With the fiscal cliff behind us, the next big issue to affect the markets and the economy appears to be the U.S. debt ceiling deadline, but according to three esteemed market strategists, having been inured to DC dysfunction, the markets have already discounted the impact of the debt ceiling.
Speaking Tuesday on Envestnet’s 2013 Outlook webinar, Liz Ann Sonders of Charles Schwab, Jeff Rosenberg of BlackRock, and Miltron Ezrati of Lord Abbett found consensus on that issue. When asked by moderator Brandon Thomas, chief investment officer of Envestnet|PMC, whether there would be a “market rout” leading up to the debt ceiling debate as occurred in August 2011, Sonders, Schwab’s chief investment strategist, said it wasn’t likely, though she didn’t entirely dismiss the notion. The debt ceiling showdown in 2011, she said, “did not cause a calamity” and instead “became a buying opportunity.” In this debate, she suggested there are economic “forces that should keep at bay what we saw back then.”
Ezrati, chief market strategist at Lord Abbett, said, “We know we can survive a downgrade; it’s known in the marketplace that default is unlikely.” While he expects to “see more volatility because they will play brinksmanship” in Washington, he predicts that “the markets will react more calmly.”
Rosenberg, chief investment strategist for fixed income at BlackRock, said the major risk in the talks is that “political stalemate leads to failure” but that the markets “will discount that until it happens.” What’s the most likely scenario in Washington over the debt ceiling? “Expect what we’ve seen” already over the fiscal cliff deal, Rosenberg said: “Lowering the bar and jumping over it, claiming success without doing anything to solve the long-term problems; this is not about compromise, it’s about winning.”
So if the markets are not waiting for the politicians to act, where are the opportunities in the markets in 2013, and what will happen to the economy?
On the economy, Sonders cited the ISI U.S. Diffusion Index—which tracks 45 economic indicators—which suggests that “since recession, we’ve been in a choppy pattern.” The fiscal cliff, she said, was “always more of a slope” than a cliff “without an immediate impact on the economy.” The law that brought us back from the cliff, she said, is likely to cut about 1% out of U.S. GDP this year due to the effect of higher taxes, though that still “doesn’t get you into recession territory.”
Among those economic forces keeping recession at bay is continued Fed easing—“The Fed no longer on an island, there’s been a massive amount of central bank easing” worldwide which has been the “big push behind economic growth.” Citing another of her favorite economic indicators—the Housing Market Index, from the National Association of Home Builders and Wells Fargo—Sonders says housing has already shown “an unprecedented surge up off the bottom” and “based on fundamentals, housing is beginning to be a big contributor to economic growth,” accounting for perhaps 1% in GDP, which would offset the fiscal cliff deal’s drag on the economy.
Equities, she argued, are “reasonably valued” and could go even higher due to low inflation. While Sonders expects consumer confidence to be held in check now through mid-year, she then expects a rebound in the second half of the year. While not a market-timer, Sonders suggested investors shouldn’t “get over-exposed” to equities right now, especially cyclical stocks, and in fixed income, she suggested shortening the duration of holdings.”
Picking up on the fixed income theme, Rosenberg said to expect only limited increases in interest rates, so “major segments of fixed income will return low-single digits” in 2013. “The old era of fixed income investing is over,” so he suggests “reducing duration, in both taxable and tax-exempt, increasing allocation to credit risk.” Since he expects that default rates on high-yield bonds will remain low because of the global background of high liquidity. However, he says that in the high-yield space, “returns will come from income, not from price appreciation.” While he says that “you’ll be paid adequately for the risk you’re taking” in high yield, investors can expect only 5%-8% returns in 2013, less than half of the 16% return in 2012.”
Rosenberg called municipal bonds “one of the biggest beneficiaries of fiscal cliff deal,” arguing they have been strengthened as “prospects for meaningful tax reform have declined.” And what about the credit risk of munis? Are chances higher for default there? “State and local finances are on the upswing,” partly because of rising tax revenues from the recovering real estate market, along with significant cost reductions already taken by states and municipalities. “Tax receipts are increasing” among local governments as the economy improves.
Ezrati (left), senior economist and market strategist at Lord Abbett, sounded a similar theme in seeing “tremendous value in equities and the risk-on trade and the complete lack of value on the risk-off trade.” Confirming the markets’ discount of the debt ceiling, he said that “if the market is priced for ugly events, then all you need is a muddling through to get the market to move up—that was the experience last year and will dominate 2013.”
At Lord Abbett, “we think the economy will limp along” without the return of recession; Europe won’t solve its problems; and that “Washington won’t solve its problems but will avoid some of the great fears.”
Reflecting the movement of funds into fixed income in a year (2012) when equities did so well, Ezrati explained the psychology behind those fund flows. “Investors know they’re losing money in this asset class,” but they’re willing to pay for the risk insurance of merely getting back the money they’ve invested rather than seeking a return. “The easy money has been made in junk and munis,” Ezrati concluded, “we’re emphasizing people should be moving toward credit risk.”