3 Sectors for the New Year

 | Jan 09, 2013 | 2:00 PM EST
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As investors weigh whether to trade on or ignore Washington's coming war over the debt ceiling, I'll offer three takes.

Be Wary of Defense

I agree with Jim Cramer's persistent call to tune out the "cliff dwellers" and keep an eye on fundamentals instead. Wall Street consensus assumes that the year's best fruits will be backloaded and emerge in full only after one more big bang from D.C. policymakers. That may prove to be the case. But what if the initial resolution of the fiscal-cliff-redux challenges emerging after Valentine's Day only beget new delayed trigger dates and uncertainties? The cautious might find themselves missing the year's best gains, as did those who sat out last summer. My advice might be to gird for a bigger fight over the re-emerging budget sequester instead of the debt limit, which will surely be extended in the end, though in such small gulps as to be annoying.

Republicans have come to believe that Democrats are simply unable or unwilling to cut spending, thus a grand bargain is unlikely. But that same Pavlovian instinct might also make the political left more likely to blink when sequester-related spending cuts are set to be triggered after March 1 (in the absence of an agreement on alternative savings). It was President Obama and the White House, after all, that insisted on addressing the sequester in late December. That was not lost on Speaker John Boehner, as he reflected in a recent interview with the Wall Street Journal. As a result, the GOP believes that the sequester, not the debt limit, may be its ace in the hole. And Republicans' growing resolve to test the Democrats' willingness to absorb a massive discretionary spending cut after March 1 suggests that the risk of acute, then prolonged, uncertainty for defense stocks only seems likely to grow.

Meanwhile, most defense stocks remain near their highs reached late last year, having surprised in their resiliency amid the post-election fiscal-cliff faceoff. As my defense-savvy partner, Byron Callan, points out, investors may have assumed that if sequestration was triggered, Lockheed Martin (LMT), Raytheon (RTN), Northrop Grumman (NOC), General Dynamics (GD) and others would have retained their defensive luster amid an accompanying recession. But now Byron writes that coming weeks might be different for the defense group because the names may have greater relative exposure to risk from this set of cliffs than the last one. I agree.

Stick With the Builders; Don't Mortgage the Banks

Banks have had an unbridled streak of good news this week, perhaps helping to extend a rally that resumed shortly after election day. Measured by the KBW Bank Index (^BKX) and Financial Select Sector SPDR (XLF) (up 14% and 12%, respectively, since Nov. 14), banks and financial stocks have nearly doubled the return of the S&P 500. That's not bad for what we had seen as fairly pronounced "red stocks," presumed to benefit from reduced regulatory pressure in the event of a Romney-Ryan victory and return of a GOP Senate.

This week gave evidence that at least some relief is on the way, as banks on Monday got a break on liquidity rules at the Basel, Switzerland, regulatory meeting, and from a hatchet-burying foreclosure-review deal from the U.S. Office of the Comptroller of the Currency. Also, a constructive final Qualified Mortgage (QM) rule from the Consumer Financial Protection Bureau is expected Wednesday or Thursday. The QM will be crucial in determining how broad a cohort of non-agency/private label loans will be legally granted a future "safe harbor" as a result of carrying plain-vanilla terms or debt-to-income ratios ensuring a borrower's ability to repay. With regulators unable to agree on separate but no less stringent Qualified Residential Mortgage (QRM) criteria to shield securitizing lenders from a 5% risk-retention requirement, there's a good chance the CFPB's fine work on QM might be adopted as a unified standard to meet both the suitability and "skin in the game" mandates of the Dodd-Frank Act.

This would ultimately prove a good thing for mortgage insurers, though they might twist in the wind this spring as their fate, and the QRM's original notion of a 20% down payment requirement, is debated once more between regulators and the Treasury Department, which has a jaundiced view of the industry.

Meanwhile, the positive effects of the capital freed up by the delay and easing Basel liquidity requirements may be partially offset by an expected sharp drop-off in mortgage originations, as the refinancing boom abates and a rebounding U.S. housing market fails to generate enough purchase-money demand to make up the difference.

As competition among banks intensifies, downward pressure on mortgage interest rates is expected to be a boon for homebuilders, who'll not only see customers awash in low-cost financing options but also not have to take as much risk in their own captive lending arms during their next leg of a recovery.

Muni Bonds Deserve Another Look

Finally, it's worth noting that municipal bonds' tax advantages will likely continue to be at risk, even after dodging a bullet in last month's fiscal-cliff fix. (Indeed, in raising top rates and taxes on investments, the American Tax Relief Act made tax-exempt income even more attractive.) There is a good, if not great, chance that comprehensive tax reform serving as a necessary predicate for any tampering with the muni interest exemption may never materialize.

Meanwhile, it'll be hard to worry about the other major threat to the munis -- rising interest rates that might increase yields and clip prices -- if the coming face-off over the debt ceiling and sequester produce another bout of prolonged uncertainty into summer or fall. Even the sharpest muni muse, Morgan Stanley's Michael Zezas, remains cautious, but he acknowledges that recent valuations may be aligning the group for a fresh look.

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