. Meanwhile, new car registrations sank to a 15-year low in France last month and to the lowest levels ever recorded in Spain (we're talking about some time before 1989! Then again, who needs a car to drive to work when there is no work?).

China saw a 51.5 PMI, up from 50.5 in November. Domestic orders hit a 23-month high of 52.9 from 50.8 — but export orders slipped to 49.2 from 52.1. This dichotomy suggests that the governments latest infrastructure stimulus package is percolating through domestic order books but that foreign-derived demand is sagging on the back of still-weak economic conditions globally.

After all, just because the unexpected 0.3% decline in November US construction spending (together with downward revisions to the data reported for September and October) was ignored by Mr. Market in yesterday's monstrous relief rally, doesn't make it unimportant. Unlike diffusion indices, construction expenditures (the slide centered in non-residential activity) feed directly into real GDP growth, which looks set to do little better than achieve a feeble 1.5% annual rate in Q4, and likely closer to flat this quarter.