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New York, November 20, 2012, Advisor Update®
Following the election, equity markets entered a steep decline and by Friday the 16th had retraced more than half of the gains made over the summer. While the election was the initial catalyst to start the selloff, we believe that poor Q3 earnings and a poor global growth outlook weighed on markets as much as post-election rhetoric. Overly optimistic corporate earnings outlooks are something that we have warned about repeatedly, and our portfolios have been positioned appropriately for this recent selloff.
With the election out of the way, all eyes are now focused on the impending “fiscal cliff,” something that we have discussed at length in previous Advisor Updates® and Webinars (email us to request recordings). After being soundly defeated in the Presidential election and losing seats in both the House and Senate, the GOP has taken a much softer stance on tax hikes, and appear willing to accept some measures that they had previously rejected. Conversely, the President has taken a much tougher stance, and appears prepared to push through as many tax hikes as Republicans will allow.
While much of the rhetoric we’ve heard from Democrats has tried to frame the debate in terms of the middle class against the wealthy, the impending tax increases on upper-income individuals represent only 7% of the entire fiscal cliff. A much larger portion of the fiscal cliff falls on middle income and poor families through the expiration of the payroll tax cut, the alternative minimum tax, extended unemployment benefits, and through cuts to various programs as a part of the Budget Control Act. We hope Democrats in Washington will not allow an enormous tax hike on the middle class to go through while pretending they are targeting the wealthy.
Furthermore, framing the debate in such a way misses the point entirely that the US has one of the most progressive tax systems in the world, and one that has become much more progressive over the past several decades. Top earners’ total tax rates have changed little over the past thirty years, and have even risen for the top 1%, while the bottom 80% of earners have seen their tax rates fall significantly. After adjusting for income distribution, the US already has the second most progressive tax system of all OECD countries.
After weathering the recent selloff very well, we used the opportunity to add to our equity allocation by taking a position in Japanese equities across all of our portfolios. In order to raise cash for the purchase, we liquidated our position in agency mortgage-backed securities (MBS). MBS have been a favorite position of ours for most of the year, largely because we expected the Federal Reserve to begin a new quantitative easing program of buying MBS and therefore driving up their price. This has happened, and we therefore have liquidated the position for a profit.
We like Japanese equities for several reasons right now. The first is that they are very under-owned both domestically and by foreigners relative to historical averages. We therefore do not expect them to participate significantly in any selloff that may occur if an agreement on the fiscal cliff cannot be reached.
But more importantly, the political situation in Japan has changed over the past several years, and we expect the Yen to finally begin to weaken after sustaining a forty-year bull market against the dollar. Japanese Prime Minister Noda will likely be forced to hold snap elections at the end of the year, and his ruling DPJ party is likely to lose to the opposition LDP party. The LDP party is much more inclined to pressure the Bank of Japan to weaken the Yen in an attempt to emerge from the deflation that the country has been mired in for two decades. Furthermore, Japan is on the verge of running a current account deficit for the first time since 1981, which will also put downward pressure on the Yen.
A weakening yen would be very positive for Japanese equities and the major Japanese exporters especially. We also benefit doubly from a weak Yen because the product we own is hedged against the Yen. In effect, we are long Japanese equities while at the same time short the Yen.
After focusing our equity exposure in the US for the past several quarters, increasing risks at home (fiscal cliff) as well as poor relative valuations make US equities less attractive. We will continue to look to add foreign exposure as opportunities present themselves.
Please email us your comments, questions, etc.
John Forlines III and Court Hoover