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Happy New Year! With the uncertainty concerning the fiscal cliff largely removed, the U.S. stock market may be poised for performance. Some reasons for optimism may include:

· A U.S. economy that is growing and looks to gain momentum. Coupled with low expectations, this sets the stage for positive surprises, despite the economic drag of higher payroll taxes and higher tax rates for higher income earners.
· An improving U.S. housing market.
· An improving growth rate in China .
· Likelihood of increasing employment growth in the U.S. due to a stronger housing market and increasing employment in the energy sector.
· A gradual decrease in total energy prices.
· Diminished risks in Europe .
· Investors, who have lacked courage to re-engage in the stock market, are beginning to do so cautiously, and higher stock prices will draw them toward more of a risk taking stance.
· Long term interest rates are beginning to creep up and may prompt investors to favor stocks as they begin to take profits on fixed income instruments.
· Manufacturers are now poised to begin reinvesting. Now that the uncertainty surrounding the fiscal cliff is over, business sentiment should rebound significantly.
· The positive seasonal effect on stocks that usually takes place between November and April was delayed last year due to the U.S. elections, Hurricane Sandy, and the fiscal cliff. It is now ready to return to its typical seasonal cycle, and possibly a January rally.

There are some clear signs that the Chinese economy is rebounding. After slowing from its 30 average growth rate of 9.9% to a level of 7.4% in the third quarter of last year, it is likely that China ’s growth will now accelerate again. Exports are rising, credit is growing, and industrial output and profits are trending upward. More importantly, the risk of a “hard landing” in China has diminished significantly. Political change has ushered in a new Premier, Xi Jinping, who is pro-business, pro-growth, and anti-corruption.
Near term risks in Europe have decreased because of the European Central Bank’s unconventional monetary policies. Greece , Portugal , and Ireland are sticking to the programs imposed by European politicians and the ECB. While the European economy is still not in great shape, the risks of a catastrophic sovereign credit event have diminished sharply. This is best demonstrated by the fact that bond yields in these countries have been steadily progressing downward, and that the Euro has remained relatively strong. One growing European risk is France , whose Socialist government and lack of commitment to labor market reforms are inching it, slowly, toward crisis.
2012 brought record amounts of corporate bond issuance in the United States, because corporations were able to issue low coupon bonds (whose interest payments are deductible), and buy back their own common stock (whose dividends are much higher and which are not tax deductible). This was made possible by low interest rates coupled with high demand for “safe” assets such as Treasuries and high grade corporate bonds.
However, investors may want to consider the possibility that we are soon approaching the end of extremely loose monetary policy in the United States . If growth and employment continue to move in the right direction, expect the Fed to signal an end to its policy of buying $85 billion per month of bonds. Some members of the Fed’s policymaking committee favored doing exactly that on January 3rd. Short term key interest rates should remain at nearly zero at least as long as the unemployment rate is above 6.5% and inflation expectations stay below 2.5%. When the interest rate pendulum begins to swing in the other direction, record amounts of bond purchases are likely to reverse their current course in favor of stocks. Though a clear change in Fed policy is unlikely this year, it is wise to be prepared for it. With interest rates as low as they are, it takes only a small rise in rates to wipe out a year’s worth of bond yields, (or worse). This will come as a shock to many who have bought into the bond market rally in the last year. “Safe” assets, such as government and corporate bonds, are at risk now, and are even quite dangerous. When interest rates begin to climb again due to the forces outlined above, a stronger dollar may ensue, especially if the prospects of U.S. energy self sufficiency increase.
The next short term risk to the stock market will be the debt ceiling negotiations which must be resolved before the end of February.
Hopefully, both political parties will negotiate well in advance of the deadline, and begin the process of implementing spending cuts before the rating agencies (who all have the U.S. on “watch list negative”), contemplate a downgrade of the nation’s credit rating.
For the year 2012, the Dow gained 7.3%, the S&P 500 increased 13.4%, and the Nasdaq rose 15.9%.

Grant Rogers

Partner

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