Of all the uncertainties facing investors over the past few years, the U.S. presidential election was among the most significant. And now that the election is over, asset managers and investors alike are assessing the opportunities and risks—such as the looming “fiscal cliff”—within their respective markets.
Given the desire of some investors to reassess the landscape, several of the portfolio managers utilized by South Coast have provided their perspective of how the election’s outcome may affect the taxable fixed-income, municipal bond, domestic equity, and international equity markets.
Taxable Fixed Income
The fixed-income markets reacted strongly to the election results with the yield on the 10-year Treasury note declining by about 13 basis points (bps) to 1.62% the day after the election. While this move occurred as equities posted a sharp sell-off, for the bond market the election removed some uncertainty about the potential direction of monetary policy. This policy has involved a significant amount of quantitative easing under Federal Reserve chairman Ben Bernanke, and Mitt Romney’s platform suggested not only a new Fed chairman but also a potential unwinding of the policy accommodation that has been in place over the past several years.
Bernanke, however, could still step down in early 2014. If this occurs, it is likely he would be replaced by a chairman that shares his views on the benefits that accommodative monetary policies can provide to the economy. For example, a potential successor to Bernanke could be Janet Yellen, who is vice chair of the Federal Reserve and is considered to be a policy “dove.”
With the notion that there may not be much change in monetary policy, the middle of the Treasury yield curve outperformed following the election amid the prospects for further, large-scale asset purchases. Part of this outperformance, particularly as it relates to the long end of the curve, could be that long-term inflation expectations may also eventually increase under the continuation of accommodative monetary policies. Additional asset purchases could also continue to benefit both agency and non-agency mortgage-backed securities.
If the political parties continue to delay dealing with the issues that resulted in the fiscal cliff, and the sequestration in particular (which involves across-the-board spending cuts), the probability of another credit rating downgrade rises substantially. Although another downgrade could lead to further market volatility, it is possible that this turbulence could be mitigated if large investors with a mandate to hold only ‘AAA’ securities receive a “carve out” and retain the ability to hold large amounts of Treasuries.
High Yield and Convertible Securities
Although the two presidential candidates presented stark differences, we do not expect the election outcome to cause a significant shift in the investment environment. The election does, however, remove some uncertainty about policies that are in place or that may be enacted in the near future.
During President Obama’s second term, investors might expect economic policy to resemble that of the president’s first term. The Treasuries rally may also be a reflection of the policies that have produced subpar gross domestic product (GDP) growth over the past several years. These policies are consistent with low interest rates for longer periods of time and continued subpar economic growth. A continuation of the secular shortage of yield should provide important support for credit spread products, particularly investment-grade corporate debt, high-yield bonds, and floating-rate loans.
Another post-election concern is that taxes on dividends and capital gains are likely to increase, making financial assets less attractive. One of the problems is the uncertainty of how far the administration will go in attempting to push tax rates higher. Some preliminary administration plans have called for the long-term capital gains rate to increase from 15% to 20%. Although that would certainly make stocks less attractive, that increase isn’t too severe. On the other hand, a potential increase on the dividend tax rate, from 15% to more than 40% in 2014, could be a major negative, given the uncertainty and magnitude of that policy change.
Given the voluminous coverage of the fiscal cliff, we believe that most of its related concerns are priced into the market. For example, major defense contractors have underperformed the market and are generally valued at eight times earnings—a significant discount to the S&P® 500 Index1 price-to-earnings ratio of about 14 as of early November 2012.
However, there are investable, post-election themes, including certain healthcare segments, such as hospital operators. After all, the election removed a large degree of uncertainty around the Patient Protection and Affordable Care Act, which could represent the movement of billions of dollars over the next several years.
Considering the fiscal cliff concerns, any comprehensive resolution to the issue could create notable opportunities in certain sectors of the high-yield, floating-rate loan, and convertible bond markets. Also, in a status quo environment of low interest rates and further demand for spread products, these asset classes should also continue to benefit from relatively healthy credit fundamentals.
The election’s largest positive implication for the municipal bond market is that rates on federal income taxes will not be declining. For tax-sensitive investors, this resolution should continue the demand for municipal bonds, especially if President Obama continues to seek a reversion of the top tax rate to 39.6%.
The strong demand could persist even if a 28% cap on the interest exemption, which was suggested in the president’s latest budget proposal, comes into play. This is because the yields on most municipal bonds at all maturities are currently higher than those on Treasuries with similar maturities. Therefore, the tax-equivalent yields may remain attractive, regardless of the exact amount of the tax exemption. However, the prospect of a cap on the interest exemption becomes the downside scenario in the market, which, while negative, is still better than a potential elimination of the exemption as may have been a part of Romney’s proposals to eliminate some tax-related loopholes.
From a fiscal support perspective, it’s likely that the federal government under an Obama administration will maintain a relatively large budget when compared to what may have occurred under Romney. Therefore, federal support to state and local governments should remain near its current levels. Although the election provides an additional degree of certainty regarding the Affordable Care Act, it should be noted that after the election, 30 states will be governed by Republicans. This representation could bring more state challenges to the healthcare law or decisions to opt out of parts of the plan, as well as more initiatives to lower state and local tax rates.
There also were election implications for certain states and territories. The election may have had negative credit implications for Puerto Rico, for example. After achieving some fiscal improvements, the territory’s current governor lost his reelection bid, and the new governor might not have similar priorities. In Michigan, voters rejected a proposal that would have mandated emergency managers for fiscally troubled cities, which would have increased the hurdles for these cities to declare bankruptcy.
Conversely, one of the more positive developments was the passage of a California proposal to increase taxes on the highest levels of income. This not only increases the value of the in-state tax-exemption for California residents but also it avoids substantial budget cuts to schools and local governments. The credit rating agencies had expressed concern if voters had not approved this measure.
Overall, the positive implications from the elections should outweigh the negative. This was reflected by the votes that approved more than $30 billion in new municipal bond issues, the largest of which was $2.8 billion for the San Diego school district. These outcomes should create more supply in an environment of strong demand. Voter approval also suggests that they are in favor of the objectives of municipal bond financing and are willing to take on more debt for local improvements.
As a result of the election, our outlook for economic growth is less optimistic. A number of President Obama’s policies, including the Affordable Care Act and its associated taxes, an emphasis on regulation, and likely tax increases on capital gains and dividends, are likely to impede growth. A continuation of anti-business rhetoric is also likely to hinder risk-taking by businesses. Had Governor Romney won the election, more stimulative policies, such as a reduction in the corporate tax rate, may have been enacted and corporations may have repatriated more of their overseas earnings.
Although the election removed a large uncertainty that may have been weighing on corporate decision-making, a number of uncertainties remain. For example, many of the regulations authorized under the Dodd-Frank banking reform bill remain unwritten, and those unknowns continue to hang over much of the banking industry. More generally, it remains unclear what President Obama’s second-term agenda will be.
In addition, these impediments are coming at a time in which economic growth and growth expectations have been declining. Corporate earnings also appear to have peaked, after three and a half years of expansion. Sales growth has declined from double digit levels as recently as 2011 to low single digit levels currently. With more than 40% of corporate earnings originating overseas, a reacceleration in global GDP would likely be necessary to improve the earnings outlook.
Given this environment, we have not altered our views on sector performance, and we continue to invest in companies that have, historically, demonstrated an ability to prosper in difficult times. In particular, we consider companies that are exhibiting resilience via strong product launches, for example, or via exposure to other relatively strong sectors or customers. At the same time, we continue to look for areas of opportunity where valuations are attractive, and where fundamentals are sound.
From an international viewpoint, the effects of the election on overseas industries and companies are less apparent. It’s still the overall global macroeconomic environment that is dictating ebbs and flows. Given that the election did not change the political makeup of Congress or the White House, we are not changing our posture, which is relatively neutral on whether to emphasize cyclical or defensive stocks.
There are clearly major issues that must be addressed in the United States that will have an unambiguous impact on global growth prospects, the largest being decisions related to fiscal policy. These issues are not new; they were merely postponed until after the election.
We are not building our portfolio around handicapping how these discussions will work out. While we may adjust once the direction is clear, at this point our portfolios are focused on companies that are improving their cash flows and earnings, are not overly leveraged, and are undervalued, based on our assessment of their longer-term prospects.
One area under the microscope now is U.S. health care. While we own a number of global pharmaceutical stocks, the exposure in the international equity portfolios to healthcare providers and insurers in the United States is very limited. In the energy arena as well, some of the policy discussion is more pertinent to domestic companies than to the global integrated oil companies in our markets. In both sectors, however, there may be some beneficiaries overseas that provide equipment into what may be favored industries here in the future, but at this point it’s not clear cut.
Last, one must consider the potential path of the U.S. dollar vis-à-vis the various currencies in which we invest. Since most major economies have been growing below capacity, there has not been a strong reason for their currencies to appreciate. The major influence strengthening the dollar over the past few years has been its stable, safe-haven status. Despite the issues facing our new government, we don’t see any reasons in the short term to disrupt this effect. Until one sees either sustained growth in Japan or Europe or a cessation of eurozone-breakup worries, the major foreign currencies are unlikely to offer a more stable or higher-yielding alternative.
Certain emerging market currencies should continue to provide strength based on their solid financial situations and current account surpluses, but we are not anticipating any major directional changes in the dollar relative to these currencies as a result of the election results. However, if our fiscal situation is not addressed and credit rating agencies downgrade the United States, the dollar may slip until the situation is resolved.