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Fiscal Cliff Obscures Fading Fundamentals

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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, say Allianz experts.

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Fiscal Cliff Obscures Fading Fundamentals

  1. 1. October 2012 Viewpoints Fiscal Cliff Obscures Fading Fundamentals Our experts on Washington, the economy and the markets weigh in on why the alarm bells sounding over expiring tax breaks and automatic spending cuts could be a red herring for investors. Key Takeaways ■■ nvestor fears about going over the “fiscal cliff” may be exaggerated. Our experts believe the chances of I it happening in its entirety are slim.Peter LefkinHead of External and ■■  more tangible threat is the weakening U.S. economy. Earnings are declining, manufacturing has slowed, AGovernment Affairs and companies may reduce reinvestment and hiring.Allianz of America ■■  undamentals are eroding both at home and abroad: Europe is still steeped in crisis and China’s growth F has cooled. ■■  he market may not be discounting weakening conditions appropriately; the global slowdown may hurt T corporate earnings in the near term. ■■ n this slow-growth environment, focus on companies with strong balance sheets and high, sustainable dividend I yields. Rather than trying to time the market, stay invested and trade tactically around core positions.Scott MiglioriCIO Equities U.S.Allianz Global Investors Fears of the U.S. economy falling off a “fiscal cliff” have effectively pushing the economy into a recession. And been percolating among investors, conjuring up frightening taxpayers would face the largest tax hike in U.S. history, images of a deep recession. But the chances of it actually an average of $3,500 per household, as estimated by the happening in its entirety are slim, our experts say. Tax Policy Center. “The fiscal cliff is akin to the Y2K scare,” says Ben Fischer, A Slow Waddle chief investment officer and portfolio manager at NFJ Despite the precarious implications of congressional Investment Group. “Everybody hyperventilated over it for inaction, there’s been no movement inside the Beltway— two years. But, at the same time, there was a lot of thought at least not publicly. With little impetus for politicians being put into preventing dire consequences. It’s not going to come to the bargaining table before the presidentialBen Fischer to be as bad as it theoretically could be.” election, Democrats and Republicans are likely to wait untilCIO, Portfolio ManagerNFJ Investment Group the lame-duck session of Congress in mid-November. The fiscal cliff is Washington, D.C. parlance for a hairy mix of policy changes that includes expiring tax breaks Extreme market pressure is the only force that will speed and automatic government-spending cuts. If allowed to legislative talks. “As long as Treasury yields are well occur all at once, then it could put an estimated 4% dent in behaved, there’s not going to be a huge incentive for gross domestic product (GDP) and jack up unemployment Congress to do a heck of a lot,” says Scott Migliori, to 9.1%, according to the Congressional Budget Office, CIO Equities U.S. of Allianz Global Investors. continuedwww.allianzinvestors.com
  2. 2. However, like most things in Washington, crisis compels action— budgetary framework. “The days of pretending that deficits don’teven if that means a frenzied, eleventh-hour resolution. “Look at the matter may soon come to an end,” he says.TARP [Troubled Asset Relief Program] bill,” says Peter Lefkin, head of Meanwhile, the recently upheld Affordable Care Act will go into effect,external and government affairs at Allianz of America. “Everybody raising taxes to expand the nation’s health-insurance coverage.hated it initially, then Congress came back two days later with somewindow dressing, and it passed.” While this type of stopgap may Handicapping Washington politics can be a fool’s errand, but with sobe enough to ward off disaster, it virtually ensures that longer-term much at stake and some collaboration already in play, it’s reasonablesolutions get short shrift. The bigger picture, Lefkin says, is that the to expect progress. “If President Obama wins, he might be inclinedUnited States needs meaningful tax reform and a comprehensive to negotiate,” Lefkin says. “If the Republicans sweep, then everythinglong-term debt-reduction plan. will be postponed until next year.” A Romney win coupled with a Democratic Senate will likely mean some sort of middle groundAlong those lines, the bi-partisan Simpson-Bowles plan—first between the two.introduced in 2010 under President Obama and shot down becauseit didn’t include details on entitlement cuts—has been resurrected asthe deadline for sun-setting policies looms. Presidential candidate Mitt Focus on FundamentalsRomney’s (R-Mass.) running mate, Paul Ryan (R- Wisc.), has laid out his However, getting hung up on the perils of political inertia obscures aown proposal, which includes restructuring Medicare and Medicaid far more tangible threat. The U.S. economy is weakening: Corporateand a budget that simplifies and flattens the tax code. earnings are declining and manufacturing activity has slowed significantly. The ISM Manufacturing Index was under 50 for threeThere are also conversations going on behind the scenes: Senate straight months, dropping more than 10 points from the beginningFinance Committee Chairman Max Baucus (D-Mont.) and House of 2011—although the September report shows expansion. Similarly,Ways and Means Committee Chairman Dave Camp (R-Mich.), the global Purchasing Managers Index (PMI) has dropped to 48.1Washington insiders say, are having a meaningful dialogue on how to from 57.4 over that time frame. Wall Street analysts expect SP 500tackle tax reform, unemployment benefits and entitlement programs. companies to report a 2.7% year-over-year decline in third-quarterThe goal is to build a “bridge” over the fiscal cliff—albeit quietly at operating profits. If these numbers hold up, that would mark the firstfirst. “These back-room conversations are kept under wraps to avoid drop in quarterly earnings in nearly three years. In terms of top-linebeing used as timber wood along the campaign trail,” Lefkin says. growth, less than 40% of SP 500 companies have beaten quarterly revenue estimates.Congress is likely to allow some cliff components Manufacturing activity has slowed significantly in 2012to take effect, punt on others and reach a ISM Manufacturing JPMorgan Global Manufacturing PMIcompromise on the thorniest issues. 70 65 60Pass or Punt? 55 Index ReadingUltimately, Congress is likely to allow some of the cliff components totake effect, punt on others and, hopefully, reach a compromise on some 50of the thorniest issues. For example, the alternative minimum tax (AMT) 45patch is likely to be renewed, given the number of Americans it impacts, 40Lefkin says. Taxes on dividends and capital gains and current income- 35tax brackets could be extended despite being a point of contention for 30the President where it concerns upper-income households. Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012The payroll tax holiday, which has been in effect for the past two years, Source: FactSet. JPMorgan. ISM. Data reflect 10-year period ended Sept. 30, 2012.will not be renewed, Lefkin says. Congress views it as an opportunity Past performance is no guarantee of future results.to send a message that it is “taking the deficit seriously.”The sequester—a series of congressionally mandated spending cuts As a result, many companies are reluctant to reinvest in theirthat was rather Draconian by design—cannot take effect without businesses and add jobs until they see some clarity on economicplunging the economy into recession, he says. Given that reality, conditions. The fiscal cliff isn’t helping matters. In fact, only 29%he expects Congress to buy some time—at least six months—to of CEOs polled by Reuters expect employment at their companiescome up with a better solution. One idea currently being floated is to grow in the next six months, compared to 34% who expecta “mini sequester” that allows about 20% of the $109 billion in cuts headcount to decline. “Psychologically, it’s already having anto occur. Some sequestration, according to Lefkin, is necessary to impact,” says Migliori, who heads U.S. equity investments for Allianzconvince both parties that there are political consequences for a failed Global Investors. “CEOs don’t like uncertainty when planning their
  3. 3. businesses and making significant hiring and capital-spending Still, it’s important to stay grounded. “There’s a very low probabilitydecisions. It’s created a drag on activity and it will continue to be a of going over the cliff,” NFJ’s Fischer says. “Politicians may be self-drag until we see some progress.” 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 thatLooking overseas, Europe is still steeped in crisis. China’s meteoric scenario, you would want to be in defensive, high-quality stocks.”growth has cooled, renewing chances of a hard landing. This erosionof fundamentals, both at home and abroad, is likely to lead to more Perhaps the biggest danger the fiscal cliff poses to investors isgrowing pains. As such, hard numbers showing economic contraction preventing them from taking risk. Many investors are going to try toare more palpable headwinds than the “what ifs” and worst-case time any acceleration in the economy, which is one of the biggest self-hypotheticals surrounding the fiscal cliff that are currently souring inflicted mistakes they can make. “Once they get to the other side ofsentiment. the fiscal cliff, they’ll see that taking risk is a good thing,” Fischer says. Where to InvestScott Migliori: “I’m not as concerned about the How should investors prepare for what’s next? Coping with wild cardsfiscal cliff transpiring as I am about the market not like the fiscal cliff will be about avoiding companies that stand to losecurrently recognizing how significant the global the most in a bear market. And more importantly, investors need toslowdown is.” 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 bestInvestors should pay attention to macro risks—provided they’re the performers,” Migliori says.right ones. “The market is not discounting weakening conditionsappropriately,” Migliori says. “I’m not as concerned about the fiscal Irrespective of the fiscal cliff, the U.S. is likely to be stymied by sub-cliff transpiring as I am about the market not currently recognizing par growth and low interest rates either due to sluggish economichow significant the global slowdown is. Not to mention its impact on activity or the Fed pinning interest rates near zero. “Historically, incorporate earnings over the next couple of quarters.” Indeed, volatility these periods of financial repression, free cash flow, earnings stability,has been relatively tame amid this contraction with the VIX—the and secular growth—where you can find it—are the best areas of theCBOE Volatility Index, a proxy for fear in the markets—hovering in the market,” Migliori says.15 to 16 range. “Be opportunistic,” he adds. “When the market is getting too optimistic about progress on policy decisions, you need to be willingVIX may not be discounting slowing economic conditions to get more defensive. The flip side is that when it looks like Greece CBOE Market Volatility Index is going into the abyss, you need to take the other side of that trade. 30 You have to be willing to trade tactically around core positions based on the opportunities that present themselves. The market is going to 25 have a fairly wide trading range.” While stock picking will be a difference maker in a market in flux,VIX 20 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 15 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, 10 have the best chance of going up. With a modest 3% growth rate and Jan Feb Mar Apr May Jun Jul Aug Sept Oct 2012 2012 2012 2012 2012 2012 2012 2012 2012 2012 a 3% dividend yield, you’d come out okay.” Among sectors, Fischer Source: FactSet. Chicago Board Options Exchange. Data reflect year-to-date sees energy, particularly oil companies, health care and tech as having through Oct. 4, 2012. Past performance is no guarantee of future results. attractive yields and the ability to grow dividends.So how do investors put headlines about pending doom in Some investors may have some hesitation about dividends in the faceperspective? At Allianz Global Investors, we believe that the fiscal cliff of tax increases. Ostensibly, the tax hike will have some impact on theirshould be evaluated like myriad other confidence killers: a breakup income, but it doesn’t make dividend-paying stocks toxic. On the contrary,of the euro zone, a hard landing in China and last year’s debt-ceiling the fiscal-cliff cost could have little effect on dividend payers’ total return.debate. “There’s likely to be some spikes in volatility between now and Across favorable and unfavorable tax climates, dividend payers havethe end of the year as the uncertainty and fear increases,” Migliori says. outperformed non-dividend payers over long stretches.
  4. 4. Still, the long-term consequences of politicians taking our debt issuestoo 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 Securityand Medicare and things could go from bad to worse. “At somepoint, people will stop buying our bonds,” says Lefkin, a longtimeWashington insider.The structural issues of U.S. fiscal policy notwithstanding, investorsshould focus on more concrete risks to their portfolios. Low interestrates and low growth mean real returns matter. The fact is, centralbankers are all but forcing investors to own stocks to outpace inflation.So don’t fight the Fed. Instead, focus on companies with strongbalance sheets and high, sustainable dividend yields. And rather thantrying to time the market, stay invested and trade tactically aroundcore positions.The bottom line: Heed the warning signs of weak economic dataglobally, expect earnings to decline in the short run and worry lessabout a perfect storm of expiring tax breaks and spending cuts. Thefiscal “if” will work itself out.A Word About Risk: Equities have tended to be volatile and, unlike U.S. Treasuries, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, lesstransparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets. Dividend paying stocks are notguaranteed to pay dividends. Bond prices will normally decline as interest rates rise and can fluctuate due to the credit risk of the issuer.The material contains the current opinions of the author and contributors, which are subject to change without notice. Statements concerning financial market trends are basedon current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not beinterpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as adviceor interpreted as a recommendation.©2012 Allianz Global Investors Distributors LLC, 1633 Broadway, New York, NY 10019, www.allianzinvestors.com, 1-800-926-4456. AGI-2012-10-10-4827

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