Archive for November, 2012

Transcript: Tom Gallagher 11-16-12 #920

November 16, 2012

WEALTHTRACK Transcript

#920- 11/9/12

 

CONSUELO MACK:  This week on WEALTHTRACK, setting your investment course for the next four years. What does the Obama win mean for the economy, your taxes, and your portfolio? A WEALTHTRACK exclusive with longtime number one ranked Washington analyst Tom Gallagher is next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK. I’m Consuelo Mack. The waiting is over. The decisions have been made. President Obama has four more years. The Senate remains with a Democratic majority and the House of Representatives is firmly controlled by Republicans. What is being called a” status quo” government has a big job ahead of it: to right a struggling economy and get America back on the growth track. The economy was the number one issue in the exit polls.

No one said it would be easy. Wall Street’s initial reaction to the election was negative. The Dow suffered its biggest decline in a year, off more than 300 points or 2.4% on Wednesday. But the 12 months leading up to the election has been an impressive one with stocks up across the board. Even before the President and Congress begin their new term in January, he and the lame duck legislators have critical work to do. The dreaded and much heralded fiscal cliff looms large. As much as $700 billion in across the board spending cuts and tax raises are set to automatically take affect the first of January unless Congress and the White House take action to avert it. If they don’t, the economy could be thrown into recession.

Another major and related challenge: the federal debt limit or ceiling as it is called. Currently set at $16.4 trillion, it is expected to be hit some time before year end. If it’s not raised or the deficit reduced, the government won’t be able to pay its bills and risks default on its debt. This week, Fitch Ratings agency warned “The economic policy challenge facing the president is to put in place a credible deficit-reduction plan necessary to underpin economic recovery and confidence in the full faith and credit of the U.S.” If it doesn’t, Fitch said it will downgrade its triple-A credit rating of U.S. treasury securities. Another ratings agency, Moody’s, has threatened to do the same and Standard and Poor’s did so in August of last year.

What’s the likelihood of a credible deficit reduction plan happening? What will the election mean for the economy, markets and your portfolio? This week’s guest is noted Washington analyst Tom Gallagher, who has ranked number one in his field by Institutional Investor magazine for ten years in a row. Before becoming a principal at The Scowcroft Group last year, where he advises clients on U.S. monetary, fiscal and political matters, Tom was the head of ISI Group’s policy research team in Washington. I began the interview by asking Tom Gallagher about the prospects for the fiscal cliff being avoided between now and the December 31st deadline.

TOM GALLAGHER:  I think it’s more likely than not that the lame duck session will come up with a compromise that averts the worst of the fiscal cliff; that is some of the elements of the fiscal cliff will likely take place. The payroll tax cut will probably expire.

CONSUELO MACK:  Unemployment benefits extension, that kind of stuff?

TOM GALLAGHER: Exactly. That sort of thing. But most of everything else… it’s not that I think there will be a deal on the underlying issues. There won’t be a grand bargain on the deficit involving title cuts and tax increases, but instead, it will be what Speaker Boehner talked about- a bridge to move these issues into next year to, let the winners of the election decide these big questions. They’ll probably have some kind of process set up to facilitate an agreement on these issues next year. And I think the motive for doing that is that none of the leaders want a recession next year. That’s what will happen if they don’t do that; the fiscal cliff, by some estimates is almost 5% of GDP

CONSUELO MACK:  Yes, right.

TOM GALLAGHER: The economy is only growing at 2%. So that’s a formula for a recession according to just about any forecaster. So I think the desire to avoid blame for the recession, not mandate from voters to compromise, that leads to that outcome. Now having said that, what’s that, a 2 in 3 probability, a 1 in 3 chance that we go over the cliff. The last experience we have with this kind of negotiation was the super committee process, which did end in failure. So that’s a good basis for pessimism about this, but I think the difference is the consequences of failure of the super committee process were automatic spending cuts that were to take place 15 months later.

CONSUELO MACK:  That seems like an eternity to them.

TOM GALLAGHER:  Right. I think this is more like the debt limit negotiations in June and July of 2011 where the consequences of failing to raise the debt limit were immediate and drastic. Had they not raised the debt limit, they would have had to start cutting spending by 40% across the board, which is 8% of GDP. This is more like that set of negotiations where the consequences are serious and immediate. So I think that provides the incentive to get an agreement really to kick the issues over to next year and to set up a process to facilitate more orderly deficit reduction.

CONSUELO MACK:  So let’s talk about the debt ceiling. And according to the Treasury, we’re going to hit that $16.4 trillion debt ceiling limit sometime this year. So what’s the outlook for that?

TOM GALLAGHER: That’s when the debt ceiling is formally hit, but then there are some standard accounting maneuvers that the Treasury will do get them into February or March. Most private estimates are that the effective deadline is some time toward the end of the first quarter next year. So that’s one of the issues that’s all connected in this fiscal cliff set of negotiations that are about to take place. I know the House Republicans, Speaker Boehner this week said he didn’t want the debt limit to be part of these talks, but the White House really wants it, and I think that will be part of the Bush tax cuts, the automatic spending cuts, all these issues will be resolved in one… will be resolved in one set of negotiations.

CONSUELO MACK:  And “resolved” can be many, many outcomes.

TOM GALLAGHER: A resolution can be kicking the can.

CONSUELO MACK:  Just talk to me about the dynamics. We have a status quo government. The guys in office now are going to be in office again in January, so has anything changed? So this gridlock that the markets are afraid of, that business leaders are afraid of, is there any reason for that to change next year?

TOM GALLAGHER: Small reasons to expect it. It is odd that you had the lowest approval rating for Congress ever, so what did voters do but return each party to the majority in the House and the Senate. And so there isn’t much of a message to change. I’d say the message from voters is kind of an awkward one. The message is to get things done without compromising on the priorities of your party’s base. That’s a very difficult thing to do. That’s why my expectation on the fiscal cliff isn’t really based on the perception that the winners have a mandate to compromise. It’s more that they have a desire to avoid blame and that that will lead to the kind of compromise that moves issues off into next year, but it doesn’t really create the conditions for a major deal, you know, a grand bargain next year on entitlement reform and tax increases. I think that’s probably… that’s an unlikely scenario.

 

CONSUELO MACK:   So therefore, from our point of view as citizens, you know, as far as the economy is concerned and as far as, you know, our desire for more jobs, for our desire not to have, you know, taxes raised in a very dramatic fashion, so what’s the outlook for us then next year after the inauguration?

 

TOM GALLAGHER:  I think in some ways the fiscal cliff is a great metaphor- you have so many things happening. The economy does risk going off a cliff at the end of the year.

 

CONSUELO MACK:  Sequestration. You name it; it’s a nightmare for the economy.

 

TOM GALLAGHER: But in some ways it sets up a false image of what the stakes are in this. It’s not just this dichotomy where we either… it’s not a binary situation where either we go over the cliff or we avoid it. We’re entering a period where fiscal policy, you know, spending and tax policy, is likely to be a headwind for several years because it is a priority. Voters have sent that message that they want the deficit to come down. The problem with the fiscal cliff is that it’s too much too soon. It’s 5% of GDP when the economy is not growing very fast. So the idea is to try to smooth it out. There will still be some headwind from fiscal policy next year. Instead of 5%, it will be maybe 1%, 1.5% of GDP. So perversely, voters may want growth, but the policies that are likely to come out of the fiscal policy debate are going to be a headwind on the economy.

CONSUELO MACK:  Right.

TOM GALLAGHER: I think that’s… it gets back to it’s an inherent part of economies that have been through financial crisis- that initially, you get government support to prevent a severe recession from becoming a depression, but then at some point voters, more than markets, voters demand the deficits be shrunk and that is what creates the headwind for the economy.

CONSUELO MACK:  So the markets, in fact, you know, on occasion are demanding that the deficits be shrunk, too, because when they think, for instance, that gridlock will continue, the markets are not necessarily positive, right, or what do you think? What are the dynamics- the political dynamics- that you think we should be watching that will affect the markets?

TOM GALLAGHER: From the market point of view, I think the market is much, much more nervous about too much deficit reduction next year than they are about too little deficit reduction over the next several years. You look at how the market would reflect concerns about long-term deficits. You can see high long-term interest rates, you can see credit default swaps on U.S. treasuries being high, other ways that you might detect that, and there’s just no evidence that markets are nervous about that.

However, they are nervous about too much deficit reduction next year. I think that’s a good candidate to explain why markets fell so much the day after the election. It’s a status quo election. You get that out of the way, the next thing to focus on is the fiscal cliff. And so they get nervous about a recession next year. It doesn’t mean that politicians should ignore long-term deficits. I’m not arguing that at all. I think that ideally the politicians would have back loaded deficit reduction. That allows the economy to get through this deleveraging process further before the deficit reduction kicks in. The problem is that sounds like it lacks credibility. So politicians don’t like to do that. But if you’re in favor of front-loaded deficit reduction, you should let the economy go over the fiscal cliff, because that’s pretty material deficit reduction up front. I think markets are more worried about too much deficit reduction next year.

CONSUELO MACK:  Let’s talk about what we do know that’s certain. Obamacare, the Affordable Care Act, it is law. It is going to happen, right, so that’s something that’s going to have an impact certainly on the health care sector. It’s going to have an immediate impact on upper-income Americans because there’s going to be this 3.8% tax on investments. So tell me about that new reality. What we should be paying attention to as far as the impact of the Obamacare, Affordable Care Act is?

TOM GALLAGHER: We know the policy, we know the law. The law is in place. There’s no uncertainty about that. With this election outcome, not just Obama being reelected, but the Senate remaining Democratic, in fact, more Democratic than the last Congress, it just tells you that health care reform is going to be implemented. So it’s really the uncertainty about the rollback that is now lifted. And I think that invites a broader perspective on the significance of the second term for Obama. I think it’s really too that his second term will be about protecting the accomplishments of the first term. If you go back to the first two years, Obama had a very rare situation in American politics where the White House and nearly 60% of the House and 60% of the Senate were controlled by the same party.

CONSUELO MACK:  A Democratic lock.

TOM GALLAGHER: They did. And so you got not just the stimulus bill but you had health care reform, you had financial services reregulation.

CONSUELO MACK:  Dodd-Frank.

TOM GALLAGHER: Exactly. So I think this is more about preserving those legislative accomplishments rather than seeking new ones, like climate change. That’s an issue that a lot of liberals would like the next Obama term to address. I think the prospect for that is remote. In other words, I don’t think it’s about expanding the agenda. I think it’s about consolidating the agenda that Obama had in the first term, and health care is a good example of that. In the health care stocks, you know, they’ve have had a pretty decent performance here; which is not a big surprise because you’re expanding coverage, so it does suggest more revenues flowing into the sector.

CONSUELO MACK:   So what we’ve seen in the first week after the election is that the financial stocks got hit really hard. So Dodd-Frank is here to stay. Regulations aren’t going to be rolled back, in other words, at least for the next two years until who knows what will happen in the mid-term election next time around. And we certainly have… so we’ve got the Affordable Care Act. So the winners and losers that the market has clearly delineated already- bank stocks have gone down, some hospital stocks have gone up, I can’t remember what else in the medical sphere.

TOM GALLAGHER:  Insurance stocks have done well.

CONSUELO MACK:   Right. So are there any other less clear winners and losers or is there something you would say you should definitely, you know go, with the trend? This is a long-term trend?

TOM GALLAGHER:  Not really. I think that these sector implications were well-telegraphed, you know, well-analyzed in advance, and in a normal election year, there might have been some momentum for some of those plays, you know, maybe being nervous about coal under reelected Obama. That sort of thing. But I think the fiscal cliff just truncates all of that. The markets are always ready for next big thing. Now the next big thing is right upon us. So I think that the way Washington will affect the markets for next couple months will be through the fiscal cliff implications. Defense stocks are one clear bellwether for the outlook for the fiscal cliff. I think dividend-paying stocks.

CONSUELO MACK:  Right, defense has already been cut. It’s going to be cut more.

TOM GALLAGHER: Right, but if the outlook is poor for a compromise, then defense stocks get hit worse. I think defense stocks are probably priced for resolution. So there’s that risk.

CONSUELO MACK:  All right.

TOM GALLAGHER:  And I think dividend-paying stocks would be another one because the gridlock…

CONSUELO MACK:   Because tax rates on dividends will go up.

TOM GALLAGHER:  This year they’re 15%. Next year they go up to 44.6%, even under capital gains. Capital gains only goes to about 23.8%, maybe 25%, depends on what elements you’re including in that. So the dividend stocks can be another one if you think… if the market thinks Washington will have a protracted gridlock on this, that you go through the end of the year and well into next year, then those are the sectors that are going to sell off. So I think that’s the focus on Washington right now. I think it’s fiscal cliff plays, not Obama reelection plays, that are the thing that will be driving the markets.

CONSUELO MACK:  So Tom, what do I do? Do I get more defensive now because of the uncertainty and we don’t know what’s going to happen?

TOM GALLAGHER:  It depends on your time frame. My timeframe is longer than most of this stuff.

CONSUELO MACK:   So ours is on WEALTHTRACK, too, but sure we care what’s going to happen tomorrow.

TOM GALLAGHER: Try not to read the papers for the next couple months. I would not try to time the fiscal cliff. I mean, one thought I’ve had is if you have some cash and you see dividend or say equity income funds sell off a lot because of fears of a protracted gridlock and high tax rates, then I would be inclined to be a buyer of those just because I don’t think that you’ll get protracted stalemate. If we don’t get it at the end of this year, I think it will be one quickly in the beginning of next year. And I think the only one you get really high dividend taxes is under this protracted gridlock scenario, an overlooked development when the Senate Democrats came up with their tax bill that was their basis for the election year debate. Republicans had theirs. Democrats had theirs. Democrats lined up with Obama on every issue, except the top tax rate on dividends. Obama was going to let it go back to 44-6. Democrats said, no, keep it at 20%. That tells you that just about any compromise that comes out of Congress is going to keep dividend taxes… they’ll go up a little, but they’ll probably stay on par with capital gains.

But for the most part, I think other than something like that, I would just try to look past all this. and say that fiscal policy is not likely to cause a recession. It is a reason not to expect robust

Growth- the U.S. is growing at about 2%. There are signs that with housing turning around, that maybe it could rise a little bit above that. But I think fiscal policy is not a reason to expect it to get much stronger than that. So I would try to look past that and say, we’re still in a deleveraging environment, but the U.S. has had a better policy response than the rest of the world. So I actually feel fairly good about the prospects for U.S. equities relative to other major equity markets.

CONSUELO MACK:  Well the other thing that’s going on, too, is you’re a South Dakota native, but your brother or sister state, North Dakota, is having this incredible boom in natural gas production. And that’s another area that you think could be a real big positive for the U.S. and for the economy and business, right?

TOM GALLAGHER: Right. And when you look at the problems that the major economic centers have, you know, the U.S. has fiscal policy, Europe has everything, you know, its sovereign debt crisis and its banking problems, China is trying to cope with the massive property bubble that came in the response to the financial crisis here. I think the U.S. problems are relatively better. I like the line that Mohamed El Erian at PIMCO used about U.S. treasuries a few years ago: “they were the list dirty shirt in the laundry.” I feel that’s the way with U.S. equities. And so the energy story is part of the longer term… I think we’ve had a better policy response than other countries have. We have a better energy situation. It’s for largely having economic forces, market forces, not so much government policy.

CONSUELO MACK:  And you think it’s still positive even though the President until recently was not, you know, focusing on alternatives and really, you know, didn’t approve the Keystone pipeline. But you think it’s not going the change, that’s still a very positive outlook under this president?

TOM GALLAGHER: Most of these trends are more bottom up. If you’re waiting for policy, I think it’s a mistake to overweight policy too much on these kind of things, so I think that’s another advantage that the U.S. has. I think demographics are another advantage. So I think the influx of immigrants. I mean, you look at Japan, China, you know, the demographics suggest that we are going to age less fast than most of the rest of the developed world. All of those to me say that over a somewhat longer time period, the U.S. still is good. I think the deleveraging process still limits how fast growth can be, but I like our situation better. So you do have this issue, can politicians avoid having a self-inflicted wound, and that’s what we’re all looking for. We’re looking for evidence of that in terms of how the two sides are going to behave in this post-election period, and so provided that we get through the fiscal cliff, then I do feel better about prospects for U.S. equities.

CONSUELO MACK:  Another certainty is Ben Bernanke is here at least until the end of his, what is it, the end of 2013. And, you know, we don’t know whether he’s going to go or stay, but we do know that the Obama administration is more dovish. They like the easing. They like what the Fed’s doing, so some the Fed policy will stay the same for the foreseeable future, correct?

TOM GALLAGHER: Yes. I mean, there was this risk that if Romney won, he said he would replace Bernanke. I think frankly a lot of Fed watchers have thought for some time that Bernanke is unlikely to seek a third term. If he were open to it, there’s still the issue of whether he could get over a Senate filibuster. So I think there’s still an expectation that Obama will appoint someone to replace him at the end of January 2014 when his term expires, but that it will be someone who will reflect continuity in policy. So I think that’s really not an issue that you can expect the elements of Fed policy, which got very aggressive in their September meeting, in terms of the rate guidance and the open-ended QE, that that’s going to play out as expected without kind of interruptions from the political arena.

CONSUELO MACK:  So keep buying treasury, mortgage-backed securities and interest rates, short-term interest rates will… well, long-term rates will probably stay pretty low.

TOM GALLAGHER: I’m not a believer that– I think the majority view is that the Fed is significantly holding up asset prices above their fair value with what they’re doing. I’m more of a believer that you have those temporary effects, but the stock market is really following the economy more than it is, you know, Fed policy. I think Fed policy is a good insurance against a big downturn, but I think its impact is relatively limited in a deleveraging environment. So I wouldn’t want to base my investment philosophies on the effectiveness of quantitative easing. A lot of people thought that therefore you should be long equities when the Fed launched their open-ended QE, but initially after that meeting, the economic data were still weak, so the markets were weak until the data turned around. I would follow the data, not the Fed in terms of investments.

CONSUELO MACK:  One Investment for a long-term diversified portfolio, and I will preface this by saying that you told me a long time ago, don’t buy or sell stocks depending on who the occupant is in the White House. So what’s your One Investment?

TOM GALLAGHER: My one stock for the future really reflects what we were just talking about. I think in the past when I’ve been on your show, I talked a lot about income-oriented strategies: MLPs, tax-exempt funds.

CONSUELO MACK:  But now?

TOM GALLAGHER: But I still believe that, but I think those are pretty fully priced. So I just think from a medium to long-term perspective, the S&P 100 is a good place to be; OEF is the ticker for the iShares ETF. I just think that reflects this notion that we had a better policy response to the financial crisis. We’ve got advantages in terms of demographics and energy, but you want big cap companies with solid balance sheets, which is why I tilt a little more toward the S&P 100.

CONSUELO MACK:  All right, S&P 100. Tom Gallagher, we’ll see what happens. Thank you so much for joining us on WEALTHTRACK.

TOM GALLAGHER: Thanks for having me.

CONSUELO MACK:  At the conclusion of every WEALTHTRACK, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: stay with your chosen stock positions. As Tom Gallagher just told us, the occupant of the White House should not determine whether you buy or sell stocks. What should help you make that decision are all of the tried and true considerations such as your personal financial objectives, tolerance for risk, investment time horizon, and the level of stock prices.

If history is any guide, next year should be positive for stocks. According to Strategas Research Partners, the last three times a Democrat won the White House for a second term, the S&P 500 gained an average annual return of 21.5% in the first year. Let’s hope history repeats itself!

Next week we have a big treat for you. I will sit down with investment legend John Bogle. The founder of mutual fund giant Vanguard and creator of index funds will share his investment lessons of a lifetime- a not to be missed interview! And if you would like to see this program again, please visit our website wealthtrack.com. Premium subscribers can see WEALTHTRACK 48 hours in advance, and additional interviews with our guests are available in our WEALTHTRACK Extra feature. And that concludes this edition of WEALTHTRACK. Thank you for watching and make the week ahead a profitable and a productive one.

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Jeffrey Applegate, Chief Investment Officer of Morgan Stanley’s Wealth Management, is also an avid history buff. The book he recommends to WEALTHTRACK takes us back to the early Middle Ages in England, a time of tumult and upheaval which Applegate says laid the found for the modern state and still has relevance today.

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