Political Wildcards Add Uncertainty to Market Prediction

The savvy macro-economic investor should realize that current political wildcards make any strategy highly problematic.

In the past couple of months, vastly divergent predictions about the probability of a recession in the coming year have received widespread coverage in the business news.

On September 30, the highly respected Economic Cycles Research Institute (ECRI) notified its clients that “the U.S. economy is indeed tipping into a new recession. And there's nothing that policy makers can do to head it off.”

ECRI's recession call isn't based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down — before the Arab Spring and Japanese earthquake. Downturns in the Weekly Leading Index and other shorter-leading indexes have followed. In fact, the most reliable forward-looking indicators are now collectively behaving as they have on the cusp of full-blown recessions, not "soft landings." Here's what ECRI's recession call really says: if you think this is a bad economy, you haven’t seen anything yet. The ECRI has a far better track record in predicting turns in the economy than most Blue Chip economists. Its judgment, if correct, has profound implications for both Main Street and Wall Street.

By contrast, Warren Buffett recently told Bloomberg Television’s Betty Liu on “In the Loop”, “I would bet very heavily against that (a recession).” “How fast the recovery will come, I don’t know. I see nothing that indicates any kind of a double dip.” In a separate interview with Public Television’s Charlie Rose, Buffett said, “It's very, very unlikely we'll go back into a recession. ...We're coming out of a recession." He based his prediction on data he has reviewed from the 70 companies in Berkshire Hathaways’ portfolio.

So we have two contradictory predictions from respected sources, both stated with a high level of conviction. In the face of political wildcards, which impose a high level of uncertainty on the future performance of markets and the economy, it’s difficult to choose between them.

The Euro/European debt crisis has had a profound influence on market and economic behavior over the past year. Looking forward, what steps will be taken to address that crisis and how will markets react? If you read commentaries about this crisis in leading economic media such as the Wall Street Journal, Financial Times and the Economist, you will conclude that uncertainty abounds. The Wall Street Journal began a recent front page article on the crisis as follows:

The world's hopes that Europe will resolve its debt crisis in a bold stroke are running into a stubborn reality: Solutions that work on paper are often unattainable in a euro zone of 17 sovereign countries. ...Even if leaders do enough to avoid a financial meltdown, resolving the deeper causes of the debt crisis—which include economic disparities that Europe hasn't figured out how to redress within the euro framework—is likely to take years, analysts and officials warn.

On October 27th, the European community announced a plan to restructure the debt of Greece, to increase the capital of key European Banks and to set up a fund which would backstop the debt of other fragile member nations such as Spain and Italy. The markets rejoiced and the S&P 500 climbed 3% on the day of the announcement. After the market closed, Christina Romer, President Obama’s original Chair of the Council of Economic Advisors, summed up the view of many sophisticated observers: “What we have is a plan to have a plan and the devil is in the details. We don’t yet have the details.”

Uncertainty surrounding resolution of the Eurozone problems is matched by uncertainty about the Obama jobs plan. The largest component of Obama job’s plan is a proposed one year reduction in the payroll taxes of $240 billion – $175 billion for a 50% reduction in employee payroll tax payments, and $65 billion for employers’ reductions. If Congress does not adopt Obama’s proposal, extending and expanding the payroll tax holiday, employees will see their payroll taxes go up by about 40%. Most of that money translates into direct consumption, according to most economists. The difference between enacting the Obama payroll tax plan and doing nothing, allowing the current reduction to expire, is $240 billion in stimulus. Moody’s indicates that action or inaction will translate into an impact on Gross Domestic Product of between 1% and 1.5%, either positively or negatively. The Economist summed up the situation:

America is currently on course for the most stringent fiscal tightening of any big economy in 2012, as temporary tax cuts and unemployment insurance expire at the end of this year. ...America’s economy risks being pushed into recession by its own fiscal policy and by the fact that both political parties are more interested in positioning themselves for the 2012 election than in reaching compromises needed to steer away from that hazardous course.

While many political commentators predict that the parties will by year’s end agree on Obama payroll tax proposal, both election year maneuvering and the recalcitrance of Republican Congressional leadership cast substantial doubt on whether that program will be enacted.

Resolution of the national debt issue is yet another source of uncertainty. The congressional committee of twelve charged with coming up with a plan to curb the national debt in the coming decade is due to report by the end of November. Most commentators doubt that this committee will be able to agree on a plan. A key unknown is the degree to which the market has already factored in this possibility. Merrill-Lynch recently predicted: “The United States will likely suffer the loss of its triple-A credit rating from another major rating agency by the end of this year due to concerns over the deficit. The trigger would be a likely failure by Congress to agree on a credible long-term plan to cut the U.S. national debt.”

The political systems both in Europe and the United States are facing severe challenges in the aftermath of the financial crisis. The European system is largely undeveloped and full of roadblocks. The political system in the United States increasingly appears broken. Blaming and finger pointing predominate to an unusual degree over compromise.

In the face of this uncertainty, prudent macro-economic investors should take a cautious and watchful approach, keeping up to date on the news coverage of these political challenges. Two of the most successful hedge fund managers, George Soros of the Quantum Fund and Ray Dalio of Bridgewater (currently the largest hedge fund), suggest that investors stay open minded to different outcomes as events unfold and adjust their investments accordingly.

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