Gaming the System: How to Make a Mint Off the Government
Business + Economy

Gaming the System: How to Make a Mint Off the Government

iStockphoto/The Fiscal Times

Few things are ever clear in Washington. But politicians generally hope to keep their jobs, which leads them to behave a little better during an election year—and 2014 shapes up as big for both parties.

Battles over the Affordable Care Act, the debt ceiling and the budget have left both sides scarred. Next year, they will have to play nice—or at least nicer—to hold or win ground in the midterm elections. That's welcome news for investors who, though they may have scored big gains in the stock market this year, had to weather some nasty cross currents along the way.

Related:  2013 Has Been Another Horrible Year for Hedge Funds 

"I see very positive themes coming out of Washington in 2014," says Greg Valliere, chief political strategist at Potomac Research Group. Unlike a year ago, Valliere says, there is little chance of a significant tax increase, or a government shutdown or debt crisis. Meanwhile, the budget deficit continues to fall, which should help keep interest rates from spiking as the Federal Reserve unwinds its massive bond-buying program. Here's how Washington stands to impact your portfolio in 2014:

Another Good Year for Stocks
This, of course, is no slam dunk. A slew of economists believe we're in for years, if not decades, of slow growth and puny average annual returns from stocks. JPMorgan projects growth of less than 2 percent per year the next five years; Robert Gordon, an influential economist at Northwestern University, says this lull will go on for two decades.

Notables, including Robert Shiller and Bill Gross, believe stocks will rise less than 5 percent a year for the foreseeable future.

Related:  Companies Sound the Alarm on 4th Quarter Earnings 

But there promises to be little headwind from Washington, and surprisingly strong employment data this month and a healthy revision of GDP in the third quarter suggest investors may be underestimating the recovery. Economic drag from tax hikes, spending cuts and policy uncertainty cut nearly 2 percentage points off growth this year, estimates Michael Hanson, senior economist at Bank of America Merrill Lynch. Next year such "fiscal drag" will cut just a half point off GDP. Growth should accelerate to more than 3 percent by year-end, Hanson says.

There will be tussles for sure. Republicans want to keep the focus on problems with the rollout of Obamacare. But they are no longer trying to repeal the law, and neither side has the stomach for a government shutdown. Some now expect a deal on the budget and debt ceiling by Christmas, putting those issues aside for nearly two years. That would eliminate a big uncertainty and clear the way for the market to focus on improving fundamentals. BlackRock's year-ahead strategy calls for overweighting stocks. Merrill Lynch forecasts a 10 percent to 12 percent S&P 500 gain next year.

Boost for Defense Contractors
The expected budget deal would roll back some of the spending cuts known as the sequester and greatly benefit Pentagon spending. Valliere estimates that defense spending was scheduled to decline by $50 billion in 2014. But with a budget deal, it might fall by just $20 billion, providing an additional $30 billion to the defense industry. Aerospace and defense technology stocks stand to get a lift.

Even with Pentagon cuts this year, defense shares managed to post nice gains as the industry cut costs and beat Wall Street's low expectations. Among analyst favorites for next year are United Technologies, which just raised its dividend by 10 percent, Lockheed Martin, the largest defense pure play, and Northrop Grumman, which along with its drone and other defense businesses has deep experience in health-care technologies that might be called upon as part of the Obamacare fix.

Rx for Health Care
The fight for Obamacare has been won. There may be some changes, and as a political issue Republicans will keep the heat on over the messy rollout. But health-care companies will end up with perhaps 50 million new customers, many of which may need a lot of medicine that they have been doing without, says Chris Krueger, political analyst at Guggenheim Washington Research Group.

That's good news for pharmaceutical firms, medical services and equipment providers. Stocks like MerckSanofi and Johnson & Johnson should be on your radar, says Barry Ritholtz, chief investment officer of Ritholtz Wealth Management. He also likes Health Care SPDR, an ETF. Meanwhile, hospitals will no longer be on the hook for free emergency room services, as they have been for three decades, a change that should boost profits at hospital companies like HCA and Tenet Healthcare.

Medical laboratories and research companies also should get a lift from the budget deal. An important source of funding for companies like Thermo Fisher Scientific and Agilent Technologies is the federally run National Institutes of Health, whose budget would be partly restored in almost any deal.

The Taper Is Real
No one really knows when the Fed will begin to pull the plug on its $85 billion-a-month bond-buying program. It could happen before Christmas, or not until March, by most accounts. And even then there is no saying how aggressively the Fed will choose to yank support. But it will be happening in 2014, and bond yields almost surely will float higher.

Don't look for a bloodbath as the bond market adjusts. The Fed will tread carefully and continue to provide stimulus for years to come if necessary. The 10-year T-bond yield is just under 3 percent now and "long rates at 4 percent are not in the cards anytime soon," says David Leduc, chief investment officer at Standish Mellon Asset Management. Still, long-dated bonds carry unusual risk at the start of a cycle of rising interest rates. You could easily end up with a loss to principal that overwhelms a T-bond's income.

That's a stiff price to pay for the safety of Treasurys, especially when they aren't all that safe. For income, you may be better off in the stocks of multinational companies that pay a dividend of around 3 percent, foreign bonds or higher-yielding corporate debt where the interest payments are big enough to compensate for a hit to principal.

This article originally appeared in CNBC.

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