Equities markets will be influenced by government actions throughout 2013. Witness the opening two-day rally on the back of the U.S. “fiscal cliff” deal despite the fact the deal was a shell of the grand bargain U.S. President Barack Obama envisioned.
Not only will political grandstanding manipulate investor sentiment, but increased government spending – or, as Obama likes to say, “investment” – will be a significant driver of growth. Spending at the local, state and federal levels in the U.S. account for 40% of the country’s gross domestic product (GDP). Unless American consumers start spending, growth in government expenditures backstopped by the largesse of the U.S. Federal Reserve Board will be the most influential contributor to U.S. GDP in 2013.
Before I get into strategy, a little background is in order.
The intent behind government “investment” is to offset the slowdown in private-sector spending. But that is not an easy fix because consumer spending – even at the current contracted levels – constitutes the largest component of the U.S. economy. Potential replacements such as business investment, government spending or a ramp-up in exports take time and can lead to unintended consequences – most notably, inflation and trade wars.
That said, there are some analysts who believe that rampant consumer spending is not necessarily good for the economy. It is certainly the most volatile component of GDP and, according to William R. Emmons, writing in the Regional Economist, a publication of the Federal Reserve Bank of St. Louis: “The relationship between the share of U.S. GDP accounted for by consumer spending and the rate of economic growth generally has been inverse; that is, they are negatively correlated.”
According to Emmons, the correlation between the variables was negative 0.31 over 10-year intervals between 1951 and 2012. Taking the numbers to another level, he compared decades using two variables: average share of consumer spending in GDP, as correlated against the average annual rate of GDP growth. The correlation between these two variables between 1951 and 2012 is a monumental negative 0.82 (correlations run from negative 1.00, which is perfect negative correlation, to 1.00, which is perfect positive correlation). This high negative correlation indicates that “decades of relatively high consumer spending in GDP, such as 2001 through 2010, [also are decades] in which economic growth was weak.”
So, what does this all mean for the financial markets in 2013? If the American consumer is less influential, that may have a longer-term impact on market volatility. In fact, that could be one explanation why the Chicago Board Options Exchange’s volatility index is at historical lows.
Another, seemingly contradictory possibility is that short-term moves in the markets will be amplified by sentiment shifts in reaction to the dysfunction that permeates Washington, D.C. The short-term volatility resulting from the on again/off again fiscal cliff negotiations will pale in comparison to the debt-ceiling debate that will shift into high gear by mid-February. But reversion to the mean will act as a stabilizer, as cooler heads recognize that while political points of view may impact sentiment, only government action, or lack thereof, impacts GDP.
From a strategic perspective, short-term shifts in sentiment can stifle buy-and-hold growth mandates but can be fertile ground for strategies that drive income, downside protection and clearly defined entry and exit points.
For 2013, your clients should focus on writing calls against blue-chip, high dividend-paying stocks. Bonds may offer some defensive positioning within the portfolio, but I encourage short-term maturities and/or real-return bonds with an inflation hedge.
As for sectors, banks and utilities should be overweighted, given their stable, above-average dividends. Look for blue-chip stocks in those sectors that have a liquid options market for the covered-call writing overlay.
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