The fast-approaching fiscal cliff is causing some money managers to abandon traditional year-end portfolio moves in order to play it safer while others already are focusing on the next big crisis: when Washington tackles the federal budget deficit.
“We've gotten more cautious,” said Hersh Cohen, co-chief investment officer, managing director and senior portfolio manager with ClearBridge Advisors LLC in New York, which manages $60 billion mostly equities.
“It's clearly having a huge effect on businesses, and it's affecting confidence.”
“We're all going to be living day to day on what's coming out of Washington,” said Russ Koesterich, chief investment strategist for New York-based BlackRock Inc., which has $3.7 trillion in assets under management.
Under the fiscal-cliff scenario, almost every tax cut enacted since 2001 will expire Dec. 31. At the same time, automatic, across-the-board cuts in defense and other domestic spending that Congress adopted in 2011 will kick in, as part of an agreement to tackle the federal budget deficit. The ensuing battle over cutting the deficit could paralyze the government and the industries that rely on it for funding.
Many money managers are optimistic that a deal on avoiding the fiscal cliff will come, although markets are likely to remain volatile through at least March, as Congress tackles raising the nation's debt ceiling.
That's the bigger worry, according to Markus Schomer, chief economist at PineBridge Investments LLC, New York, who noted the U.S. is second only to Greece in terms of national debt as a share of gross domestic product. “The biggest risk is the event risk of a government shutdown, if there are protracted negotiations. Fiscal wall is a better description.”
To money managers, compromise on federal spending cuts and tax increases sounds a lot better than inaction. “What's holding us back now is the uncertainty, nothing else. This isn't an economic problem, it's a political problem,” said Mr. Schomer. “What investors care about is the path — is it credible? The good thing is that it will be decided in the next four to six months. As long as the next 10 years are laid out, I think the market will move on. Now that everyone's waking up to the fiscal cliff, I am almost ready to tell them to ignore it, because you might just miss what comes after it. In our own portfolios, we're neutral risk.”
PineBridge manages $69 billion.
“It's not as if we are suggesting people stay out of the market,” said Alan Levenson, chief economist at T. Rowe Price Associates Inc., Baltimore. “We tend to take a longer view of the market, both equities and fixed income. We'll keep the long-term view and we're expecting policymakers to avoid a train wreck.” T. Rowe had about $574 billion under management as of Sept. 30.
Added Mr. Koesterich: “If we can avoid the fiscal cliff, then we're reasonably optimistic. We think that stocks and other riskier assets can appreciate further. If it's temporary, you may want to use the volatility to your advantage. It may represent a buying opportunity.”
Until there is a clearer picture of a political compromise taking shape, Mr. Koesterich advises investors to build portfolios that can withstand “a prolonged period of slow growth” in the U.S., including U.S. megacap stocks, technology stocks in companies well positioned for international markets, and any international growth opportunities.
For long-term investors, “rationality will prevail,” said Joseph Tanious, market strategist at J.P. Morgan Asset Management in New York. “You just need to be prepared for a bumpy ride.” J.P. Morgan manages $1.4 trillion.
Hedge fund manager Clint Carlson, president and chief investment officer of Carlson Capital LP, Dallas, is optimistic about resolution of the fiscal cliff and stressed: “The big point for us is to correctly interpret the dynamics of the stock market as the end of the year approaches.
“Traditional and hedge fund managers alike already have gone from being out there looking for more deals, to pulling in their horns, trying to protect their (performance for the) year,” he said.
While “window-dressing” portfolios toward year-end — clearing out poor performers and keeping winners — is normal practice for most investors in most years, Mr. Carlson said uncertainty about taxation levels may lead taxable investors to take the opposite course of action: sell best-performing assets this year to avoid capital gains and sell laggards next year in order to claim losses as deductions.
Carlson Capital managed $6.4 billion as of Oct. 31 in a broad spectrum of hedge fund strategies.
There might be more selling pressure these days, but it's important to “remain calm” and remember that, even if tax rates spike in 2012, fixes achieved in 2013 can be applied retroactively, said J.P. Morgan's Mr. Tanious. “It would rattle the market, but it could be fixed.”
He is more concerned about the possibility of uneven tax hikes causing a greater divide in investment choices, and driving investors away from dividend-paying stocks, which “the spread between dividend and capital gains tax rates might put some selling pressure on. It's really the dividend tax rates that are the bigger concern. The capital gains tax, which would only rise to 20% from 15%, is still relatively one of the lowest tax rates out there.”
Economists worry about what will happen to an already sluggish economy if the bigger tax and budget decisions get pushed too far into 2013, but UBS AG economist Sam Coffin, New York, thinks there could be as much as 3% growth from any kind of deal. “Even a temporary fix would be an improvement over what's been hanging over us,” he said. UBS Global Asset Management last month reported having $631 billion in assets under management as of Sept. 30.
Mr. Levenson of T. Rowe Price is less optimistic, predicting delayed decisions will cause about a 1.4% drag on GDP, and bring slow growth for the first half of 2013.
“The more you get into next year, you run a reasonable risk of recession,” worried BlackRock's Mr. Koesterich. “If it looks like it's heading that way, investors do want to get more defensive, including raising their allocation to fixed income, even though it's expensive.”
And institutional investors may then want to think about lowering their exposure to the U.S., he said. “If you go over the fiscal cliff, the U.S. is no longer a safe haven.”
Even if a compromise is reached on taxation and federal spending cuts, money managers are not so sure about the behavior of other investors.
“Tax selling has the potential to change everything this year,” Mr. Carlson said, adding that his research staff is monitoring the behavior of family offices and other taxable high-net-worth investors to get a read on whether they will unleash a big sell-off before year-end. He's also keeping a close eye on private equity managers “who are making tax-driven moves now.”
“The market went from complacency to the start of fear,” agreed Mr. Cohen of ClearBridge. “The fact that we're shaken out of complacency is good; it helps the value investor, that's for sure. Our choice was to stick with really quality stuff.”
Christine Williamson contributed to this story.
