Fiscal Cliff Band-Aid, Budget Woes and Retail Lows

by Shawn Narancich, CFA Vice President of Research

Problem Solved?

The cliff is bridged, but the span is short, and daunting canyons remain to be crossed. A deal to avert across-the-board tax increases and immediate spending cuts prompted a nearly 3 percent rally on Wall Street, as traders betting against a last minute agreement scrambled to cover their short positions. As stocks shot higher, Treasuries lost a safe-haven bid and prices fell meaningfully, pushing yields on the benchmark 10-year bond to within shouting distance of 2 percent. Nevertheless, the 2012 Taxpayer Relief Act does relatively little to address the nation’s underlying deficit and debt problems. With sequestered spending cuts having been deferred by two months and Congress once again rescinding cuts to doctors’ Medicare reimbursements, federal spending continues largely unabated.  And although tax revenues may rise because of higher marginal tax rates for top earners, the sad fact remains that our U.S. government brings in only about $7.00 of revenue for each $10.00 it spends. 

Budgeting 101

The Treasury is now pulling unusual levers to keep funding itself because the nation has already reached its $16.4 trillion debt limit. So with the thorny issue of entitlement reform still unresolved, the question is whether this third rail of U.S. politics will finally be addressed. Without entitlement reform in an economy growing at 2 percent, the prospect of balancing the budget and arresting further substantial growth in the national debt is dim. In approximately two months, the Treasury will run out of rabbits to pull from its hat, so either Congress will legislate a higher debt ceiling or large portions of the government will shut down for lack of funding. Therefore, a key risk for equity investors is that political negotiations herein promise to be rancorous, putting spending cuts back on the table in exchange for votes to raise the debt ceiling. 

A Lump of Coal for Retailers?

Yes, it’s about that time again, and earnings season will take place against a fourth quarter backdrop that witnessed dislocations from Hurricane Sandy and increasing concerns by businesses and consumers about fiscal austerity. As such, earnings in an environment where estimates have been falling present another risk for equity investors. Investors gleaned some more clues about the economic backdrop for earnings following December sales reports out Thursday. Same-store sales at key retailers rose by 4.5 percent, but a mid-month lull appears to have forced them to accept lower prices in exchange for volumes. Target sales fell flat on a disappointing Neiman Marcus collaboration and Kohl’s cut earnings numbers despite beating top-line expectations. Bricks-and-mortar retailers appear to have been challenged by a post Black Friday lull, which challenged their ability to keep shoppers engaged over an unusually long holiday shopping season marked by another market share grab by online retailers. Best Buy is a good example. It serves as a de facto showroom for consumers who then buy from the likes of Amazon, which sells many of the same items for a price sans the cost of storefronts. Best Buy’s stock has lost almost half its value over the past year as its profitability has evaporated.

Wall Street trading desks return to full strength next week after a two-week holiday lull and investors will pay close attention to Alcoa’s earnings release, parsing its report for clues about how fourth quarter earnings will unfold.

Our Takeaways from the Week

  • An eleventh-hour fiscal cliff deal helped produce a strong start to the year for equities
  • Key fiscal issues remain unresolved, and with earnings season about to begin, markets are likely to be volatile