Beyond the fiscal cliff, challenges loom

The pattern of equity sector behavior since mid-summer reflects the changes in relative optimism that global policy questions would be resolved satisfactorily. In the U.S., between the time in late July that ECB President Mario Draghi pledged to defend the euro and the time the Federal Reserve announced QE3, the S&P 500 rose 8 percent. Investor anxiety regarding sovereign funding uncertainty in Europe calmed immediately following the ECB’s pledge, as if to say finally, the Eurozone has a lender of last resort. Sovereign bond yields quickly began to recede. The Fed began sending clear signals that another round of quantitative easing was coming, keeping the momentum going right up until they made the announcement on September 13. During that time, the best performing sectors in the S&P 500, using the Select Sector SPDRs as proxies, were the economically sensitive sectors of energy and financials, both up 14 percent, followed by technology up 13 percent and consumer durables, up 12 percent. The worst performers were the defensive utilities, down 1 percent; consumer staples, up 3 percent; and healthcare sectors, up 6 percent.

In the wake of the Fed’s announcement, investor optimism began to fade and, unfortunately, the day after the announcement just happened to be the high for the S&P 500, so far. Since that day, the index has fallen 5.6 percent, although it looked considerably worse before Tuesday’s 2 percent rally. Attention turned to the upcoming election, and the fiscal cliff to follow. Third quarter earnings reports were light on the top line and guidance was cloudy. In Europe, the ECB remained on the sideline. And China was getting a new government, while its economy slowed. From the market peak on September 14 and November 16, the S&P 500 fell 7 percent. All sectors were down, but the best performers, those with the smallest losses, were healthcare, down 2 percent; consumer staples, down 4 percent; and consumer discretionary, down 5 percent. The worst performers were technology, down 12 percent; energy, down 10 percent; and materials, down 9 percent. And Tuesday’s 2 percent rally, presumably triggered in response to President Obama’s assurances that the fiscal cliff will be averted, showed another change in direction, as materials, technology, and energy led the way, while utilities, healthcare, and consumer staples lagged.

There is no overstating the sway in which markets are being held by policy uncertainty. But, while averting the fiscal cliff will prevent a sharp slowdown after the first of the year, it won’t necessarily mean that economic conditions will be any better than they are now. Consumer sentiment should get a boost if the cliff is avoided, but at the same time the payroll tax cut is likely to expire. And barring the unlikelihood that Congress moves quickly on a broader tax overhaul, the business community won’t necessarily have any greater clarity on its tax regime for some time, making capital spending decisions as uncertain as they are now. What makes this important is that third quarter earnings season revealed some signs of weakness, most notably on the top line. And it wasn’t simply confined to one or two sectors. According to Bloomberg, seven sectors missed analyst estimates for revenue. Only consumer staples and financials exceeded expectations. Technology and materials missed on both. Regardless of the direction of investor optimism, most types of businesses were experiencing slowing activity.In a research report dated November 20, Deutsche Bank points out that global earnings estimates for 2013 have accelerated to the downside, declining 1.5 percent in the past month. On the downside, materials estimates have fallen 3 percent, technology and industrials 2.4 percent, and energy 2.3 percent. Conversely, consumer staples, healthcare, and telecom have fallen only 0.4 percent. In the past six months, global 2013 earnings estimates have declined 7.4 percent. In the U.S., next year’s earnings estimates have fallen 5.9 percent in the past six months after falling 1.6 percent last month. Accounting for the steepest earnings downgrades last month were materials and technology once again, while telecomm improved and financials were flat. In total, eight sectors saw their earnings estimates get lowered.

The point is simply that averting the fiscal cliff alone won’t solve all of our problems. It will prevent them from getting worse in the short run, and likely trigger another wave of optimism if it happens. But when the dust settles, we will still be confronting global economic challenges, even without the fiscal cliff.

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