Will A Status Quo Government Bring Radical Policy Changes?
Highlights from the 2012 Pitcairn Investment Forum:
Post Election Outlook
On November 14, 2012, Pitcairn clients and staff came together for our 2012 Investment Forum to explore the investment landscape. Our goal was to leave no stone unturned in understanding the dynamic world of today’s capital markets and to work in concert to get the big decisions right so you can achieve your goals, whatever they may be. At the end of the day, we were pleased to have found that the industry leaders who spoke at the Forum shared many of our views on the global environment and the post election circumstances and reinforced the benefits of long-term investing. While their opinions do not constitute our advice, they represent valuable inputs and are taken into consideration when developing recommendations for your portfolios. You can rest assured your portfolios are already well-positioned to guard against short-term challenges in the markets and to capitalize on opportunities.
Whether you were able to attend the Forum or not, we want all Pitcairn clients to benefit from the insights of the noted industry professionals who participated. Following is an analysis of the implications of our recent federal elections. We hope you find value in these ideas and we look forward to sharing more from the Investment Forum in the weeks to come.
Harold F. “Rick” Pitcairn, II, CFA
Chief Investment Officer
Seemingly endless campaigning and $6 billion in spending brought us right back to where we were in 2008—a Democratic President, a Democratic Senate and a Republican House of Representatives. Or did it?
Although the players remain the same, Dan Clifton, a partner at Strategas, one of Pitcairn’s research partners, suggests a possible attitude change for our Beltway leadership. He wonders whether the next four years could be a replay of President Clinton’s second term when after a fractious first four years, the leadership seemed to recognize they were stuck with each other and better try to accomplish something. During Clinton’s second term, we got a balanced budget, among other positives.
Our leaders face different challenges in 2012, most notably below-trend economic growth, perniciously high unemployment, and a rising debt to GDP ratio. Opinions and worries about the upcoming fiscal cliff abound, but Mr. Clifton sees potential for compromise to avoid the automatic severe budget cuts at the end of this year and also the possibility of a broader fiscal deal in 2013.
Among the catalysts that could compel compromise from both sides are elevated debt and deficit levels, rising interest costs, downgrade warnings from ratings agencies, subpar economic growth, expiring tax provisions, automatic spending cuts, unfunded Social Security liabilities, negative political ramifications of letting the AMT (alternative minimum tax) patch expire, and Republicans wanting to protect defense spending. Not to mention that congress members want to keep their jobs and the President wants to move on to larger legacy issues of immigration and climate change and may be willing to compromise on fiscal issues in order to do so.
Shaping the Compromise
One can’t truly predict how the fiscal deal will evolve, but Mr. Clifton proposes the following as a possible framework:
- $1 trillion in additional tax revenue over the next 10 years
- Immediate revenues of $200 billion this year, provided that revenue comes from closing deductions, not by rolling back Bush-era cuts on the top two tax rates
- An agreement to pursue broader tax reform next year
- Possible eventual increase in the Medicare retirement age, means testing and linking Medicare growth to inflation
- Future federal employees to assume a larger share of their pension costs
- Most of the fiscal cliff likely to be resolved, with a probable 1% drag on GDP
- Capital gains and dividend tax rates likely to be in the 25% range
It appears that the capital gains and dividend rates will move higher. In the past, increased capital gains taxation has had a negative effect on six-month stock market returns. Smaller cap stocks are more likely to be affected than larger cap stocks because they are dependent on capital intensive financing. One important historical note: the S&P 500 Index rallied through the 1986 tax reform debate.
Regarding dividend-paying companies, fear of the dividend tax increase seems overdone. High-yielding dividend payers performed well throughout the 2003 tax cut debate.
However, companies whose earnings are dependent on government spending are potentially at risk. Examples include defense contractors and possibly health care companies.
Turning to potential opportunities, Mr. Clifton sees municipal bonds, REITs, life insurance, and master limited partnerships seem poised to benefit under a higher tax scenario.
Are Higher Inflation or Rising Interest Rates on the Horizon?
Shifting from tax considerations to other post election issues, the Federal Reserve’s policy of perpetual quantitative easing has kept the Fed funds rate near zero since 2009. There are two key points to consider on this topic. First, for now the Fed is likely to remain accommodative and, as an investor, you can’t stand in the way of the Fed printing money. Second, possible longer-term results include a rise in inflation and an eventual rise in interest rates. Bonds have been in a 30-year bull market and many investors today have never seen negative returns from their core bond portfolio. Unfortunately, that is a possibility as interest rates rise.
Chatter from market pundits might suggest abandoning a fixed income allocation in the face of rising inflation. A more prudent approach would be to diversify within the fixed income market, perhaps incorporating emerging market debt, high yield securities or inflation protected securities into your bond portfolio.
Beyond the Fiscal Crisis
Mr. Clifton stresses that he is bullish on America and US equities, especially because of our country’s emerging energy independence. Expanding activity in the energy sector creates jobs, particularly for non-college educated males. It increases the country’s appeal to manufacturing companies that need a decades-long supply of raw materials and also attracts new capital to the US. Once Washington resolves our fiscal issues, we can confidently move on to benefiting from this promising shift toward energy independence.
This publication is prepared by Pitcairn for the exclusive use of its clients. The information provided should not be construed as imparting legal, tax, or financial advice on any specific matter.