In a webcast that addressed the fiscal cliff and its impact on the financial markets, the message was clear.
“No matter what deal is reached, we will face some sort of fiscal drag,” said Alec Young, global equity strategist from S&P Capital IQ, in a webcast sponsored by TD Ameritrade on Monday.
But that drag, Young points out, comes at a time when various factors may help offset it – namely stabilization in Chinese growth which should help the region achieve a “soft landing” as exports increase, positive analyst projections of an EU recession ending in the second half of 2013, and the Federal Reserve’s ramping up of its quantitative easing program to keep rates low.
“The expectation is that if nothing is done, mild recession will result next year, with pain early in the year,” Young said. “But recession is not a done deal.”
Instead, S&P Capital IQ, a multinational financial information provider and a division of Standard and Poor’s, expects Washington to contrive a short term deal to blunt the fiscal pain, coupled with an agreement to come back next year to deal with tax and entitlement reform, according to Young.
“Our base case is that [Washington] will get something done, and so we are sticking with emerging market equity and dividend players,” Young said.
The case for emerging market equity and dividend players is that they will outperform other asset classes, even if the U.S. goes over the cliff, according to Young.
Allure of Dividend Players
“There is a long term trend of high-dividend stocks outperforming low-dividend stocks, even amidst higher tax rates,” Young said. “And with corporate cash at all-time highs, the percentage they’re using to pay dividends is only 36 percent compared to [around] 50 percent on average.”
While pundits argue that a rush to high-dividend stocks will push its price to a point where it becomes overvalued, the argument on the other side is that with the Federal Reserve keeping rates low and snapping up bonds, bond yields will remain low and relatively unattractive.
“In a low rate world, investors will continue to clamor over [high-dividend stocks],” Young said. That’s because yield-hungry investors often find the added income generated by dividend players very appealing.
Emerging Market Equity
While emerging markets have lagged behind the US market all year, they’ve begun to catch up and are performing very well as the year is ending.
Many equity analysts see this continuing into 2013, supporting a bullish call in emerging market equities.
“With the Fed ramping up its QE program, there is increased liquidity in the financial markets,” Young said. “Usually emerging markets tend to fare better as you get easy money from central banks [because of stronger trend growth].”
Emerging markets are also trading at a discount of 10.7 times of earnings, in comparison to the S&P 500 trading at around 16 times earnings.
While low valuation without a catalyst can be a value trap, Young suggests this is not the case.
“Growth rate, export data, manufacturing data, and retail sales have shown positive signs, all indicating a trough in China,” he said. “The China soft-landing case should be supported once the effect of its leadership transition is fully settled.”
With macroeconomic data pointing towards significant advantages overseas, particularly in China, certain sectors in the U.S. are receiving added focus.
In particular, S&P Capital IQ’s holdings are overweight in the industrial sector as well as the healthcare sector, according to Young.
“We feel that the effects of China’s data have not yet been fully integrated, and that there’s still room for it to affect industrials positively,” he said. “Healthcare is more of a defensive play, because its earnings are less volatile and dependent on the fiscal cliff.”
Despite positive signs from overseas markets and a fiscal cliff that is likely to reach some kind of compromise, according to S&P Capital IQ, there remains a potentially larger concern among investors.
“The big hurdle is the $16.4 trillion debt ceiling that is rapidly approaching,” Young said.
The legal limit for how much the U.S. can borrow will be reached at around February or March, according to the Congressional Budget Office. This means that even if an agreement is reached over the fiscal cliff before January 1, there is the potential of another standoff between Democrats and Republicans over whether or not to raise the debt ceiling.
Young admits that the U.S. needs to see something taking shape next month in regards to talks over the debt ceiling, otherwise the U.S.’s AA credit rating may experience yet another downgrade. This could result in raised borrowing costs, which would in effect hurt prices of outstanding bonds.
“The deeper we get into January, the more difficult it becomes,” Young said. “If by late January there is still no progress, it would be a very negative situation, and would be a big shock to people.”
Credibility in the Markets
For the U.S. markets to have credibility entering 2013, there needs to be credible commitment from Washington to deal with fiscal consolidation in regards to tax and entitlement reform.
“Right now, business spending is very weak, because companies don’t have a sense of what the tax environment will be like next year,” Young said. “Companies need long term visibility of what tax rates are going to be before they commit to spending.”
If Washington can overcome partisan gridlock, then there will be room for P/E multiples to expand, and the potential of a secular bull-market, according to Young.
“We were fairly positive on stocks in 2012, and continue to be in 2013,” Young said. “Uncertainty from many moving parts leads us to be less positive, but our overall theme has not changed. That’s because in a low-rate environment, equity income is as important as ever.”