Austerity Ahead: Should We Worry?

So far in 2013, I’ve had a cautious but positive message for investors.

Yes, the global economy isn’t exactly perking along. This week’s news on European growth isn’t encouraging, and America Movil’s (NYSE: AMX) earnings shortfall in Mexico is troubling tidings from the developing world.

But Chinese growth does appear to have at last turned the corner. And here in the US, corporations are sitting on a mountain of cash ready to be put to work. US unemployment remains high by historical standards. But this week’s jobless claims were the lowest in four years, a clear sign this lagging indicator is still turning up.

Results from the ongoing fourth-quarter and full-year 2012 earnings reporting season basically reflect this global dichotomy. Companies most exposed to the weakest segments have taken hits. Major auto companies, for example, have seen European sales lag.

Pricing differentials in North American energy have risen to new highs, due to the combination of surging oil and gas production, lackluster internal demand and a lack of midstream infrastructure to get energy to market. That’s causing smaller producers and service companies to retrench, even as benchmark oil prices remain at high levels.

Finally, seeing tepid economic growth ahead, several high dividend companies have reassessed their future cash needs and cut payouts. That’s not only set off a temporary panic in their own stocks, but those of other big payers as investors worry about who’s next.

But so far at least, these negatives have not outweighed the positives for the overall market. Most companies have reported few surprises in their numbers.

The S&P 500 has continued its march upward, as have other major stock indexes. If the old saw holds that the first six weeks forecast the year, 2013 should finish in positive territory as well, just as the four previous years have.

The Wild Card

However, a wild card lurks for the markets and global economy—i.e., the level of austerity that lies ahead because of Washington’s budgetary decisions, and what sort of multiplier effect (if any) this belt-tightening will have on the US, and by extension the world.

Worries about a catastrophe were strong at the end of 2012. The result was many stocks sold off rather than ran up in the fourth quarter.

Those concerns greatly diminished with the New Year’s Day Deal to prevent a full-on fiscal cliff. That kept George W. Bush-era tax rates in place for 99 percent of Americans and put a lid on investment taxes at 20 percent. And worries waned further when enough Congressional Republicans removed politics from the debt ceiling debate, eliminating the specter of a first-ever US government debt default.

The tax deal, however, did leave unresolved the issue of the “sequester,” mandatory across-the-board spending cuts agreed to in the September 2011 debt ceiling arrangement. And it left open the possibility of the first US government shutdown since the early 1990s, if Congress and the president can’t agree on a budget this spring.

The politicians waited until the last possible moment to resolve the fiscal cliff issue in January. Despite the bold statements we’re hearing now, it’s likely enough legislators will cobble something together in the next few weeks, at least to avoid the worst of the mandatory cuts at the Pentagon.

Whatever is agreed to, however, will almost certainly feature more austerity—just as the sequester would. Therein lies the rub: Who will it affect and by how much?

Retail sales data released this week were heralded as somewhat encouraging. Mainly, despite the hit to paychecks from higher Social Security taxes, they rose slightly from the prior year. On the other hand, the rate of growth was marginal, compared to robust increases for both November and December.

More ominous are the data from across the pond. More than four years past the 2008 crash, support for euro zone unity appears to be strong as ever. But it’s equally true that only Germany has rebounded, while growth continues to slide and unemployment rise on most of the continent.

Budget cutting and holding the line on monetary policy have been good for the euro since last summer. And the currency’s move from a low of roughly USD1.20 to around USD1.35 recently has been a plus for US investors in European stocks and euro-denominated bonds. Gains have been far more impressive against the Japanese yen, which has lost roughly 18 percent of its value against the US dollar over that time frame.

Euro strength, however, has been pure poison for the Continent’s exports. That’s at the same time those exports have become all the more vital for companies dealing with a floundering market in Europe.

Recession Odds

The question is, could the US federal budget austerity we see this year wind up having a similar impact? As I’ve pointed out here, the answer depends on what extent there is a multiplier effect, which economists on the right deny exists and those on the left believe could create another relapse similar to the one that occurred in 1937 during the Great Depression.

In my somewhat tongue-in-cheek January 18 Mind Over Markets—“Your Best Economic Forecast”—I posited the wagering service Intrade.com as a better economic forecaster than most. That’s in large part because the odds are based on actual bets, rather than proclamations issued from 30,000 feet.

At that time, Intrade bettors were giving 22 percent odds that the US would slip into recession in 2013. Those odds are now down to 15.2 percent, which is encouraging.

The fact that they’re that high, however, also affirms my own macro view. Mainly, we will see more federal government austerity in 2013. It will not be enough to cause an outright recession, but it will do damage to companies in affected industries, as well as to those with high leverage and less-than-reliable revenue.

Absent action in Congress, the sequester will go into effect in March, so we’ll find out sometime during the next couple of weeks the dollar amount of the austerity. The possible multiplier effect will likely have come into focus by mid-summer. And we’ll very likely see the full impact on corporate earnings starting with the second-quarter results released at that time.

As for stocks, they’ll likely begin to price in the potential damage and risks immediately following the announcement of cuts. But again, the actual impact won’t become truly clear for several months, when real numbers go to post.

Hence my argument for being careful now, even as the overall stock market continues to wend its way higher. Stay invested in stocks—they’re the only game in town with bonds and cash yields at record lows. But keep a close eye on what you have, watch your leverage and above all stay diversified and balanced.

1 Comment So Far

1. 

   Reply Dian Love February 16, 2013 at 7:18 PM EDT

   Best overview I have read for predicting the near future of the market and the global economic situation!