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Wall Street Steward Blog

2012 Mid-Year Outlook

Campaign 2012: What the Elections Hold for Investors

At the mid-point of the year, we continue to believe that:


  • The U.S. economy will grow about 2%, supported by soft sentiment and hard data continuing to converge,

  • The U.S. stock market is likely to post an 8 – 12%* gain, backed by mid-to-high single-digit earnings growth,

  • Corporate bonds will post modest single-digit gains and outperform government bonds,**

  • Policy-driven events will hold major consequences for investors.

In our 2012 Outlook, we stated that the party that emerges in control following the November 2012 elections will forge the decisions that will represent one of the biggest shifts in federal budget policy since World War II. In the second half of the year, these elections will likely become an increasingly potent driver of the overall markets and determine whether our expectations for the year come to fruition.

Currently, our outlook over the second half of 2012 for the economy, the stock market, and the bond market are on track based on our 2012 Outlook. However, financial markets will react in anticipation of potential election impacts and influence stock and bond market performance. In the stock market, we continue to focus on sectors that derive more of their growth from more rapidly growing emerging markets and business spending. In the bond market, we continue to focus on higher yielding sectors that may outperform in a low-yield environment resulting from political uncertainty, sluggish economic growth, and ongoing risks from Europe.

What do the elections hold for investors? To answer this question, we analyze what we believe are the most relevant issues in the second half of 2012 and 2013. We can think of these issues as campaign stops in our journey across the current political landscape.

The White House


The stock market usually performs well in an election year. The four-year presidential cycle of stock market performance has been remarkably consistent over the years, with strong performances in years three and four of a presidential term [Figure 1].


Income growth and related job creation may be the key measures by which the presidency will be judged. Historically, inflation-adjusted, after-tax income growth of about 3 – 4% appears to be the key for incumbents to get 50% of the popular vote [Figure 2]. Above 4% the incumbent gets re-elected; below 3% and the challenger wins. Between 3 – 4% a lot of other factors come into play, making it close. As we start the second half, this measure is about 1%, suggesting that President Obama faces an uphill battle for re-election.


The economy is impacted by fiscal, monetary, and regulatory policy — all influenced by the election winner. The outcome of this year’s election will help determine the path taken in 2013 to address U.S. fiscal challenges, including the debt ceiling and potential debt downgrades.

Congress


No matter which party controls the White House, we believe the changes in Congress may have a dramatic impact on the second half of the year. The election may result in one party controlling both chambers. Markets will likely embrace this prospect regardless of party affiliation; history suggests that the markets have tended to perform best when Congress was controlled by one party [Figure 3]. A Congress that can work together is critical after last year’s debt ceiling debacle and debt downgrade.


Congress has the potential to move from gridlocked to unlocked in 2013. This matters a lot to investors because of the need to avoid the budget bombshell that is about to hit our economy next year.

How to Invest: Despite our outlook for sluggish U.S. economic growth of about 2% and a mild recession for Europe, we expect high-single to low double-digit returns for the S&P 500. We expect these gains to be driven by earnings growth in the high-single digits and a modest rise in the price-to-earnings (PE) ratio from recession-like levels as sentiment begins to rebound.

Mid and small capitalization companies tend to perform better after the economy emerges from mid-cycle soft spots and credit markets improve.

Federal Reserve (Fed)


The Fed always acts in presidential election years and recently said it is “prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions.” A third round of monetary stimulus (round three of quantitative easing — QE3) is still on the table, which may result in increased Treasury yields and outperformance of high-yield bonds.

A look back at prior rounds of Fed bond purchases shows that Treasury yields actually increased following the start of bond purchases. In each of the three prior bond purchases — QE1, QE2, and Operation Twist — the yield on the 10-year Treasury increased almost immediately [Figure 4].


What would prompt the Fed to do QE3? The Fed has a dual mandate to promote low and stable prices and to foster conditions that lead to full employment. Recent data points on employment, the overall economy, and inflation suggest the following: 1) softening labor market, 2) slowing economy, 3) stabilizing core information, and 4) deteriorating financial conditions — all of which may point to QE3.

How to Invest: The extension of the Fed’s Operation Twist into the second half of 2012 may help high-yield bonds outperform relative to Treasuries.

The Budget Bombshell


The 2013 budget will have the biggest impact of any budget in decades, even if no action is taken in Washington. The most likely budget impact is a fiscal tightening of more than 1% of Gross Domestic Product (GDP) in 2013. We believe a fiscal tightening of $200 billion-plus (with about half from tax increases) totaling about 1.3 – 1.5% of GDP is likely in 2013 and will be comprised of:

  • The likely expiration of the payroll tax ($112 billion),

  • A reduction in discretionary spending (about $80 – 90 billion), and

  • The imposition of the 3.8% Medicare tax on investment income ($21 billion).

How to Invest: We maintain our forecast of mid-single-digit returns for the bond market in 2012, as even modest fiscal tightening will help support high-quality bond prices through late 2012.

Taxes


Already written into law for 2013 are big tax policy changes including the expiration of the Bush tax cuts, the payroll tax cut, and the new Medicare tax on investment income. Both President Obama and House Republicans have proposed changes, but we do not expect a major direct impact on the stock or bond market.

The far bigger impact is an indirect one determined by the magnitude and direction of overall fiscal policy taken (or not taken) in 2013 to the put the United States back on a path to financial stability. We do not expect a sweeping re-write of the tax code in 2013 for a few reasons.


  • Under a divided government, there is unlikely to be enough common ground upon which to base a new code.

  • Republican priorities (e.g., Bush tax cuts, Obama’s Affordable Care Act — ACA) will not allow for the political bandwidth to tackle comprehensive tax reform.

  • It is not politically easy to reduce tax rates while raising the same amount of revenue.

How to Invest: We find municipal bonds attractive and do not expect changes to the municipal tax exemption.

Wall Street Sectors


The November elections will impact all of the stock market sectors [Figure 5]. We believe analyzing the market by the industries most impacted one way or another by the elections’ outcome can help us evaluate potential investment opportunities.

 

 


How to Invest: We suggest focusing on less “election-sensitive” sections. Our favorite sectors remain Technology and Industrials. These sectors may experience a neutral to modestly positive impact from election results. We are less favorable on sectors where election results could lead to disparate outcomes, and therefore potentially more volatile performance, such as Health Care and Financials.

Europe


In addition to the U.S. elections in November, developments in Europe will have a major impact on the stock and bond markets. A wave of change is sweeping Europe; 12 of the 17 Eurozone governments have collapsed or been voted out over the past two years. The turnover is related to the sovereign debt problems, austerity measures, and recession taking place in the Eurozone.

In the second half of this year, Europe will likely focus on austerity commitments and additional measures to stabilize the Eurozone. Policymakers and leaders are unlikely to agree on details that would immediately alleviate pressures. This means that Eurozone concerns may linger and drive continued volatility.

How to Invest: Geographically, we favor the U.S. markets and, to a lesser extent, the emerging markets over the foreign developed markets such as Europe.

Postscript: Putting it in Perspective:


Although the issues facing policymakers at home and abroad in the second half of 2012 may seem daunting, the issues may not be so dramatic as they seem at first. Remember that in the first half of 2012 Greece defaulted, Spain needed a bailout, and total U.S. Federal debt-to-GDP crossed over 100%. Yet, a global crisis did not erupt, and U.S. stocks and bonds posted gains.

IMPORTANT DISCLOSURES
*LPL Financial Research provided this range based on our Earnings per Share Growth estimate for 2012, and a modest expansion in the Price to Earnings Ratio. Additional explanation can be found throughout this publication.

  • We believe corporate bonds will outperform government bonds as the economy avoids recession enabling the extra yield of corporate bonds over comparable government bonds to be a primary driver of returns.

Names of securities mentioned herein are for informational purposes only and should not be considered investment advice or guidance, offer or solicitation, offer to buy or sell securities, nor a recommendation or endorsement by LPL Financial of the security or investment strategy. LPL Financial does not endorse or evaluate individual equities.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

Small Cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the Small Cap market may adversely affect the value of these investments.

Mid-capitalization companies are subject to higher volatility than those of larger capitalized companies.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Past performance is no guarantee of future results.

Consumer Discretionary Sector: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services.

Consumer Staples Sector: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. It also includes food and drug retailing companies.

Energy Sector: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels.

Financials Sector: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs.

Health Care Sector: Companies are in two main industry groups—Health Care equipment and supplies or companies that provide health care-related services, including distributors of health care products, providers of basic health care services, and owners and operators of health care facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products.

Industrials Sector: Companies, whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure.

Manufacturing Sector: Companies engaged in chemical, mechanical, or physical transformation of materials, substances, or components into consumer or industrial goods.

Materials Sector: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel.

Information Technology: Companies include those that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products.

Telecommunications Services Sector: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network.

Utilities Sector: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power.

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