Beyond the precipice
By Bob Landaas
Now that the election is over, all eyes are on the so-called fiscal cliff – the tax increases and government spending cuts that could topple the U.S. economy back into recession if they take effect as scheduled in January.
I find an interesting potential for compromise. There is talk of splitting the difference between 35% and 39% for the top marginal income tax rates and of embracing a Mitt Romney idea to reduce tax deductions for the wealthy.
There seems to be wide agreement on limiting the number of Americans subject to the alternative minimum tax as well as the estate tax.
Both sides of the aisle have shown support for a middle-of-the-road approach while at the same time effectively postponing the hard decisions that ultimately have to get made.
The deficit becomes a problem only when interest rates go up in a meaningful way. People miss the point that the only reason we can tolerate deficits and not have to reduce spending a lot is that the average interest expense on Treasury debt right now is under 1%. That allows Congress the opportunity to continue to kick the can down the road. Politicians excel at postponing hard decisions.
As rates gradually move higher, that’s what’s going to force their hands. Ultimately, higher interest expense on the deficit is what will force the politicians to act. The fiscal situation is not really a cliff. The only element that made this issue immediate was that tax cuts were expiring.
The lack of a sense of urgency will allow Congress to modify tax increases and to reduce the spending cuts and thus avoid a desperate Thelma-and-Louise approach to dealing with the deficit.
We expect a compromise that will allow both parties to move forward in attempting real deficit reduction and a tax policy that everyone can live with.
Meanwhile, as my colleague Marc Amateis points out, short-term events shouldn’t skew portfolio decisions. Try not to let distractions such as politics interfere with your long-term financial plans.
“Don’t make any major changes to your investment portfolio based on the unknowns of what’s going to happen here, assuming you’re already following the proper fundamentals of diversification and allocation,” Marc says.
“Every one of us has our own personal biases and frames of reference. Don’t let them affect the way that you invest. Don’t let your personal bias or opinion of the election or anything else affect the way that you invest.”
Now we can return to the fundamentals of investing: Interest rates and earnings.
Earlier in the fall, forecasts called for a 2% earnings decline in the third quarter. Final numbers showed slightly positive growth.
We did see the first decline in corporate revenue since 2009. But that was because revenue from energy and utility companies was down and because the dollar rallied for part of the quarter, which held down revenue from international operations. Without currency impact, revenue would have risen 4%.
Now that the dollar is weakening relative to the euro and the yen, revenue should continue to do well. Also, the headwinds that held back U.S. economic growth – consumer spending, housing, household debt, to a lesser degree employment – are becoming tailwinds.
For the year, earnings for the Standard & Poor’s 500 should grow more than 7% to about $104 per share, excluding negatives, according to analysts surveyed by Bloomberg. They expect that growth to accelerate to 10% next year and more than 11% in 2014.
The real surprise of the second half of this year has been the performance of international stock funds. For the first half, international funds were up only half as much as domestic funds. Now they’re at the top of the leader board for 2012 performance.
Much of this can be attributed to a weaker dollar. Many international markets remain historically inexpensive relative to the fundamentals, with higher dividend yields and stronger growth prospects.
Marc Amateis reminds investors to diversify their bond portfolios with international bonds.
“As with overseas stocks, there is potential for overseas bonds because of the weakness in the dollar and the higher interest rate environment in other parts of the world,” Marc says.
The case for global growth remains strong. Globalization is an irreversible force, and we’re just now beginning to experience the benefits of a coordinated global economy.
In the early stages of globalization, we were able to increase aggregate production. Now, aggregate demand is growing as many workers around the globe experience increases in wages. Not only are these forces irreversible, they are in their infancy.
The bottom line is that investors are best served by looking at the big picture of growth and earnings. Those forces are much larger than short-term concerns that any of us might have.
Bob Landaas is president of Landaas & Company.
initially posted Nov. 29, 2012