Head of External and Government Affairs
Allianz of America
CIO, Portfolio Manager
NFJ Investment Group
CIO, US Equities
Allianz Global Investors
Fears of the U.S. economy falling off a “fiscal cliff” have been percolating among investors, conjuring up frightening images of a deep recession. But the chances of it actually happening in its entirety are slim, our experts say.
“The fiscal cliff is akin to the Y2K scare,” says Ben Fischer, chief investment officer and portfolio manager at NFJ Investment Group. “Everybody hyperventilated over it for two years. But, at the same time, there was a lot of thought being put into preventing dire consequences. It’s not going to be as bad as it theoretically could be.”
The fiscal cliff is Washington, D.C. parlance for a hairy mix of policy changes that includes expiring tax breaks and automatic government-spending cuts. If allowed to occur all at once, then it could put an estimated 4% dent in GDP and jack up unemployment to 9.1%, according to the Congressional Budget Office, effectively pushing the economy into a recession. And taxpayers would face the largest tax hike in U.S. history, an average of $3,500 per household, as estimated by the Tax Policy Center.
A Slow Waddle
Despite the precarious implications of congressional inaction, there’s been no movement inside the Beltway—at least not publicly. With little impetus for politicians to come to the bargaining table before the presidential election, Democrats and Republicans are likely to wait until the lame-duck session of Congress in mid-November.
Extreme market pressure is the only force that will speed legislative talks. “As long as Treasury yields are well behaved, there’s not going to be a huge incentive for Congress to do a heck of a lot,” says Scott Migliori, CIO US Equities at Allianz Global Investors.
However, like most things in Washington, crisis compels action—even if that means a frenzied, eleventh-hour resolution. “Look at the TARP bill,” says Peter Lefkin, head of external and government affairs at Allianz of America. “Everybody hated it initially, then Congress came back two days later with some window dressing, and it passed.” While this type of stopgap may be enough to ward off disaster, it virtually ensures that longer-term solutions get short shrift. The bigger picture, Lefkin says, is that the United States needs meaningful tax reform and a comprehensive long-term debt-reduction plan.
Along those lines, the bi-partisan Simpson-Bowles plan—first introduced in 2010 under President Obama and shot down because it didn’t include details on entitlement cuts—has been resurrected as the deadline for sun-setting policies looms. Presidential candidate Mitt Romney’s (R-Mass.) running mate, Paul Ryan (R- Wisc.), has laid out his own proposal, which includes restructuring Medicare and Medicaid and a budget that simplifies and flattens the tax code.
There are also conversations going on behind the scenes: Senate Finance Committee Chairman Max Baucus (D-Mont.) and House Ways and Means Committee Chairman Dave Camp (R-Mich.), Washington insiders say, are having a meaningful dialogue on how to tackle tax reform, unemployment benefits and entitlement programs. The goal is to build a “bridge” over the fiscal cliff—albeit quietly at first. “These back-room conversations are kept under wraps to avoid being used as timber wood along the campaign trail,” Lefkin says.
Pass or Punt?
Ultimately, Congress is likely to allow some of the cliff components to take effect, punt on others and, hopefully, reach a compromise on some of the thorniest issues. For example, the alternative minimum tax (AMT) patch is likely to be renewed, given the number of Americans it impacts, Lefkin says. Taxes on dividends and capital gains and current income-tax brackets could be extended despite being a point of contention for the President where it concerns upper-income households.
The payroll tax holiday, which has been in effect for the past two years, will not be renewed, Lefkin says. Congress views it as an opportunity to send a message that it is “taking the deficit seriously.”
The sequester—a series of congressionally mandated spending cuts that was rather Draconian by design—cannot take effect without plunging the economy into recession, he says. Given that reality, he expects Congress to buy some time—at least six months—to come up with a better solution. One idea currently being floated is a “mini sequester” that allows about 20% of the $109 billion in cuts to occur. Some sequestration, according to Lefkin, is necessary to convince both parties that there are political consequences for a failed budgetary framework. “The days of pretending that deficits don’t matter may soon come to an end,” he says.
Meanwhile, the recently upheld Affordable Care Act will go into effect, raising taxes to expand the nation’s health-insurance coverage.
Handicapping Washington politics can be a fool’s errand, but with so much at stake and some collaboration already in play, it’s reasonable to expect progress. “If President Obama wins, he might be inclined to negotiate,” Lefkin says. “If the Republicans sweep, then everything will be postponed until next year.” A Romney win coupled with a Democratic Senate will likely mean some sort of middle ground between the two.
Focus on Fundamentals
However, getting hung up on the perils of political inertia obscures a far more tangible threat. The U.S. economy is weakening: Corporate earnings are declining and manufacturing activity has slowed significantly. The ISM Manufacturing Index was under 50 for three straight months, dropping more than 10 points from the beginning of 2011—although the September report shows expansion. Similarly, the global PMI has dropped to 48.1 from 57.4 over that time frame. Wall Street analysts expect S&P 500 companies to report a 2.7% year-over-year decline in third-quarter operating profits. If these numbers hold up, that would mark the first drop in quarterly earnings in nearly three years. In terms of top-line growth, less than 40% of S&P 500 companies have beaten quarterly revenue estimates.
As a result, many companies are reluctant to reinvest in their businesses and add jobs until they see some clarity on economic conditions. The fiscal cliff isn’t helping matters. In fact, only 29% of CEOs polled by Reuters expect employment at their companies to grow in the next six months, compared to 34% who expect headcount to decline. “Psychologically, it’s already having an impact,” says Migliori, who heads U.S. investments for Allianz Global Investors. “CEOs don’t like uncertainty when planning their businesses and making significant hiring and capital-spending decisions. It’s created a drag on activity and it will continue to be a drag until we see some progress.”
Looking overseas, Europe is still steeped in crisis. China’s meteoric growth has cooled, renewing chances of a hard landing. This erosion of fundamentals, both at home and abroad, is likely to lead to more growing pains. As such, hard numbers showing economic contraction are more palpable headwinds than the “what ifs” and worst-case hypotheticals surrounding the fiscal cliff that are currently souring sentiment.
Investors should pay attention to macro risks—provided they’re the right ones. “The market is not discounting weakening conditions appropriately,” Migliori says. “I’m not as concerned about the fiscal cliff transpiring as I am about the market not currently recognizing how significant the global slowdown is. Not to mention its impact on corporate earnings over the next couple of quarters.” Indeed, volatility has been relatively tame amid this contraction with the VIX hovering in the 15 to 16 range.
So how do investors put headlines about pending doom in perspective? At Allianz Global Investors, we believe that the fiscal cliff should be evaluated like myriad other confidence killers: a breakup of the euro zone, a hard landing in China and last year’s debt-ceiling debate. “There’s likely to be some spikes in volatility between now and the end of the year as the uncertainty and fear increases,” Migliori says.
Still, it’s important to stay grounded. “There’s a very low probability of going over the cliff,” NFJ’s Fischer says. “Politicians may be self-interested, but they’re not stupid. But if it did happen, there would be a very negative market impact, and likely a significant recession. In that scenario, you would want to be in defensive, high-quality stocks.”
Perhaps the biggest danger the fiscal cliff poses to investors is preventing them from taking risk. Many investors are going to try to time any acceleration in the economy, which is one of the biggest self-inflicted mistakes they can make. “Once they get to the other side of the fiscal cliff, they’ll see that taking risk is a good thing,” Fischer says.
Where to Invest
How should investors prepare for what’s next? Coping with wild cards like the fiscal cliff will be about avoiding companies that stand to lose the most in a bear market. And more importantly, investors need to look at companies that are well insulated from macro turbulence. “Stable-growth companies that generate significant cash flows and are less economically sensitive will probably be some of the best performers,” Migliori says.
Irrespective of the fiscal cliff, the U.S. is likely to be stymied by sub-par growth and low interest rates either due to sluggish economic activity or the Fed pinning interest rates near zero. “Historically, in these periods of financial repression, free cash flow, earnings stability, and secular growth—where you can find it—are the best areas of the market,” Migliori says.
“Be opportunistic,” he adds. “When the market is getting too optimistic about progress on policy decisions, you need to be willing to get more defensive. The flip side is that when it looks like Greece is going into the abyss, you need to take the other side of that trade. You have to be willing to trade tactically around core positions based on the opportunities that present themselves. The market is going to have a fairly wide trading range.”
While stock picking will be a difference maker in a market in flux, don’t bet on a broad-based rally, Fischer says. “It’s hard to picture a scenario that would result in a bull market given the structural drag we’re seeing. One way to increase your real capital is by investing in high-quality dividend-paying stocks that raise their payouts over time. Those with the best financials and the ability to boost their dividends, have the best chance of going up. With a modest 3% growth rate and a 3% dividend yield, you’d come out okay.” Among sectors, Fischer sees energy, particularly oil companies, health care and tech as having attractive yields and the ability to grow dividends.
Some investors may have some hesitation about dividends in the face of tax increases. Ostensibly, the tax hike will have some impact on their income, but it doesn’t make dividend-paying stocks toxic. On the contrary, the fiscal-cliff cost would have little effect on dividend payers’ total return. Across favorable and unfavorable tax climates, dividend payers have outperformed non-dividend payers over long stretches.
Still, the long-term consequences of politicians taking our debt issues too lightly will be costly. The nation is consistently running deficits of $1.2 trillion per year. And the deficit has doubled in the last five years. Combine that with the fiscal overhang of underfunded Social Security and Medicare and things could go from bad to worse. “At some point, people will stop buying our bonds,” says Lefkin, a longtime Washington insider.
The structural issues of U.S. fiscal policy notwithstanding, investors should focus on more concrete risks to their portfolios. Low interest rates and low growth mean real returns matter. The fact is, central bankers are all but forcing investors to own stocks to outpace inflation. So don’t fight the Fed. Instead, focus on companies with strong balance sheets and high, sustainable dividend yields. And rather than trying to time the market, stay invested and trade tactically around core positions.
The bottom line: Heed the warning signs of weak economic data globally, expect earnings to decline in the short run and worry less about a perfect storm of expiring tax breaks and spending cuts. The fiscal “if” will work itself out.