The fiscal cliff or the fiscal fudge – what do investors do now?

8th January 2013

Markets celebrated the resolution of the fiscal cliff by tripping over the 6,000 mark for just the second time in a decade. But what now for investor?

This early fillip may be welcomed by investors who have spent five years waiting for markets to recover to the levels seen before the pre-Lehmans credit bubble burst so spectacularly.

But are certain areas more or less exposed to the machinations of policymakers over the fiscal cliff?

The immediate market response to the US agreement concerning tax rises gave some clues as to the likely long term winners from any fiscal cliff bounce.

Markets in general rallied, but the biggest beneficiary was the Nasdaq, which was up over three per cent on the day. The high beta markets of France and Germany also charged higher, while the FTSE 100 and more defensive US indices of the S&P 500 and Dow Jones were middle of the pack. The laggards were Japan and China.

This would suggest that the Japanese and Chinese markets may be more insulated from US political machinations over the fiscal cliff – though both economies are export-dependent and neither could insulate itself from a slide in US GDP entirely. It also suggests that unloved 'risk on' markets – i.e. markets they tend to be avoided by investors during times of uncertainty – may be the biggest beneficiaries

However, markets cannot necessarily be trusted in the short-term and the answer is likely to be more nuanced over the longer-term. If the fiscal cliff is resolved satisfactorily, the majority of commentators believe one of two scenarios is likely: They either believe that US markets should rally because the US has great companies likely to profit from a global recovery; Or that US markets will lag because its companies are relatively expensive and other stock markets are likely to benefit more from a recovery in its GDP figures.

This was recently addressed in the Telegraph.

It concluded that the US markets were unlikely to rally significantly on resolution of the fiscal cliff, simply because they were too expensive: "The cyclically adjusted price to earnings ratio, known as Cape, smoothes p/e ratios over a decade. The US was one of the most expensive stock markets, as measured in a recent Cape analysis by Cambria Investment Management. It put the US on a Cape ratio of 20.9, compared with 12.47 for the UK and 7.23 for Italy," the paper argued.

If the fiscal fudge is not then turned into a more permanent agreement also covering spending, then equity markets may not be the place to be, whatever the outcome. Research by Fidelity suggests that there are a number of vulnerable sectors. For example, defence and healthcare companies are likely to suffer in both scenarios. Chad Colman, portfolio manager, industrials at the group says: "Half of the $1.2 trillion cuts…have to come from the defence budget, and you can’t cut some components of the budget, such as military personnel. So that leads to an estimated 12 per cent to 15 per cent cut to the rest of the defence budget. That’s a big cut!"

He adds that although the law states that all of the cuts have to be spread evenly across all programs, it is difficult to build 85 per cent of a submarine, so certain parts of the defence industry are likely to bear a disproportionate burden.

There is also a proposed 2 per cent cut in the health care budget. Fidelity believes this will primarily affect health care providers, such as hospitals, nursing homes, and long-term care facilities, rather than the multinational companies, which are globally diverse and exposed to a lot of different health care markets.

So those areas may be worth avoiding, but which areas could be beneficiaries? That depends on the outcome of the talks, but assuming that a resolution is found, higher beta markets are likely to rally.

Recent data from EPFR Global, who monitor fund flows, suggests that investors are not only abandoning their long-held preference for bonds over equities, but also their long-held preference for high income defensive stocks.

Instead, emerging markets have been a key beneficiary. As Daily News Analysis India reports: "Of the $5.1 billion inflows into equities last week (ending January 3), emerging market equity funds received $3.4 billion."

This is in spite of relatively weak performance from some emerging markets, notably China, in 2012. Asset allocators are reasoning that emerging markets are likely to reap rewards from any recovery in the US economy, but they may also offer some protection if the deal does not turn out as planned.

These views are echoed by Russ Koesterich, BlackRock chief investment strategist writing in etftrends. He suggests that investors should look outside the US where possible, but if they prefer to stick to US markets, they should prioritise mega-caps over domestically-focused smaller caps.

However, he also cautions against turning negative on dividend stocks just yet: "While certain segments of this style appear expensive (i.e. US utilities), dividend stocks are still attractive despite a higher dividend tax rate. US corporations have the wherewithal to raise dividend payouts to compensate investors for any change in tax treatment. Investors would want to look for companies that are cash-flow rich and have a track record of increasing payout rates."  

The temptation would be to direct cash towards the most unloved markets of Europe and Japan, in the hope that any ultimate resolution of the fiscal cliff will prompt a surge. This is certainly a possibility, but many analysts dismiss the idea that there is likely to be anything other than a fudged compromise in the end and therefore this is sti
ll a risky strategy.

There is also the question over what would constitute a 'resolution' of the fiscal cliff for markets.

The majority of analysts believe that without a resolution, the fiscal cliff would knock around five per cent off US GDP. Experts are generally expecting a figure no worse than two per cent and some substantially less. A number of estimates are given here in the Washington Post. Washington Post. He says: "JPMorgan estimates that the fiscal cliff deal will subtract about 1 percentage point from growth in 2013, according to its appraisal of the Senate version of the bill." Certainly if the deal tipped the US back into recession, the markets would react badly. They are prepared for some hit to GDP, but not a catastrophic one.  

Seeking Alpha presents a doomsday scenario, pointing out that if certain economic assumptions are wrong, the impact of tax hikes on the economy may be far greater than previously thought.

 

 

 

The article concludes ominously: "US equity markets are certainly not discounting any more than a trivial prospect of a fiscal cliff scenario, and they are certainly not discounting the low growth and high macro volatility scenario that the US faces for the next decade (even if the fiscal cliff of 2013-2014 is averted)."

In this scenario, all bets would be off. Even the now unloved fixed income markets might regain some popularity. As it is, the outcome, and likely winners and losers, remains uncertain. Investors might want to curb their enthusiasm until the ultimate outcome is clearer.

Cherry Reynard is an award winning financial and investment journalist

 

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