Will U.S. Fiscal Loose Ends Cause the Markets to Unravel?
January 24, 2013

One would hope that after the United States avoided going over the fiscal cliff there might be some calm in the financial markets, but the forecast still calls for potential choppiness ahead with a good chance of uncertainty because there are fiscal loose ends that still need to be tied up. The U.S. Congress and the Obama administration have addressed the tax side of the equation, but delayed making the tough decisions on the spending side which are also needed if they are to have a fighting chance at tackling the nation’s mounting deficit. And of course, the U.S. still hasn’t closed the debate on the debt ceiling, which could result in another market storm.

Perfect Storm of Policy and Employment Growth

So the questions are: how certain is this oncoming storm and how big will it be? Ed Perks, Sr. Vice President and Director of Portfolio Management for Franklin Equity Group®, is on full alert, but says he’s also finding some likely rays of light.

Ed Perks

First, the challenges. Perks’ fundamental concerns center on two main themes—monetary policy and employment growth.

“When I reflect on monetary policy, not just in the U.S. but globally, to some extent these are uncharted waters, with fairly unprecedented amounts of monetary involvement or activity. I think that does raise some concerns in the market, because of what might be the long-term  unintended consequences, either in the debasement or the devaluation of the currencies, or, ultimately, finding a way to progress out of this level of monetary involvement or easing in order to ultimately see some kind of unwinding of this activity.

“On a micro basis, I think the biggest concern we have is employment growth.”

“On a micro basis, I think the biggest concern we have is employment growth. We’ve had a period of fairly high unemployment, not just in the U.S., but also in many of the economies in other developed markets, particularly in Europe. And I think that’s a real challenge. That’s something we’ve seen  the Federal Reserve recently  tie its monetary policy to in an effort to keep supporting the markets and be as accommodative as possible until that unemployment rate comes down. I think that will continue to be a pretty significant challenge.”

Energizing Housing, Employment and…Energy

These are real and clear concerns, but Perks also sees some stronger threads developing in the U.S. economy. One, to the relief of many, is the housing market. Housing tends to touch different parts of the economy, such as construction, materials, and the retail consumer sector. Housing growth has tended to lead to employment growth—albeit at a slower-than-average pace compared to past downturns—which in Perks’ view, still appears to be sustainable.

Perks thinks the energy sector is another promising area now. 

“We have seen tremendous employment creation and job creation in the energy sector. I think that’s something that can continue in the U.S. We’ve also seen a benefit from lower energy prices. I think that is leading to a bit of a manufacturing renaissance in the U.S.”

The clarity on taxation that came with the U.S. fiscal cliff deal—particularly the taxation of dividends—should also prove positive for equity investors, says Perks. Despite slower economic and sales growth for many companies in 2012, lower long-term interest rates have allowed many corporations to extend maturities and refinance debt at lower costs. Corporate balance sheets as still flush with cash, leading to what Perks believes could be another year of strong profit margins. What might companies do with all that cash?

“As we think about what companies will likely do with free cash flow; we think dividend payments/share buybacks will be a big part of it. That’s where we think the opportunities will continue to be: high-quality companies across a wide range of sectors in the equity market.”

How Low Can They Go?

Given what looks to be a continued low-rate environment, Perks says uncovering opportunities in the credit or fixed income market may be challenging this year. He says the opportunity set in the asset class could be different than it has been in the past, at least for his strategies.

“We have continued to selectively find fixed income market opportunities with an emphasis on situations where there is potential for credit improvement. For example, we recently have been favoring corporate term loans, which we believe can offer attractive current yields, low exposure to rising interest rates in the intermediate and longer term, and positioning that is typically either senior to other debt in a company’s capital structure or benefits from being shorter in maturity.

So, as he sets course for 2013, what is Perks preparing for?

We expect U.S. fiscal issues to be both the biggest challenge and greatest opportunity for investors. Finding a middle ground between government revenue increases and long-term spending reforms amid the coming set of fiscal deadlines may pave the way for greater confidence in the economy with positive implications for both credit and equity markets.”

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What Are the Risks?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in a portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. These securities carry a greater degree of credit risk relative to investment-grade securities. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.