Letter - January 2013

 

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Cause for Optimism

In Washington and on Main Street debate rages over the issue of how to deal with long-term deficits and debt and whether to pay for them by raising taxes or cutting spending. This is bound to be one of the great discussions of the 21st century. How it is resolved, for better or worse, will affect America’s place in the world order as well as the degree of prosperity at home. This is not a debate that is going to be settled overnight. We believe it will be an evolutionary process stretching over many years, not a determining factor for 2013. The debate has begun and that is a good thing but don’t expect the issue to be solved in the short term.

Meanwhile, citizens are angry about the bitter partisanship, acrimony and nastiness that have characterized policy debates in Washington. The approval rate of Congress hovers in the low double digits. From time to time, volatility shakes the stock market. Individual investors have been withdrawing funds from the stock market for years though there is some indication that this may change in 2013.

Nonetheless, we feel there is cause for optimism in the coming year despite the shenanigans of elected officials.

We have written before about the revolution in domestic energy production. It is powerful. The recently acquired ability to access natural gas from shale deposits is transformational. The newfound abundance of natural gas is driving a renaissance in industrial production as the cost of this key input to the manufacturing process has declined sharply. As a result, oil, chemical and steel companies among others are beginning to invest in new plant and equipment and are increasing employment. The United States is suddenly the world’s low cost producer in a number of industries.

The domestic automobile industry is reviving strongly. Fourteen million light vehicles were sold in 2012 and over 15 million are expected in 2013 up from 11 million only a few years before. The industry is expanding domestic employment and investing in new plants, models and technology.

The housing market appears to have hit bottom. Prices and the number of units sold are rising. Mortgage rates remain historically low, encouraging buyers. Builders of new homes are expanding production. Should prospective buyers become convinced that the worst has passed; there could be a surge in activity. Fear of missing the bottom motivates buyers. The housing industry has gone from being a headwind to being a tailwind for the economy. It will add to GDP this year for the first time in a long time.

As we look into 2013, there are certain trends that we think will continue.

The Federal Reserve will continue to promote low interest rates by buying in the market $1 trillion worth of government and mortgage securities. Low interest rates help the banks rebuild their balance sheets and support the housing and auto industries. By buying bonds in the open market, the Fed injects liquidity into the economy and helps the Federal Government sell its debt at low cost. It is interesting to note that the Fed actually buys over 90% of the new debt issued by the US government to fund its annual deficit. Without Fed buying, interest rates would be noticeably higher and deficits more costly to finance.

American politics will continue to be tempestuous in 2013. An unsatisfactory mini-deal was reached at the start of the year to avoid the “fiscal cliff” but confrontations will continue. In February, the limit of how much debt the federal government can issue needs to be raised in order for the government to continue to pay its bills. Republicans controlling the House of Representatives want the President and the Senate to accept spending cuts to address the country’s long-term, unsustainable accumulation of debt. It may well be a nasty fight and could shut down the government for a while. Markets will probably surge or sell off on each sound bite from this or that politician. But a deal will be made, however inadequate. As mentioned above, we believe the debt issue will be solved in an evolutionary process over time.

Internationally, the euro crisis runs on but markets are beginning to settle down. Interest rates charged by the market have come down in the weakest nations, Greece, Spain, Portugal and Ireland. This is a good thing. The Euro has been surprisingly strong. Euro members have begun to take measures to restore competitiveness. Recovery continues slowly. Confidence is improving.

In Asia, China is always the big story. Fears of a hard landing for the economy seem to be misplaced. Economic statistics point to a reacceleration of growth. While concerns continue about the country’s financial institutions, we expect calm sailing for this year.

Stock markets around the globe had a pretty good year in 2012. Strong corporate profitability and ultra low interest rates have helped prices rise. Increasingly, investors are desensitized to the political drama in the seats of government. There is a sense of being able to muddle through.

Stocks continue to be the best of bad bunch when it comes to asset classes. While interest rates are unlikely to go yet lower, corporate earnings in the US are expected to rise 5% in this year. This could be the year that asset allocation accelerates into stocks and out of fixed income. As long as the problems facing the world remain on a slow simmer, stocks could have a way to run.

There is cause for optimism.

We wish all our clients and friends a Healthy, Happy and Prosperous New Year.

Tom Herzig


 

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