If there is one sentiment that fiscal policy debates in Washington have taught investors not to expect over the years, its optimism. Time and again, we have seen our politicians respond to serious questions on the future of our nations economy by kicking the can down the road, or worse.
Could it be different this time around for 2013?
Congress and the White House are facing a year-end deadline to reach an agreement on avoiding the combination of tax increases and spending cuts known as the fiscal cliff. However, there is a real if somewhat remote possibility that the current standoff could lead to a genuine long-term solution that puts the nation back on track toward fiscal health, and brings about a new bull market environment for investors.
Beyond the immediate incentive of the fiscal cliff, a number of other crucial drivers should encourage lawmakers to reach a long-term agreement now rather than wait for another day, including a total U.S. debt burden that surpassed 100% of GDP in 2012; the looming threat of downgrades on the nations credit rating from ratings agencies; and the expiration of the current debt ceiling in the first quarter of 2013.
That said, the odds of a long-term grand bargain being reached on all these items in 2013 are relatively low. Indeed, we estimate the odds of significant legislation that incorporates adjustments to both tax rates and entitlement programs and redirects the nation back toward fiscal sustainability at approximately 10% to 15%.
Nevertheless, it is important that financial advisors remain aware of the broadest spectrum of possible outcomes from the current fiscal cliff issue, and be prepared to plan on a contingency basis for their clients.
In concrete terms, therefore, what would a grand bargain long-term solution to the fiscal cliff issue mean for financial advisors and their clients?
Stocks
We would expect stocks to outperform bonds and cash in this scenario. Though short-term positive effects on earnings would likely be minimal, price-to-earnings valuations could rise 2 to 3 points (or the equivalent of a 25% gain in broad market indices) as confidence returns and reverses the pessimism that has persisted in recent years among individual investors.
By industry sector, cyclical stocks that are more favorably impacted by a brighter outlook for future growth would likely outperform defensive stocks. Along the same lines, shares of smaller companies with more significant growth opportunities would likely outperform large caps, while domestic stocks would benefit versus their overseas counterparts as investors began to seek improved clarity and stronger economic prospects in U.S. markets.
Bonds
High-quality bond performance in this scenario would be heavily influenced by sector and maturity exposure, although total returns may be flat-to-down. Price declines in the high-quality fixed-income markets would most likely be limited by the prospects of anemic growth over the near term and the Feds determination to maintain low interest rates while unemployment remains high.
Investors should be wary of Treasuries in the environment we have described here, as markets would begin to factor in the probability of higher long-term interest rates in response to stronger growth prospects and put downward pressure on longer-maturity bonds. In this case, we would expect short-term bonds to experience the strongest performance, followed by intermediate-term instruments.
Municipal bonds would likely benefit under these circumstances from attractive current valuations and the prospect of higher taxes in the future. Munis, however, would be impacted by rising rates along with other high-quality bonds, which may drive declines in total returns.
Mortgage-backed securities should perform well as housing and homeowner credit improve along with employment, although these positive forces could be countered to some extent if the Federal Reserve slows its bond-buying program aimed at these instruments.
The outlook for corporate bonds would also improve in this bull case, led by the high-yield sector. Returns on corporate bonds may be mitigated somewhat by increased issuance and rising overall rates in a stronger long-term growth environment, but we would still expect to see positive total returns in the sector due to narrowing spreads.
Generally, short-term bonds would likely fare better in this improved environment, as long-term rates would rise more quickly than short-term rates due to ongoing near-term economic weakness.
A Pleasant Surprise
While coverage of the current fiscal cliff negotiations in Washington, D.C. has focused primarily on the potential downside to the economy if lawmakers fail to reach an agreement, there is also the possibility that investors could be faced with the pleasant surprise of an unexpectedly positive outcome that would put the nation back on the path to fiscal sustainability and long-term growth.
By thinking through the bull case according to our outline above, advisors and investors can prepare themselves for the upside should the nations capital experience a sudden outbreak of long-term compromise in 2013.
Preparing for the unexpected is an important part of risk management, usually with the emphasis on the downside. But with a 13% approval rating for Congress, pessimism seems deeply entrenched leaving the risk of a return of optimism in 2013 as an outcome worth considering as 2012 comes to a close.
Jeffrey Kleintop is the chief market strategist at LPL Financial.
