Waiting for Symptoms

January 22, 2013

Economic numbers in the week ahead will also provide little evidence of this tax effect, as they will still mostly represent a temperature reading on December rather than January.
-David Kelly, chief global strategist, JP Morgan

This has been a particularly severe cold and flu season, a fact to which I can personally attest, having been laid low by two separate viruses in the past three weeks.  Both times, as I recognized the first symptoms, I could only speculate nervously about how ill I would eventually become.

In the first weeks in January much the same could be said of U.S. consumer spending.  The New Year’s Day compromise on taxes, while welcome from a budgetary perspective, contained a jarring 2% increase in payroll taxes and this increase, along with other tax hikes on upper-income households, is likely to take a toll on consumer spending.  However, because so little media attention had been focused on the payroll tax issue, many workers may have been surprised at the lightness of their first paycheck of 2013.  As cold reality sinks in over the next few weeks, spending at shopping malls, gas stations, grocery stores and restaurants are all likely to take a hit.  Some consumer services could also be impacted as families are more reluctant to sign up for new smart-phone services or cable subscriptions.

None of this will be reflected in earnings numbers this week, even as the earnings season gets into full swing with 80 of the S&P500 companies set to report.  While analysts expect only low single digit year-over-year gains on both revenues and earnings, companies reporting so far have generated satisfactory surprises on both scores.  However, this of course reflects fourth quarter activity and the biggest threat from fiscal adjustment has always come from its actual rather than anticipated impacts on household finances.

Economic numbers in the week ahead will also provide little evidence of this tax effect, as they will still mostly represent a temperature reading on December rather than January.  Both Existing Home Sales on Tuesday and New Home Sales on Friday should show further gains in line with other recently strong housing data while home prices, as reflected in the FHFA Index should show continued increases.  Unemployment Claims will probably bounce back from an aberrationally low reading last week, while the Markit PMI index could see a decline, in line with weak readings on the Philadelphia and Empire State manufacturing indices last week.

However, the most telling numbers could be the Redbook and ISCS chain store sales indices due out on Wednesday.  The Martin Luther King Day long weekend was a fair test of consumer spending across the United States without much weather to disrupt mall traffic.  Retailing numbers over this past weekend could provide the first concrete measurement of the consumer impact of higher taxes.

Even with a bigger-than-expected consumer impact, higher taxes should slow, rather than derail, the economic recovery.  The economy will continue to be supported by much improved consumer and corporate balance sheets and a resurgent housing sector.  Uncertainty about debt and deficits in Washington has fallen both because of the New Year’s Day compromise and because of the decision of  House Republicans to vote to increase the debt ceiling for a few further months, thus focusing the negotiations on how to replace the much reviled “sequester” with more thoughtful long-term spending cuts.

Outside the United States, growth appears to be accelerating in Asia but still stalling in Europe.  Central Banks remain in an extremely accommodative stance around the developed world and while this positioning is achieving little in boosting economic growth it has served to prolong a bond-market rally and thereby generate a huge valuation gap between stocks and bonds for the long run

For most investors, it is this valuation gap that matters and continues to point to a long-term opportunity in being overweight equities relative to fixed income.  Someone coming down with a cold may want to change their plans for this weekend but not for their summer vacation.  Similarly, the U.S. economy should weather a slump in consumer spending in the months ahead and long-term investors should still focus on relative valuations rather than short-term volatility in making portfolio decisions.