'Foolish Washington gridlock' could dampen equity markets

The Dow Jones Industrial Average lacked the ambition to move meaningfully above 13,000 last week. While a new 52-week high of 13,005 was achieved Tuesday, it seemed that the absence of new positive surprises cooled investors' enthusiasm a bit. While no significant decline occurred, trading gave way to a close of 12,978, a loss of just 5 points from the previous week. In the last issue of Weekly Bulletin, we suggested the market may be due for a breather from its unrelenting march higher. It could occur due to any number of things, such as a spike in oil prices, a weak employment report, or an unexpected flare from Europe. Likely, any pullback would be shallow, since the fundamental underpinnings of the economy and corporate America don't warrant a steep decline at this juncture. As the political campaign heats up, however, investors may become more aware of an issue that has been mostly overlooked. The U.S. economy is growing, but at a below trend pace, and it is possibly going face some stiff fiscal headwinds in 2013. The loss of fiscal thrust as a result of the expiry of the payroll tax reduction, the Bush-era tax cuts, and the extended unemployment benefits is not trivial. Additionally, the Budget Control Act of 2011 is scheduled to phase in next year. The latest Congressional Budget Office projection warns that a fiscal drag could amount to 1.6% of GDP. This past week, the government revised the previously-released GDP growth figures for the fourth quarter of 2011. The headline looks good at 3.0%, a markup from the 2.8% estimated earlier, and the fastest pace since the three month period ended June 30, 2010. Looking inside the GDP report, however, we note that 1.9% came from inventory building. The inventory calculation fluctuates in its influence to overall GDP, sometimes adding, while at other times subtracting. Yet if economic activity is looked at excluding the inventory stocking, then the 1.1% that is left hardly provides a hearty margin. Furthermore, if this same growth rate carries into 2013 and encounters the fiscal headwind that is expected, our economy is going to need more than an inventory stocking aberration to keep growing. We suspect fiscal policy will become an increasingly important issue as the election draws closer. While we still favor stocks over bonds and cash, watching another bout of foolish Washington gridlock later this year would not be a welcome event for the equity markets. In fact, the force of fiscal contraction could instead be best to rally the bond market. Mark Luschini is the chief investment strategist for Janney Montgomery Scott LLC.