War Room 25 Oct 2012

Eve of Election Update

War Room•Monthly macro discussion

•Using tools in context

•Update on HiddenLevers Features

•Your feedback welcome

Eve of Election Update

I. Fiscal Cliff – Brinksmanship Assumed

II. Housing – Rebound Emerging

III. Europe – Debt Crisis = no. Recession = yes

IV. Scenarios

HiddenLevers

FISCAL CLIFF – BRINKSMANSHIP ASSUMED

Fiscal Cliff - BasicsTAX INCREASES

• Bush Tax Cuts – Average family gets $3000 tax hike

• Cost of Bush tax cuts expiring over next decade - $4 trillion

• Payroll Tax Cuts expire

• Medicare tax on high earners (Obamacare)

• Estate Tax goes from 35% 55%

• Capital Gains + Dividends Tax : 15% normal income tax rates

• Total tax increase: almost $500b

SPENDING CUTS

• First spending decline since 1999

• Obama – Stimulus spending = over

• Unemployment extensions = over

• Teacher + Police earmarks = expired

• Fed - Operation twist – over

• Debt Ceiling hit end of 2012

• Defense spending cuts – $500b

• Discretionary spending cuts– $700b

Total Impact of Tax Increases + Spending cuts

Total = 5% of GDP

TAXMAGEDDON

Fiscal Cliff – Basics

Romney + GOP Congress

Romney + Dem Congress

Obama + GOP Congress

Obama + Split Congress

Obama + Dem Congress

Romney + Split CongressStatus Quo

ObamaDem 53/47GOP 242/193

execsenatehouse

(pipe dream)

(pipe dream)

Fiscal Cliff – Post-Election Behavior Change?

congress since 2010

congress post-election

Seriously?

“Administration officials have been expressing that confidence for weeks, even as they say no real negotiations are happening.” – NY Times

Two thirds of economists assume resolution without damage to economy – USA Today

Potential Trump Card:

1. Obama win = clock ticking + some new clout

2. Defense spending + Bush tax cuts = GOP agenda

Conclusion Romney wins – lame duck, can kicked into 2013Obama wins – worst case more likely, but GOP may buckle

Fiscal Cliff Update – Worst Case Scenario Advantages of Worst Case Scenario

• No sudden economic collapse

• Falling market forces government to focus

• Deficit Balanced – automatic austerity

Disadvantages

• Long term effects of belligerent parties

• Recession very likely – 5% hit to GDP

1840s – worse than Thelma + Louise

• Disagreement between north + south on tariffs on Euro goods

• 1830 agreement that in 10 years tariffs would be eliminated (Think Bush Tax Cuts)

• 1838 major financial crisis after boom

• 1840 US sliding into deep depression

• 1842 1/3 of states defaulted on foreign loans President Tyler cabinet resigned

The Deal:

• John Tyler vetoed bills to keep high tariffs

• Original bargain struck 10 years before abandoned

• Tariff preserved but way lower

• Southern states seething led to secession/war

Fiscal Cliff Update – Effect on USD + Treasuries

Dollar Rally in Fiscal Cliff

MACRO:Flight to dollar as safety

FUNDAMENTALS: Lower Deficit = Stronger USA

Rally in US Treasuries 2011

Counter-intuitive – 10y integrity

2012: Intuitive – stronger USA

HOUSING – REBOUND EMERGINGHiddenLevers

Housing - Competing Trends:

Long Term Home Prices - Downward

Housing - Competing Trends:

Affordability

Affordability is highest in decades

Historically low mtg rates + price declines

75% of homes sold now affordable to median income buyers

In many markets buying < renting

Sources: National Associations of Realtors, Home Builders, and Wells Fargo

NAR Affordability Index

NAHB Housing Opportunity Index

Home builders' confidence and stock prices soaring over last 2 years

US home sales + new housing construction starts both rising since bottom in early 2011

Housing - Competing Trends:

Home Sales + Construction Upward

Source: HiddenLevers

Housing - Competing Trends:

Home Price + Foreclosure Issues Remain

Low mortgage rates + low home prices = affordability

But home prices continue to drag on household wealth

Residential foreclosures remain high + existing home sales trend much weaker than new home sales

Source: HiddenLevers

Consequences:

1. Home prices may suffer up to 30% more downside

2. Good chance of US economy going into recession

3. Pendulum’s don’t stop in the middle

4. Home ownership dies as an American tradition

Housing Update – Rebound Emerging

Consequences:

1. S+P to new highs, but muted impact from here

2. Industrial commodities will benefit most

3. Employment picture change will be cause

4. Rebound will in turn affect employment in sector

EUROPE – DEBT CRISIS = NO. RECESSION = YES.HiddenLevers

Europe – Basics

S&P + Euro continue to move in lockstep, up + down over 3 months

Source: HiddenLevers

Europe Update – Draghi commitment Spanish Bonds – 10Y Benchmark Yields

Source: Bloomberg

1. ECB pledged unlimited bond purchases to Spain

2. Spain bond yields have fallen considerably since early Sept

3. ECB interventions key to this decrease

4. Spain default = Euro Zone

5. Pulse of banking crisis rests on this lever, no matter what drama is in news

Europe Update – Now in Recession

• ECB intervention = buying time

• ECB so far unwilling to engage in QE a la Fed

• European austerity policies failed to deliver growth

• Even German economy sliding now

US big caps pulling out of Europe

no more diapers

plant shut downs

$15b out of EU banks

Europe Update – Why no action? Significance

• Greek economy shrunk almost 20% since peak

• Unemployment in Greece at 25% = Depression levels

• Unemployment in Germany at 5% = Germans not feeling pinch

Source: Economist

Guidance

1. Spain default or other PIIGS follow Greece out

2. Poorly handled, with no plan of action = bloodbath

3. At risk – anything priced in US Dollars

4. Defending Euro/Swiss Peg will be difficult

5. Think Lehman

Europe Update – Greece Defaulted, did not Exit

Guidance

1. Greek default + Euro exit almost fully priced in

3. Well handled, with guidance and action = rally

4. Proof - Gold is a commodity, not a reserve currency

5. Think GM, Bear Stearns

SCENARIOSHiddenLevers

HiddenLevers – Product Update

• iPad app now in App Store – very beta

• House-holding of portfolios

• Advanced Analytics – multiple time frames

Coming soon – Integrations:1. Schwab Portfolio Center

2. Money Guide Pro

3. Fortigent