The Path Of Least Resistance

In 2013, many different forces will combine to influence the direction of the markets to follow the path of least resistance leading to modest single-digit returns in the U.S. stock and bond markets. The path for the year may be set at the end of 2012, or in early 2013, as critical decisions are implemented:

• Washington will likely finally rise to the challenge of this self-imposed crisis and form the compromise between the parties that will meet the least resistance — extending some of the Bush-era tax cuts and cancelling some of the scheduled spending cuts. However, going down this path risks delaying progress toward a more permanent solution that makes the government’s finances sustainable.

• The Federal Reserve (Fed) is likely to continue its bond-buying program of quantitative easing (QE). This open-ended QE is the path of least resistance among Fed decision makers and one which will buy the Fed more time to determine if more aggressive monetary policy easing is needed or if the economy can withstand a lessening of stimulus.

• Major hurdles to further European integration overcome in 2012 set the stage for progress toward a tighter fiscal, economic, and banking union. A high degree of resistance to splitting apart counterbalanced with strong stances against unconditional support is likely to keep Europe on a middle path toward slow continued integration.

• The U.S. economy faces the weakest global economic backdrop since the Great Recession of 2008 – 09 heading into the looming fiscal drag of tax increases and spending cuts. These forces are only partially offset by the benefits of Fed stimulus, the positive consumer wealth effect driven by the rebounding housing and stock markets, and the lifting of business uncertainty as the budget decisions are resolved. The combination is likely to result in a path leading to flat-to-weak growth for the U.S. economy.

Our base case path is supported by our view that key decision makers will find it is better to determine a way to overcome an avoidable and unnecessary economic recession, buy time to actually propose and vote on competing long-term fiscal visions, and do something to help restore confidence in Washington’s ability to govern. Ideally, this could help maintain investors’ appetites for U.S. equities and Treasuries. For the markets, the path of least resistance is likely to include modest single-digit returns for stocks as sluggish profit growth dampens stronger gains, but prices are supported by low valuations and improving clarity as uncertainties begin to fade. Bond yields may rise only slightly, restrained by sluggish growth and a Fed committed to keeping rates low, leaving returns to be limited to interest income at best.

However, there are paths that differ from this base case outcome: a bear path where the consequences of fiscal contraction damage confidence as well as the economy, and a bull path where an historic opportunity to address the U.S.’s long-term fiscal challenges is embraced and leads to sustainable solutions. Which of these three is the path of least resistance is likely to be determined by the end of the first quarter of 2013.
 

 
The Base, Bull, and Bear Case Paths

The hard-fought election will likely be followed by more fighting in a divisive and bitter “lame  duck” session in Congress running through year-end 2012. The stakes are high as those on Capitol  Hill seek to mitigate the budget bombshell of tax increases and spending cuts, known as the fiscal  cliff, due to hit in January 2013.  The two parties have very different visions of what a deal  should look like. Failure to reach a compromise in the coming months could lead to a recession and  bear market for U.S. stocks in early 2013.

However, a deal is in the best interest of those on Capitol Hill. The Republicans have a lot of items that are important to them to lose in foregoing a deal with Democrats: the Bush tax cuts would expire and the looming spending cuts hit defense  spending hard while not really impacting the big entitlement programs (such as Social Security,  Medicare, Medicaid, and the Affordable Care Act). To avoid being blamed for a return to recession on their watch, Democrats may only need to compromise on extending the middle-class tax cuts, which  President Obama already communicated his support of during his campaign, and delaying the impact of  some of the spending cuts. The path to a deal may not be a straight line, but is the outcome we view as most likely and upon which we base our expectation of modest returns for stocks and bonds —  with no bear or bull market — in 2013.

While a deal may be likely, there are risks for investors.  In October 2012, with the S&P 500 having risen back to within 10% of all-time highs, markets seemed confident that the Senate Democrats would quickly find a compromise with House Republicans to avoid  going over the fiscal cliff. However, a compromise may be hard to reach. Recall that the gridlock in Washington was no help to markets in 2011, as the unwillingness to compromise on both sides of  the aisle led to the debt ceiling debacle in August 2011, which sent the S&P 500 down over 10% in a few days despite the ultimate approval of the increase to the debt ceiling. A bear market and  recession could be looming if policymakers choose this path.