FYI | Nov 15 2012
– Cliff scenarios
– Economic implications
– Suggested trading strategies
By Andrew Nelson
While in some ways the resolution of the Presidential elections has removed a bit of doubt about the leadership of the US for the next four years, it has still left us with a hung jury as far as the nation’s fiscal direction is concerned.
Just taking a look at the post election hype shows us the national budget is the President’s, the nation’s and the world’s main concern, but we already know that over the last four years delivering an agreed upon national budget has proved very elusive. And in the meantime, we sit and stare at the prospect of no agreement being reached and the further prospect of the US Government continuing to kick the can down the road. In the meantime, the country will operate with no fiscal policy other than month to month survival. Not the stuff healthy markets are made of.
This lack of a negotiated budget outcome and an ensuing surfeit of policy is what we have come to call the fiscal cliff and with it comes automatic tax hikes, spending cuts and the lack of any sustainable budgetary direction. It’s also not a far stretch to think that another debt downgrade would result. Given the whole world is piled into US bonds; there’s nobody that wants to see this happen.
One thing’s for certain, post this ugly wrangle, neither of the US’s main political parties have a clear mandate after the elections, although Democrats, in maintaining the Presidency and a majority in the Senate, would likely argue otherwise. Still, if history can be used as a guide, a slow and torturous ordeal awaits us in avoiding or safely negotiating passage over this cliff. Given we’re talking about a New Year deadline; it is generally agreed upon that some sort of a run-in with this cliff will happen. The only questions that are being discussed now are: just what sort of descent, how long of a trip down and what sort of landing will the US and the rest of us experience?
The logical extension of these questions for investors are: what will financial markets look like on the way down and post bounce, and where should my money be during and after the trip?
A team at the BlackRock Investment Institute see a toss-up between a pair of fiscal cliff scenarios. Firstly, we’ve got the Sky Dive scenario, which is right over a high cliff with a very short, sharp stop at the bottom. Painful. Or there’s a chance we may well see a last-minute skidding stop at the edge of the precipice that may allow for an arduous, if reasonably safe climb down. Less painful.
In the meantime, BlackRock predicts markets will all start to suffer from a new psychological disorder known as “cliff anxiety” over the next few months and sadly, there’s no pill for this. In the meantime, expect market volatility to increase. Although, there is a slim chance of an early resolution, in which case risk assets would be looking at a nice, hard run.
Let’s let dream time be, however, and turn to the practicalities. Even under a best-case scenario, BlackRock notes the US economy will probably run into some sort of trouble next year. What is looking like a probable hike in payroll taxes combined with a lapse of extended unemployment benefits alone would cut the current 2% gross domestic product growth in half. This would quickly see the appetite for US assets dry up given global investors are already suffering a mild case of cliff jitters on top of a new case of cliff anxiety. On the other hand, the team notes the United States could become the biggest G7 growth story, newly powered by shale oil and gas. That’s if politicians are able to put ideology aside and cross the aisle to compromise.
In the meantime, BlackRock says play defence. Even though we all knew the cliff was coming fast, the team notes market volatility has been low of late, almost eerily low. Have a look at out of the money options to hedge against risk asset sell-offs, or look at jumping in on the relief rallies we’re sure to see.
One thing we do know is the US Federal Reserve will probably keep rates low for quite a while longer, which continues to fan the flames under yield plays, while also boding well for corporate credit and tax exempt municipal bonds. Gold and most commodities also look good, says BlackRock.
Another tip offered is to focus on income rather than capital appreciation in higher-yielding, fixed income investments. The trick will be to keep a sharp eye out for the second when inflation or economic growth starts to push up rates. The team notes some bonds only have a miniscule yield safety cushion built in to make up for price declines. “One strategy is to be relentlessly neutral: Buy undervalued assets and sell similar, but pricier, ones.” says BlackRock.
Another idea is to go global, with BlackRock pointing out that current ultra-loose monetary policies have done a pretty fair job of propping up US stocks. However, this artificial rally has got to lose steam some time and probably sooner rather than later. In this case, the team advises taking a look at emerging markets and yes, even some of the heavily discounted European stocks.
Also keep an eye out for some election dividends, with BlackRock noting the more cashflow rich companies that are still able pay and increase dividends remain among its top global stock picks. This remains true even in the case of a US dividend tax hike. Right now, US payout ratios are at record lows and investors are desperate for income. Something is sure to give.
Lastly, BlackRock advises being smart about the sectors you’re in. Energy companies, especially oil producers and infrastructure are a good place to look, given the likelihood a divided government is unlikely to increase regulation and decrease returns. Healthcare stocks are also expected do well, especially if a deficit reduction deal reached.
On the other hand, stay away from financials, as BlackRock sees them continuing to struggle with low rates and an increasing amount of rules. If it’s a sector you must be in, then look to mortgage lenders, given the leverage to an eventual US housing recovery.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
