PREPARING YOUR INVESTMENTS FOR UNCERTAINTY
Consistently successful investment strategies require thoughtfully developed tactics to achieve investor’s financial goals under different economic scenarios. With only 1 week remaining before we elect the next commander in chief, uncertainty is the most important scenario to be considered by investors who expect successful investment results.
As we approach the November 6th U.S. Presidential election, among other factors, there are both known and unknown economic risks, and opportunities, that will impact your portfolio in 2013. The greatest unknown factor is whether it will be Barack Obama or Mitt Romney who will lead the country through the economic obstacle course ahead.
With that uncertainty in mind, I took this opportunity to share Index Strategy Advisors view of the potential outcomes you can most likely expect. The analysis below will help you to reconsider how your portfolio can be positioned to succeed in spite of any meaningful differences between a Romney or Obama administration.
THE ECONOMY CONNECTS POLITICS TO YOUR INVESTMENTS
The economy has a major influence on the success of your investment strategy and upon elections. Historically, the four most influential economic factors on elections are GDP growth, the inflation rate, unemployment, and consumer sentiment. Predicting a winner in presidential elections can range from nearly impossible to easy depending on circumstances, yet we can see which factors have been associated with all the winning and losing presidential bids since 1968.
Based on history, Obama’s record offers little predictive value as to a potential winner
- Preparing your investments for the uncertainty of this election would be simpler if Romney or Obama was a clear favorite, but that is not the case as of this writing. By comparing Obama’s record to the past historical data, he is neither favored to win, nor likely to lose since high unemployment is the only factor which stands out for the Obama administration.
- Historically, a candidate running with at least two gray numbers, indicating poor performance in these areas has always lost the election (Gerald Ford in 1976, Jimmy Carter in 1980, George H.W. Bush in 1992, and John McCain in 2008). Additionally, in elections where the incumbent or his successor has run with two or more blue or black numbers, indicating neutral or positive performance, has always led to a win (Richard Nixon in 1972, George H.W. Bush in 1988 and Bill Clinton in 1996), with the exception being Hubert Humphrey in 1968.
THE FOUR RISK FACTORS THAT MATTER MOST TO YOUR INVESTMENTS FOR ELECTION 2012
With no clear favorite to win the Presidency, we must focus on the economic factors most likely to impact your investments regardless of the winner:
RISK FACTOR #1: SLUGGISH ECONOMIC GROWTH
In 2013, the newly sworn in President will face a sluggish economy, growing at a paltry rate of 2 percent or less. For over 30 years, GDP growth and stock market performance have consistently moved in tandem in the U.S., and throughout the developed economies of the world. Stock market losses have been dramatic when GDP growth dips below 2% throughout this period. Stronger economic growth will be necessary to grow your investments.
Romney’s reputation as a successful entrepreneur and his selection of budget expert Paul Ryan make him a better candidate for your investment portfolio for the sluggish economic growth risk factor.
- Economic growth starts with investment by companies. In the pre-election environment many companies are being tightfisted with their budgets. The Institute for Supply Management (ISM) report on manufacturers released on September 4th showed increased hesitation on spending and investing. The new orders index edged down 0.9 point to 47.1 (see chart below), indicating a contraction in new order flows.
- If Romney wins the election, we predict that a slight uptick in business confidence can be expected due to his stated intentions to reduce corporate taxes. Additionally, his V.P. Paul Ryan is perceived by many in the business community to have a feasible economic budget to address the Federal deficit. An uptick in business confidence would counteract the potential risk of a sustained market pullback if businesses responded unfavorably to the re-election of Obama.
RISK FACTOR#2: THE FISCAL CLIFF
The fiscal cliff refers to a variety of deficit-reduction measures that would increase taxes and reduce federal spending at the end of this year. If enacted in full, the combined tax increases and spending cuts are expected to cut the federal budget deficit by $607 billion in 2013.
The measures would also result in an estimated 4% reduction of U.S. gross domestic product (GDP) according to a Congressional Budget Office (CBO) report on August 22, which some economists characterize as “falling off a cliff.” Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects—with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.
Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.
Both Romney and Obama would work to see that Congress rescinds the tax increases and spending cuts, therefore neither candidate is better for your investments for this risk factor.
- In our view, neither candidate would be willing to risk the political backlash that would result from allowing the pending tax increases to come into effect, as this could prompt a sharp decline in the economy and a substantial loss of jobs. Therefore, the fiscal cliff risk to your investments is not tied to the election outcome.
A protracted political debate over entitlements will likely result in greater risk to your investments
- There is substantial political risk involved in the fact that a Congressional act to lift the spending cuts and tax increases would involve protracted political debate. This risk has severely damaged investment returns recently on the two occasions when major legislation was required to avert financial crises. It should be reiterated that this risk has been true for both political parties (e.g. Bush and the bailout vote in October ’08 and Obama and the Budget Control Act, a result of the summer 2011 debt ceiling debate).
The Obama Administration will bear a significant degree of criticism throughout any congressional move to lift the spending cuts and tax increases.
- We believe that neither party will bankrupt the nation; however the desire to influence public opinion and extend political posturing could hurt investors dearly. Until the actual Congressional act is passed to reverse the fiscal cliff measures, a focused dynamic risk hedging approach should be applied to protect capital from the volatility, uncertainty, and historical losses associated with delayed legislative action.
RISK FACTOR #3. TAX CUTS EXPIRING
If no action is taken by Jan. 3, 2012 temporary tax cuts expire and deep, across-the-board spending reductions kick in automatically. Both Romney and Obama will expect Congress to enact a short-term solution to the expiring tax cuts, extending them for at least one more year. A failure to act would result in a $4 to $5 trillion tax increase over the next 10 years. However, Congress could reinstate tax increases later in 2013 and make those increases retroactive to January. The obvious implications to your investment strategy are the increased taxes that would be applied to capital gains, dividends, and personal income.
Without action from Congress, all income, capital gains, dividend and estate taxes will increase along with the first tax increases associated with health care reform.
Both Romney and Obama would work to see that Congress rescinds the tax increases and spending cuts, therefore neither candidate would have a meaningfully different impact upon your investment strategy for the expiring tax cuts risk factor.
- However, if Congress does not rescind the tax increases and Romney wins, his primary asset of job and business friendly initiatives will lose its potency. Whereas Obama’s key areas of interest (social programs) will not be disproportionately hurt by a failure to lift the tax increases, Romney would have to scramble to find a ‘narrative’ to define his economic agenda. This scenario would pose additional risk to your investment strategy as a theoretical vacuum would exist in terms of policy or agenda options for a Romney administration.
FACTOR #4: UNEMPLOYMENT
Despite 30 months of private-sector job growth under President Obama’s current term, the US still confronts a large jobs deficit. Additionally, the unemployment rate remains more than two percentage points above the “normal” rate (when the economy is operating near capacity). The issue of joblessness is even worse when the millions of Americans who have dropped out of the labor force are factored into the equation.
In a historical perspective, the labor-force participation rate remains near historic lows. The challenge facing Romney or Obama in 2013 is that more than 11 million additional jobs are needed to return the US to its pre-recession employment level. At the current pace of recovery, that is more than eight years away. In its recent announcement to extend Operation Twist (aka “QE3”) for another two years, the FOMC has forecasted that its measures may lead to a continued reduction in civilian unemployment as seen below.
Just as with Factor #1 (Sluggish Growth), unemployment is an issue that has business owner’s outlook as its primary driver. In this context, Romney for the same reasons as in Factor #1 is the preferred candidate.
- Based on the FOMC’s forecasts and current policy, the employment picture may improve. However, Romney has suggested a different Fed chairman and policy approach would be part of his administrations agenda. This uncertainty clouds any speculation as to how the current monetary policy and its predicted implications would help or hurt your investment strategy.
OBAMA VERSUS ROMNEY VERSUS YOUR INVESTMENT PORTFOLIO
What you should do now
It’s unlikely that Congress will act on the provisions contributing to the fiscal cliff until after the presidential election in November. Politician’s willingness to debate until the final hour while markets sink to the brink of collapse (as seen in 2011 and 2008) should remind you that a prudent risk management system should be in place for your portfolio before the election if you want to avoid or reduce potentially significant market losses.
Obama vs. Romney
- The range of economic-policy initiatives that are both feasible and desirable are extremely limited, thus major differences between Romney and Obama are limited.
- The winner on November 8 will quickly recognize that in reality there are far fewer options for the right mix of policy reforms than his campaign doctrines suggested. In this way the differences in impact to your investment portfolio certainly are not an either/or proposition.
- The fiscal reforms required to lift the impediments to growth and job creation are prone to excessive political polarization and thus encounter major hurdles in Congress. Markets have historically collapsed during such periods.
THE BOTTOM LINE
This election boils down to diverging philosophical ideas about social and, perhaps, moral issues. As important and polarizing as they may be, however, the majority of social issues which evoke emotion and partisanship, in our estimation, will have little impact to your investment strategy solely based upon the winner of the election.
In plain English, how much tax payers will be willing to ‘help’ each other appears to be the divide between Obama and Romney that will matter the most to your investment portfolio. And it won’t matter as much based on what’s coming in the future or who will sit in the West Wing, it will matter based on how quickly Congress acts to address mistakes from the past.
Much of the debate amongst followers of either party seems to persist around the issues of fairness and social responsibility; however, both parties have consistently demonstrated a lack of fairness or responsibility to investors. We have seen markets nosedive repeatedly in passing legislation to fix (or extend) broken budgets. This time is not likely to be different; therefore we recommend a defensive stance and review of sound risk management practices for the entirety of your investment portfolio.