The U.S. “fiscal cliff” clock is ticking loudly, and so far U.S. politicians haven’t been able to cooperatively silence it. A sweeping roster of automatic spending cuts and tax hikes remain set to go into effect at year-end with what could be detrimental economic consequences.
This week, our Templeton Global Equity Group (TGEG) provides a collective perspective of potential events as we count down toward the fiscal cliff deadline, and possible implications for the savvy investor. Key aspects from the TGEG point of view:
- In its entirety, the fiscal cliff is estimated to reduce the U.S. federal budget deficit by 4%-5% of gross domestic product (GDP) in FY 2013 ($670 billion), a severe tightening of fiscal policy which, if no deal is struck, would involve sweeping tax increases and mandated spending cuts across all budget items.
- In our opinion, it is doubtful that the fiscal cliff will fully come to pass as a number of the provisions within the cliff enjoy bipartisan support for extension or renewal.
- The larger the fiscal drag, the worse for equities in the near term. The more cyclically leveraged regions and sectors would be most impacted by the fiscal cliff.
- Risk assets do not like uncertainty, creating selective investment opportunities for disciplined bargain hunters.
- Longer term, the U.S. government must proactively address its fiscal position or rising interest rates will become a secular headwind for equity markets.
[php function = 1] With the Washington status quo intact after the November U.S. elections, we doubt there have been any major, ground-breaking shifts to the key positions of the various negotiating parties. While we, at Templeton, remain highly skeptical of any process whose successful outcome hinges on genuine bipartisan cooperation, recent experiences appear to have softened political rhetoric and encouraged at least a degree of pragmatism as all sides position themselves for the negotiations.
Investors have experienced the fallout from partisan gridlock all too often in recent years. When political dysfunction derailed the debt ceiling negotiations in the summer of the 2011, the U.S. lost its coveted AAA credit rating from Standard & Poor’s and more than $12 trillion of global equity market wealth disappeared.1 The American public has just lived through one of the most negative election cycles in recent memory, and patience with political grandstanding has worn thin. While we view the conciliatory headlines emanating from Washington in recent weeks with cautious optimism, we also realize that a return to business as usual would not mark the first time that policymakers have engaged in a bit of opportunism at the cue of public opinion. [perfect_quotes id=”1436″]
The Devil is in the Details
To prevent a potentially recession-inducing fiscal contraction, some compromise on revenue, spending and entitlement reforms must occur. Congress’s current “lame duck” session won’t make this process any easier; however, a grand bargain need not necessarily be struck in the waning weeks of the year. It remains to be seen how deferral of a comprehensive deal would be taken by ratings agencies and financial markets, but given the constraints on the legislature in this transitional period, any deal that immediately reduces the impact of the fiscal cliff in 2013 may be deemed sufficient in the short term, particularly if it lays the groundwork for comprehensive reform once Congress reconvenes in 2013.
On the revenue side, this means that Democrats, who would prefer to see statutory tax rates for the wealthiest Americans revert to levels predating the prior (Bush) administration, may for the time being have to settle for raising effective rates through the closure of tax loopholes and capping or limiting of deductions. On the entitlement side, it means that Republicans, who were pushing for $1.5 trillion of entitlement savings, may have to settle for roughly half of that, or a level of savings below the level of tax revenue raised. Other technical issues like automatic sequestration, which Democrats are attempting to fund, and the debt ceiling, which Republicans are attempting to contain, are being monitored closely by ratings agencies and could incite volatility if not negotiated carefully.
We have been experiencing sustained high levels of economic and political uncertainty for several years now. Such an environment leaves little room for error, and as we’ve seen in past episodes, any failure on the part of politicians to meaningfully act will be subject to the swift censure of financial markets. None of the potential tax and spending changes guarantee an economic recession or market correction; however, they must not take investors by surprise. To a large extent, uncertainty on this issue has already been taking its toll. A recent survey found that the fiscal cliff has impacted the capital expenditure and hiring plans of roughly two-fifths of U.S. companies, with industrials particularly cautious.2 Tax harvesting strategies are also coming to fruition, with investors locking in capital gains at current rates and companies paying out special dividends ahead of expected tax code amendments. Regardless of how exactly the fiscal cliff is resolved, investors should be prepared for the economic impact of higher taxes. [perfect_quotes id=”1432″]
Viewing the investment landscape from a top-down perspective can offer a valuable and sobering second look at the market’s challenges and opportunities; yet, at Templeton, our investment process remains largely independent of macroeconomic variables. In fact, our long-term, bottom-up approach by its very nature de-emphasizes economic cycles and trends, ascribing more importance to the company-specific valuations and fundamentals that we can analyze with greater confidence. Yet, as Sir John Templeton once noted, “too few people focus on the opportunities that problems present.” When macroeconomic turmoil results in the indiscriminate downgrade of a region or sector, bottom-up values often result.
We recognize this will likely be a drawn-out process. The fiscal cliff will come and go, but the United States’ debt challenges are entrenched. Most plausible scenarios suggest that the U.S. will continue to run a budget deficit for at least the next 10 years. Policymakers’ failure to address these challenges directly will likely result in additional ratings downgrades and punitive interest rates, to the detriment of equity markets. At Templeton, we will continue to approach the region with a value-oriented, long-term framework, selectively spotting opportunities as they arise and potentially shifting more investment into the U.S. should bottom-up valuations and fundamentals warrant fuller engagement.
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What are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
1. Source: Bloomberg L.P., based on changes in the value of the WCAUWRLD Index (Bloomberg World Exchange Market Capitalization USD) 7/7/2011–10/4/2011.
2. Source: International Strategy & Investment, ISI Company Survey Update, 11/19/12.