View From the Street: Thoughts From Credit Suisse Chief Economist Dr. Neal Soss
I was recently able to get in touch with Credit Suisse's Chief Economist, Dr. Neal Soss, and ask him a few questions about his views on the economy. With financial markets being so macro driven over the last few years, it is crucial for investors to understand the macro picture and at least understand the different scenarios that can play out over the next year. With a crisis in Europe, a slowdown in emerging markets, and a fiscal cliff coming in January, it is crucial to know what the macro picture is painting before investing.
I first asked him how long the US can continue to muddle along with the rest of the world slowing down considerably, to which he replied, "Possibly quite a long time. The US is not that open to international trade. We are a large continental-scale well-diversified economy." This fact can be seen in the strength of the Canadian economy recently, and exceptionally so in Canadian employment indicators. If investors believe Dr. Soss, then a good way to play a continued muddle-along scenario would be to look at Canada (NYSE: EWC) or Mexico (NYSE: EWW).
In terms of the fiscal cliff coming at the end of the year, his views seem rather bullish given the downside scenarios that could happen. He believes that there are three groups of provisions that are on the table and could be extended, which would help to mitigate the fall off in 2013. First, he sees the extension of the upper-income Bush tax cuts as on the table. Specifically, he says that "we believe that the upper-income tax rates, including the top two marginal tax brackets, capital gains tax rates, and dividend tax rates are in play.." Dr. Soss does not believe that there is any chance that politicians would allow the middle class rates to rise, so they really aren't on the table, but top tier rates could rise to 36% and 39.6%, from the current 33% and 35% respectively.
Second, Dr. Soss sees the extension of the payroll tax cuts and an extension of unemployment benefits as on the table. Lastly, he sees the automatic spending cuts that were part of the Super Committee Impasse on the table. With much of this concentrated in Medicare and defense, both republicans and democrats have reason to kick this can down the road and renege on the agreement.
In terms of how large the fiscal drag will actually be, he highlights three scenarios for the fall-off. His first is what he calls the Low scenario, in which all of the cuts above are postponed. In this scenario, he expects a modest contraction, which would have likely happened anyways (ending of Recovery Act programs and other measures) and will result in a drag of about .9% of GDP. He notes that a fiscal drag of this size is "relatively routine, and would not be expected to have a significant impact on the [growth] outlook." In his second scenario, which he calls the high scenario, he assumes that all three of the measures listed above kick in. In this case, he sees :an overall 2.4% fiscal drag during fiscal year 2013, a much more significant hit." His third scenario, which he calls the Current Law Cliff, includes not only the three measures listed above but other, regularly passed items are not enacted. These include the passage of the AMT "patch" and the Medicare "Doc Fix" and that the middle class portion of the Bush tax cuts are allowed to expire. In this scenario he expects a 4% fiscal drag, but he sees this as highly unlikely.
He claims that the base case is the Low scenario, which is good for markets in the short term (NYSE: SPY). However, he believes that this would force the Fed to be more active. He says, "Low interest rates have cushioned federal finances considerably over the past decade or so. Since 2000, the gross debt that the government pays interest on has increased almost $7 trillion. Remarkably, the level of net interest expense is barely up from where it was. That's because interest rates have fallen about as fast as the debt has risen." Further, he adds, "Raising rates too soon could expose a key vulnerability in the financial system. This is yet another argument for expecting interest rates to remain at very low levels for a very long time." He expects the Fed to remain conservative and to avoid rapid rate hikes until the fiscal situation plays out. Just this morning, his firm's credit team said that they see an extension to Operation Twist at the June 20 meeting as more likely than not.
Traders who believe that Operation Twist will be extended might want to consider the following trades:
- long US stocks (NYSE: SPY)
- long gold (NYSE: GLD)
- long euro on a short term, tactical trade (NYSE: FXE)
Traders who believe that the Fed will not act may consider alternative positions:
- short financials, as a lack of Fed activity may hurt borrowing costs (NYSE: FAZ)
- long dollar (NYSE: UUP)
- long treasury bonds (NYSE: TLT)
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