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A Strong Start to the New Year

By David C. Blough, CFA, Senior Vice President & Investment Manager

 

“Live only for today, and you ruin tomorrow”
- Charles Simmons

 

January 2013 saw stock markets go charging out of the gates. U.S. stocks rose sharply, with the large company Standard & Poor’s 500 Index returning 5.2%, while Mid-cap and Small-cap U.S. stock indexes returned 7.2% and 5.8% each. The developed MSCI EAFE International index rose 5.3%, while the MSCI Emerging Markets Index rose a smaller 1.4%.

 

The jump in stock prices occurred as riskier assets gained in popularity. Safer but lower earning assets, like U.S. Government bonds, gave up some ground. Investors became net buyers of stocks after many quarters of net redemptions. The markets were relieved that Congress and the President reached a compromise at year end to avert the plunge over the “Fiscal Cliff”. While tax rates went up, both parties could claim victories. Most importantly for investors, capital gains and dividend tax rates remained low, compared to the average tax rates over the last half century. Furthermore, the increase in tax revenues (most of which comes from the end of the 2% tax holiday on payroll taxes) was a step in the right direction to reduce the annual deficits.

 

Another positive for stocks was improving confidence that Europe will eventually emerge from its economic doldrums. The future of the Euro as a major currency looks brighter as the months go by. And last but not least, the 2% rate of U.S. Real GDP growth, experienced over the last three years, appears likely to continue during 2013. Slow but steady growth increases tax revenues and over time reduces unemployment and welfare costs leading to smaller deficits over the next few years.

 

The Federal Deficit Problem

At year end, the  “sequester” of about $100 billion in across-the-board federal government spending cuts, was postponed by two months until March 1, 2013. This move was designed to provide more time to reach a political compromise. It looks increasingly likely as March 1st approaches, that these across-the-board spending cuts will in fact happen. In my  opinion, that would hardly prove to be a disaster. $100 billion in federal spending reductions amounts to only about 2% of the annual federal expenditures. While that will cause a mild drag on economic growth in 2013, it should not lead to a recession now that both the housing and automobile industries are showing steady growth.

 

The quote by Charles Simmons, referenced in this report, is worthy of consideration after the huge increase in the Federal debt caused by the “Great Recession” of 2008 and 2009. The Federal debt has doubled over the last five years. In 2007, the total federal debt was 36% of that year’s GDP, for 2012 the accumulated debt level had risen to 72% of GDP, a level only exceeded for a few years after World War II. The scheduled $100 billion spending cut is modest, compared to the size of this fiscal year’s $845 billion deficit as estimated by the Congressional Budget Office (CBO).

 

The federal budget deficit has been slowly declining from its peak of $1.4 trillion for the year ending 9/30/2009. It was about $1.3 trillion in both fiscal 2010 and 2011 before falling to $1.1 trillion last year. The $845 billion deficit for this year looks good by comparison, but it still amounts to 5.3% of GDP. If the sequester is allowed to occur, the federal deficit for next year is estimated by the CBO to fall to about $600 billion or 4% of GDP. These estimates assume a slow 1.5% economic growth rate in 2013 (due to the payroll tax hike and sequester) followed by stronger 3%+ growth in 2014.  

 

Longer-term the deficit problem remains. Unfortunately, deficits will begin to increase after fiscal 2015, because Medicare and Social Security payment expenses ramp up as more and more baby boomers retire. We must be thoughtful as a nation and scale back spending or raise further revenue to come up with a long-term solution that will allow the accumulated debt to settle well below 70% of GDP over the next ten years.  Kicking the can down the road is no longer acceptable, especially in the fourth year of economic recovery.

 

As we look beyond the March 1st deadline, we become more encouraged by the strengthening economy. Our current tactical outlook includes emphasis on U.S. and emerging market stocks. Stocks continue to benefit from further economic recovery and rising profits.