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Gridlock Drives the U.S. to the Fiscal Cliff

05/03/2012
Recent economic data from across the pond has confirmed my 2012 expectations for Europe – both Spain and the United Kingdom (U.K.) are back in recession. Some will argue that the depth of those recessions will be shallow, for the U.K. in particular, which should experience an economic boost from the summer Olympics. More important for investors devising their portfolio strategy is what impact the European recessions will have upon the U.S. economy. My position is that unless the German economy deteriorates into recession, the near-term impact on the U.S. will be minimal. However, it is timely and relevant to think ahead to what separates the U.S. economy from Europe and identify potential areas of vulnerability.
 
Key Considerations:
•   My “back of the envelope” calculation:  U.S. recession vulnerability will reach its height 18 months from now, in late Q4 2013
•   Investors should NOT make any significant changes to their portfolios based on the current economic evidence:
       o  Current evidence supports further asset appreciation (equities and corporate bonds) and a U.S. economy that is the “best in breed’ of all global economies
       o  My near-term expectation is “this pause will refresh”
•   A reallocation out of U.S. Treasuries into equities remains a possibility for 2012, although not near term
•  The current trajectory is for a “late cycle U.S. economic recovery” with sustainability over the next few quarters
•  The catalyst that would drive the U.S. back into recession is simple – Gridlock in Washington D.C.           
 
Avoid the Mistake, Avoid a Late 2013 Recession
 
The U.S. is in the midst of a presidential campaign season that is being depicted by the media in an extremely polarizing fashion. Of greater concern is the evidence that suggests an electorate that is disinterested with the election so far. Historically, U.S. electorate participation is necessary to motivate policymakers to address fiscal challenges to the U.S. economy.
 
The U.S. economy will be faced at the end of 2012 with the expiration of the payroll tax cut, unemployment benefits, and automatic spending cuts as a result of the Super Committee’s failure to resolve these issues. Lack of desire on the part of both Republicans and Democrats to address these issues during an election campaign will not negatively impact U.S. economic growth immediately, but it will weaken the economy’s foundation and directly impact it in mid to late 2013.
 
A failure to act could remove 1% to 1.5% from U.S. GDP. In particular, corporate earnings strength, the foundation of the post-2009 recovery, will be placed in an uncomfortable position.  House prices will also begin a renewed leg lower. I suspect that Treasuries would trade more in line with the 1981 to mid-1982 scenario than the 2008 to 2009 scenario.  
 
For those that have kept up with my thought process, market bias, and economic outlooks, you know of my stated bullish position in the past few years. I write this not for investors to take action with their current portfolios nor to reverse the optimism. Rather, I write this to introduce a concern and potential market headwind, which is based on the lack of adult supervision in D.C. and very quietly places in jeopardy the U.S. economic recovery and current immunity from recession if not rectified.
 
D.C. and the U.S. electorate need to wake up and realize how fortunate we are relative to the rest of the global economies. We control whether we continue to steer toward further asset appreciation or if we lazily turn toward the fiscal cliff.  This is not the time to let up, and it seems we are. I hope I am wrong, and that the electorate begins to demand more from D.C. , policy makers act unselfishly, and the U.S. remains best in breed.
 
A message to Washington D.C. – These are historic times, laziness has severe consequences, and “For 365 days a year, it’s Game 7.” Please remember that!

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.