1. 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
gross domestic product (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 Equities U.S. of Allianz Global Investors.
October 2012
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
■ ■ Investor fears about going over the “fiscal cliff” may be exaggerated. Our experts believe the chances of
it happening in its entirety are slim.
■ ■ A more tangible threat is the weakening U.S. economy. Earnings are declining, manufacturing has slowed,
and companies may reduce reinvestment and hiring.
■ ■ Fundamentals are eroding both at home and abroad: Europe is still steeped in crisis and China’s growth
has cooled.
■ ■ The market may not be discounting weakening conditions appropriately; the global slowdown may hurt
corporate earnings in the near term.
■ ■ In this slow-growth environment, focus on companies with strong balance sheets and high, sustainable dividend
yields. Rather than trying to time the market, stay invested and trade tactically around core positions.
Scott Migliori
CIO Equities U.S.
Allianz Global Investors
Ben Fischer
CIO, Portfolio Manager
NFJ Investment Group
Viewpoints
Fiscal Cliff Obscures
Fading Fundamentals
Peter Lefkin
Head of External and
Government Affairs
Allianz of America
continued
www.allianzinvestors.com
2. However, like most things in Washington, crisis compels action—
even if that means a frenzied, eleventh-hour resolution. “Look at the
TARP [Troubled Asset Relief Program] 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.
Congress is likely to allow some cliff components
to take effect, punt on others and reach a
compromise on the thorniest issues.
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 Purchasing Managers Index (PMI) has dropped to 48.1
from 57.4 over that time frame. Wall Street analysts expect SP 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 SP 500 companies have beaten quarterly
revenue estimates.
Manufacturing activity has slowed significantly in 2012
30
35
40
45
50
55
60
65
70
Source: FactSet. JPMorgan. ISM. Data reflect 10-year period ended Sept. 30, 2012.
Past performance is no guarantee of future results.
JPMorgan Global Manufacturing PMIISM Manufacturing
Sep
2012
Sep
2011
Sep
2010
Sep
2009
Sep
2008
Sep
2007
Sep
2006
Sep
2005
Sep
2004
Sep
2003
Sep
2002
IndexReading
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. equity investments for Allianz
Global Investors. “CEOs don’t like uncertainty when planning their
3. 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.
ScottMigliori: “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.”
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—the
CBOE Volatility Index, a proxy for fear in the markets—hovering in the
15 to 16 range.
10
15
20
25
30
Oct
2012
Sept
2012
Aug
2012
Jul
2012
Jun
2012
May
2012
Apr
2012
Mar
2012
Feb
2012
Jan
2012
Source: FactSet. Chicago Board Options Exchange. Data reflect year-to-date
through Oct. 4, 2012. Past performance is no guarantee of future results.
VIX
CBOE Market Volatility Index
VIX may not be discounting slowing economic conditions
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 investorsmayhave some hesitationaboutdividends in theface
oftaxincreases.Ostensibly,the taxhike willhave some impacton their
income,butitdoesn’tmake dividend-payingstockstoxic.On thecontrary,
the fiscal-cliffcostcouldhave little effectondividendpayers’ totalreturn.
Acrossfavorable andunfavorable taxclimates,dividendpayers have
outperformednon-dividendpayersoverlongstretches.
![However, like most things in Washington, crisis compels action—
even if that means a frenzied, eleventh-hour resolution. “Look at the
TARP [Troubled Asset Relief Program] 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.
Congress is likely to allow some cliff components
to take effect, punt on others and reach a
compromise on the thorniest issues.
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 Purchasing Managers Index (PMI) has dropped to 48.1
from 57.4 over that time frame. Wall Street analysts expect SP 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 SP 500 companies have beaten quarterly
revenue estimates.
Manufacturing activity has slowed significantly in 2012
30
35
40
45
50
55
60
65
70
Source: FactSet. JPMorgan. ISM. Data reflect 10-year period ended Sept. 30, 2012.
Past performance is no guarantee of future results.
JPMorgan Global Manufacturing PMIISM Manufacturing
Sep
2012
Sep
2011
Sep
2010
Sep
2009
Sep
2008
Sep
2007
Sep
2006
Sep
2005
Sep
2004
Sep
2003
Sep
2002
IndexReading
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. equity investments for Allianz
Global Investors. “CEOs don’t like uncertainty when planning their](data:image/gif;base64,R0lGODlhAQABAIAAAAAAAP///yH5BAEAAAAALAAAAAABAAEAAAIBRAA7)