the sequester: stock market implications

what it is

It’s a mandatory package of federal government spending cuts totaling $1.2 trillion (less assumed savings on associated debt interest) in equal installments over nine years beginning in 2013.

50% of the $110 million in spending cuts are to be taken from the military (which, by the way, accounts for a staggering 25% of total government outlays), 50% from everything else.  Social Security, veterans benefits, Medicaid and similar “entitlement” programs are exempt from cuts.  Medicare is not, but reductions, if any, are limited to 2% per year.

where it came from

Negotiations over raising the debt ceiling in 2011 spawned the sequester.  Democrats and Republicans were unable to agree on $1.2 trillion of future budget cuts back then.  So the two sides set up a “supercommitee” with a deadline to iron out differences.  At the same time, Congress passed the sequester, a kind of legislative doomsday device, that would go into effect if no agreement was reached. The idea was that the sequester was so unpalatable to both sides that they would be forced to reach some better outcome.  Of course, they didn’t.

The sequester was supposed to go into effect on January 1st.

Last year’s fiscal cliff talks postponed the start for two months.

This morning President Obama has proposed an as yet unspecified plan for pushing the sequester back further.

stock market effects

In theory–and, in my view, in actual fact–the failure of all sides in Washington to have even the bare bones of a plan to reduce a dangerously large federal deficit means that investors are placing a relatively low PE multiple on the earnings of publicly traded corporations.

The beginning of any fiscal restraint would presumably result in a lower level of near-term results.    And companies dependent on government largess would certainly be hurt.  But the earnings negative would be offset–and probably more than offset–by Wall Street awarding a higher multiple to those profits.  (The market’s reaction would be caused by a combination of relief that Washington was becoming more responsible and that a source of uncertainty had been eliminated.)

Reaction to the upcoming sequester has varied by government body:

–Politico recently reported that the military has been accelerating its spending since the start of the current government fiscal year.  The implication is that the generals and admirals are gaming the system–figuring they’d create a situation where mandated cutbacks would use up such a large amount of their remaining budget that Congress wouldn’t dare to let them happen.

–On the other hand, I’ve been noticing that 4Q12 earnings for government-dependent firms (BMC Software comes to mind) are already being depressed as their federal customers are already cutting orders in anticipation of the sequester being triggered.

what to do

The sequester represents only about 15% of the total fiscal cliff.  So it’s not the dire depressant to domestic economic activity that the cliff as a whole would have been.  And it appears to be turn out that, in true Washington style, the sequester is being pushed farther down the road.  Even if the sequester is triggered, a domestic recession isn’t on the cards.

A significant reduction in government spending this year (and beyond) is inevitable, however.  What I found telling about 4Q12 results is that Wall Street has reacted very negatively to the company announcements that this was already affecting results.

I think we all have to clearly understand, for all the stocks we hold, how much of their profit comes from government sources.  I’d be wary of any that have significant (say, 20% or more) government earnings and that are not already trading at a discount multiple.

the January 2013 Employment Situation Report

the report

At 8:30am est last Friday the Bureau of Labor Statistics of the Labor Department released its Employment Situation report for January 2013.  According to the ES, the US economy added 157,000 new jobs during the month.  This consisted of 166,000 new private sector positions, minus 9,000 layoffs among government workers.

The number was in line with expectations.  It’s also roughly the same as the figures tallied in recent months.  It’s about the number of new jobs needed, on average, to absorb new entrants into the workforce, as well–so it did nothing to lower the unemployment rate.

revisions are the real story

They’re positive.  And they’re huge!

November

The November 2012 ES initially reported job additions as +146,000 positions.  That figure was revised up in the December report to +161,000.  The (final) January revision is to +247,000, composed of +256,000 private sector jobs and a loss of 9,000 in the government sector.  That’s a +101,000 gain in jobs vs. the original job estimate, most of that coming in the January report.

December

The December 2012 ES reported +155,000 job gains.  The January report revises that up to +196,000, comprised of +202,000 jobs in the private sector and 6,000 layoffs among government workers. That’s a gain of +42,000 positions.  

my take

Despite all the angst about the fiscal cliff and its potential negative effect on the economy, the ES shows employment gains continued apace during the final quarter of 2012.  Therefore, none of the slowdown some companies experienced was caused because the job market fell apart.

Yes, some slowing happened.  But it has to have other causes.  Put a different way, slowness probably isn’t going to disappear even if job growth accelerates.

Possible causes?  …looming cutbacks in government spending, consumers’ saving more in anticipation of higher taxes.

the role of the Consumer Price Index (CPI) in Social Security …and in a lot of other things

The CPI…

The CPI, produced by the Bureau of Labor Statistics of the Labor Department, is the government’s attempt to measure the change in the prices of goods and services paid by urban consumers, who make up 87% of the country’s population.

The CPI is the result of extensive data collection efforts, both from consumers to find out what items they buy and from retail outlets to determine how the prices of those items change.

The CPI is everywhere.  It’s used to determine the annual cost of living adjustment for Social Security, as well as for COLAs in government and private retirement plans.  It’s often used for the same purpose in labor contracts.  It’s also used by the IRS to adjust Federal income tax brackets for inflation and to set threshold levels for public assistance programs like food stamps.

The CPI is now in the spotlight as a bone of contention in the debate over reduction in entitlement benefits, as a way to close the large Federal budget deficit.

…is a Laspeyres index

This means it investigates what consumers buy during a base period (for the current CPI, it’s 2007-08) in order to arrive at a fixed basket of goods and services that it regards as typical. It calculates the total cost of the basket.

From that point on, it periodically checks with retailers to get current prices, using them to update the cost of the original basket.  The ratio of the total cost in today’s dollars of the basket, divided by the cost of the same basket back in 2007-08 is the current CPI value.

What’s wrong with that?

It depends on your perspective, I guess.   But as economists knew, even when the CPI was introduced as the COLA mechanism for Social Security in 1975, the Laspeyres method systematically overstates changes in the cost of living.

That’s because it ignores the fact that consumers constantly change their market basket of goods and services as the prices of items go up and down.  They react to higher prices by switching to less expensive substitutes that they may be perfectly happy with.  The result of this substitution is that the rise in the price of a given item in the original basket doesn’t necessarily mean a rise in consumer expenditure.  But the CPI acts as if it always does.

examples

Suppose, for example, the BLS determines a family buys 10 pounds of chicken meat and 10 pounds of turkey.  Family members don’t really care which they eat.  If the price of chicken doubles and that of turkey remains unchanged, the family will stop buying chicken and buy 20 pounds of turkey instead.  So although the price of chicken has gone up the family’s food expense hasn’t.  Nevertheless, the CPI registers an increase.  The same for hamburger and turkey burger.

Or suppose the price of gasoline goes up and you join a carpool.  Or you buy a Hyundai instead of a Toyota.

Or you get fed up with cable and use Netflix and Hulu instead.

The CPI doesn’t pick up any of this.

a too-high COLA adds up

The Social Security Administration figures that using the current CPI upwardly biases cost of living adjustments by about 0.3 percentage points per year. Put another way, the 1.7% increase in benefits penciled in for 2013 should really only be 1.4%.  The rest is gravy for retirees.

Removing that upward bias from yearly Social Security COLAs would reduce total payments by an estimated $200 billion in the first decade.

the thin edge of the wedge?

Personally, I don’t consider this change in the way the cost of living adjustment for Social Security is calculated to be a big deal.  That’s because the use of the CPI has been the dirty little secret of legislators, Social Security recipients and labor negotiators for decades–although don’t try to tell that to a recipient.

Arguably, if a change to a more accurate cost of living measure for the Social Security COLA helps set the US back on a sounder fiscal footing, the subsequent rise of short-term interest rates to normal levels will benefit anyone with savings, especially seniors.

But once Social Security adopts another measure for COLAs, this sets the stage for replacement of the CPI elsewhere.  So the fight over Social Security may be more acrimonious than this program alone would warrant.

dissecting the fiscal cliff

I’m back home, in the land of electric power and heat, but no internet or TV.  I’m using my phone as a mobile hot spot, but I can’t seem to get a look at the layout of this page.  Sory if the numbers below are hard to see.

Hurricane Sandy humor:

–a runaway Coca-Cola truck knocked down a utility pole on our street on Saturday, splaying live wires all over the place.  Luckily it wasn’t the more important one the big tree knocked down during the storm.  PSEG cleaned up in a matter of hours.

–I called/chatted with Comcast to find out about restoration of internet/TV service.  The two people I spoke with were very nice but said they had no idea.  Both confirmed that Comcast continues to charge customers for service even though there is none.  You have to call them and ask for a refund!!!  Why am I not surprised?

Today’s post:

“Economic Effects of Policies Contributing to Fiscal Tightening in 2013”

On November 8th, the Congressional Budget Office issued an update on its fiscal cliff analysis, titled “Economic Effects…”.  The report makes several points:

1.  “driving over” the fiscal cliff isn’t a good idea

The problem is the domestic economy is still very weak.

The CBO predicts that continuing Washington stalemate would cause a short but sharp recession in the US during the first half of next year.  Growth would resume from the crunch, but from a lower level, in the second half.  But this would be by a small enough amount that real GDP would still end up in the negative column for the full year.

More important, unemployment would spike upward to an estimated 9.1% a year from now, postponing the return to economic normality for the country (meaning reduction in the unemployment rate to 5.5%) until early in the next decade.

2.  the status quo isn’t so hot, either

Continuing the current situation where Washington continually spends more than it takes in will ultimately force interest rates in the US–both for the government and for private borrowers–higher than they would otherwise be.  Maybe a lot higher.  At some point we’ll have a repeat of 1987, when domestic lenders refused to buy any more government debt and the long bond spiked to 10%.  The CBO implies that this is only a remote possibility at present.  But as the debt grows the problem becomes progressively harder to solve.

3.  the long-term solution

(I haven’t seen anyone write about this.)  For the CBO, two moves are important.

–broaden the tax base, don’t raise rates.

–reduce entitlement spending.

4.  in the short term, however…

(short = the next two years)

…postpone part or all of the fiscal cliff elements.  Address the deficit issues in an aggressive way in 2015, when the economy will presumably be healthier and unemployment lower. That way, we have a much better chance to get chronic unemployment under control.  If so, we’re likely to reach full employment in 2018–a time when we can attack the government fiscal mess in a more serious way.

5.  components of the cliff

The numbers are the boosts to real GDP that each would likely provide:

extend expiring income tax provisions for everyone          +1.4%

do so, but omit high-income earners                        +1.3%

extend payroll tax reduction, emergency unemployment benefits             +.7%

eliminate defense spending cuts               +.4%

eliminate non-defense spending cuts          +.4%.

my take

–The CBO analysis doesn’t take anticipatory effects into account.  In other words, it doesn’t address the issue of whether the slowdown in growth we’re now seeing in the US is adjustment in advance to the worst-case (“driving over”) scenario.  If so, the positive economic effects of breaking the logjam in Washington could be greater than the CBO estimates.

We can certainly see effects in the number of M&A deals being done before yearend—DIS/Lucasfilms is a good example.  But there are lots of others.

–Whether income tax rates rise for high-income filers has very little economic significance.  +/- 0.1% in GDP growth amounts to a rounding error.

–From a stock market perspective, the Obama-proposed increase in the tax on dividends is the key possible change that I see.

–Generally, I’m skeptical about arguments that depend on “fairness,” because I think the concept is so perspectival.  In a lot of cases, “fair” equates to just “I get more and you get less.”  Having said that, I think one of the most un-fair things in the tax code is Romney-esque carried interest, whereby high net-worth financiers turn ordinary income into capital gains.  I wonder if that loophole will be closed.