With the election behind us, it is now easier to discuss the possible paths for the economy in 2013. We have been clear that we felt businesses have been holding back as a result of uncertainty – but we must admit the recent strength in economic data suggest that the economy was already ramping up before the election results were in. The stronger than expected hiring seen in the payroll jobs report (including revisions) is being confirmed by reports of stronger than expected economic activity. Third quarter final sales likely grew at an above trend rate of 2.5% – 3.0%. Inventory stockpiling may lift real GDP growth in the quarter above a 3% annual rate — and the question is whether this is the start of something new or will there be a give back in the fourth quarter. The effects of Hurricane Sandy will surely be reflected in upcoming monthly data, and it will likely depress fourth quarter growth slightly. However, any weather weakness in fourth quarter growth may make it easier to survive the fiscal cliff, as some rebound in the affected areas will partially offset the decline from higher taxes in early 2013.
Our view on how the fiscal cliff is handled is a mix of game theory and psychology. We find it hard to believe that the Democrats will back off from their version of how to solve the fiscal cliff given their better than expected performance in the election. The President won losing only North Carolina and Indiana from the electoral states he carried in 2008. He won the popular vote by a margin of over two million, despite running even to behind in national polls. Interestingly, despite talk of turnout, 12 million fewer votes were cast in this election than in 2008. Two million lost votes were in New York and New Jersey where weather was a factor. Another four million of the shortfall was in California, and over a half million in Arizona suggesting the result was clear well before the election was called by news stations. Totals were lower in all of the major mid-western states – Pennsylvania, Ohio, Illinois and Michigan – reflecting malaise about the process compared with 2008. Considering the money spent in Ohio alone, the fact that fewer people voted (for both parties) is a testament to the disgust with the interparty conflict.
In the Senate, the Democrats picked up two seats (if one assumes Maine’s Angus King will caucus with the Democrats) with three wins on the liberal East Coast, while losing only Nebraska. They also picked up a handful of seats in the House, but remain well in the minority. Indeed, many returning Republicans found they had increased their personal margins of victory as incumbents – and, so like the Democrats, feel little incentive to negotiate on their central tenants of policy. True, the Republican Party may have suffered a setback, but that blame falls on Mitt Romney and two foot-in-mouth Senators. Still, Speaker Boehner had trouble corralling his cats before the election – and leadership challenges may arise again if he appears weak against the old enemy. Bottom line, the Government we have today looks almost exactly like the Government we had before the election. Indeed, even the Senate pick-ups in Maine and Massachusetts made little difference as they were the most liberal Republican seats, which had already proved convertible on earlier deals. We expect a lot of talk from Washington, but little action — without pressure.
It is the falling equity market that will provide that pressure, just as rising bond yields have fulfilled that role in Europe. We expect equities to ebb and flow on the swinging expectations of a resolution to the fiscal cliff — with increased volatility as the two Parties test which has the greater will. The equity market is currently upset, but not panicked. It still believes the politicians will act rationally and settle before we head over the cliff. Unfortunately, we hear far too much discussion of strategies that assume we will actually get the reversal of the Bush tax cuts and feel the bite of the sequester — the fiscal bungee jump as it has been called. As we noted in earlier missives, Washington does not see the cliff as a solid wall, but rather an increasingly painful application of pressure that can be quickly reversed by making tax laws retroactive and spending cuts reversed. Indeed, given the fiscal cliff is law, the real discussions in Washington are about who gets the benefit of avoiding the pain of the fiscal cliff – and who in Congress gets to claim victory for rewarding their constituency. Washington is a magician with accounting rules when faced by supposedly solid cutoffs like the debt ceiling. Bottom line, we expect politicians will wait and see how the big Black Friday sales go — with the equity markets selling off and tax hikes on the way – then decide whether to give up vacation time during the holiday shutdown to deal with that fiscal cliff thing.
Taking the Left Fork in the Road
Though the majority of the financial and business community is clearly disappointed in the outcome of the election, they will now begin adjusting to maximize returns in this less desired world. Some moves are already being made as firms with low pay hourly workers are cutting hours to less than 30 per week to avoid the impact of Obamacare. As some firms alter employment, their competitors will have to decide whether to shift as well. To fail to do so may allow a competitive advantage. Of course, avoiding Obamacare may not be the best strategy. Some firms will offer the best workers longer hours and medical coverage. The point is that simply standing still will likely leave a firm either paying too much for unskilled labor or losing its most skilled workers to more committed competitors. After a year of inaction, firms must now adapt or suffer the consequences.
We expect that the continued difficult banking environment will persist in 2013, limiting startups and, hence, new competition. Thus, the real game will be for market share amongst existing firms. We anticipate increased consolidation, with the most profitable firms defending that position by buying the best of the smaller firms and using cost advantages to squeeze out the weakest. Rather than using their strong balance sheets for expansion through capital investment, we see balance sheets being used for mergers and acquisitions. Providing smaller firms access to the cheap money available from fortress balance sheets will generate both higher returns and lower aggregate leverage. In previous cycles, the solution was usually from the strongest financial hands using their borrowing power to finance smaller firms and earning arbitrage profits in the process. In this cycle, debt financing is likely to be replaced with direct equity investment, as the strongest corporate hands are the key to the expansion. Trust was the primary casualty of the Lehman crisis, and it will take a long time to rebuild confidence in the financial intermediaries most at fault. Intermediation creates debt, while conglomeration and amalgamation reduces it. In a deleveraging world, size is a comparative advantage – which should benefit the equity markets to the detriment of small business proprietors.
We see the next several years as a repeat of the 1950s: with lots of volatility, low interest rates and inflation, and growing market power for dominant firms. The fifties were part of the long sweep from FDR to Reagan where rising taxes and government regulation were the trend – not only in the US, but around the world. From Reagan/Thatcher to Lehman, those trends were reversed – much as they had been during the post-Civil War sweep culminating in the Panic of 1893. After 1893, the US entered a period of strong regulatory and anti-trust sentiment until WWI – which was followed by the brief but spectacular Roaring Twenties. These sweeps are not of any determined length, but they reflect deep underlying changes in demographics and economic fundamentals. The political reality for the Republican Party today is that the Electoral College now is heavily biased toward the Democrats. In the last six elections, they have carried the East Coast (except NH), West Coast and Industrial Midwest every time. Add in NM, NH, and IA, which were won five of six times, and they start with 247 of a needed 270 electoral votes. The new Hispanic strategy of carrying NV and CO gives them a lock (at 272) without even thinking about OH, FL, or VA — never mind NC. The Republicans will be fighting an uphill battle in the Electoral College despite still close popular votes.
While individual Congressman in secure districts may not worry about this shift, Party leaders and the institutions which support the Party monetarily certainly will. The current shift on immigration is the most obvious response to this Electoral imbalance. Will a trade-off of higher personal taxes on the wealthy for lower rates on corporations be next? The Bush Tax cuts, in part, were designed to reduce double taxation and release corporate activity. It did generate a lot of small business expansion, unfortunately financed by home equity and crushed after Lehman. Lower corporate taxes would be a much more efficient strategy – especially in a global environment of lower corporate rates. Closing loopholes is always popular to talk about but hard to accomplish – unless you are handing out new goodies at the same time. Bottom line, the Congress planned the fiscal cliff to cause pressure right after an election both sides felt sure they would win. Now, both sides must address the unwinding of that mess – but do not expect it to be straight forward. We believe the unwinding of the fiscal cliff will be an integral part of broader negotiations on topics from taxes, to energy policy, to regulation. It is the biggest club everyone in Washington has to wield on each other, as well as on their constituents and lobbyists. It is not in Washington’s nature to act without a crisis – or to let a good crisis go without expanding the battle to other areas of interest. This could take a while.