Waddell & Reed

Portfolio Perspectives

U.S. fiscal cliff concerns don’t outweigh global potential

Story Highlights

  • Despite the fiscal cliff, we see several areas of support for the U.S. economy.
  • Dividend-paying sectors may feel brunt of possible tax increases on capital gains and dividends.
  • We think several factors are likely to support profit margins in foreseeable future.
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Investment Team

Manager Name

Michael Avery

Co-Portfolio Manager

Manager Name

Ryan Caldwell

Co-Portfolio Manager

Investors have turned their attention to the economy again after the resolution of the U.S. elections. All eyes again have focused on the fiscal cliff, which represents the impact of a number of tax increases and spending cuts set to go into effect at year-end. While concerns remain, we think there are several areas of support for the U.S. economy and potential investment opportunities here and abroad.

Balancing the fiscal cliff views

A combination of automatic tax increases and federal government spending cuts has become widely known as the fiscal cliff. The elements of the fiscal cliff include the Bush-era tax cuts, which also affect the tax rate on dividend payments; the payroll tax cut; extended unemployment benefits; and a number of other provisions. We estimate the potential impact at about $500 billion if Congress does not act to change the current provisions. While a huge amount, it still doesn’t sound like much for a U.S. economy that approaches $16 trillion. So we think the key issue is the potential impact on future economic growth if U.S. policymakers do not resolve these issues.

With the U.S. economy growing at about 2 percent, tax increases and spending reductions that could represent 3 percent or more of the economy might flatten growth in gross domestic product (GDP). That would not be a popular outcome. We think Congress is likely to allow some fiscal-cliff elements to expire, including the payroll tax reduction and the extended unemployment benefits. We expect more focus on resolving middle-class income tax rates and the automatic spending cuts set to take effect on Jan. 1.

If there is a compromise that avoids the deep automatic spending cuts — referred to as “sequestration” — and maintains the Bush tax cuts for the middle class, the impact could be moderated, depending on the timing of the deal. That could mean GDP growth would remain positive in 2013.

Despite the fiscal cliff concerns, we think there are several areas of support for the U.S. economy. The labor force is growing at about 0.6 percent per year, productivity is supported by a focus on new technology, access to low-cost energy is expanding and the country offers relatively good infrastructure with the oversight of a strong legal structure. We think these factors could make the U.S. an attractive country to locate a manufacturing operation. In our view, that also means there can be more upside to future U.S. GDP growth than many now believe.

The Fund for the last 10 years has focused on growth opportunities outside of the developed markets. We continue to think there are many opportunities to invest in countries with growing middle-class populations and incomes. While flat to negative GDP growth in the U.S. would have a negative impact on other parts of the world, we think significant growth still is likely in key countries. For example, we estimate GDP growth in China at 6.5 to 7.5 percent next year and India at 5.0 to 5.5 percent. We also expect a growth rate above 5 percent across the member countries of the Association of Southeast Asian Nations.

Investors have focused in recent months on the developed markets and the viability of growth in the U.S., Europe and Japan. In terms of the world’s population, about one person in seven lives in the developed world. We continue to believe that means there are significant opportunities in the emerging markets through companies that provide goods and services for this emerging middle class.

Tax rates could affect sector choices

Investors are adjusting their expectations for tax rates following the U.S. elections, and that raises questions about which sectors to consider for equities. We think sectors that have drawn recent investor interest because of stable dividend payments — such as utilities, telecom and consumer staples — may feel the brunt of expected tax increases on capital gains and dividends. In addition, many of those shares have become highly valued relative to other equities, meaning investors have been paying high prices for the dividends they receive.

We think many of these dividend payers are likely to be vulnerable as investors look to reallocate away from expected tax hikes. While the sector weightings in the Fund typically are a by-product of our stock selection process, rather than a specific sector focus, we think there are opportunities in areas including technology, energy, financials and pharmaceuticals. We think many management teams have shown discipline in terms of capital allocation and note that stock buybacks could increase if the tax rate for dividends increases.

As we look at the energy sector in particular, we would note that it hasn’t been a great performer for the year to date. But we do see potential in integrated oil companies with high free cash flow. We believe demand for energy will grow over time, which could push the value of the integrated oil companies higher. They also could benefit from higher energy prices that may be the result of increased demand.

Slow growth puts focus on margins

The current high level of U.S. corporate profits has raised concerns that a decline to levels closer to historical averages is likely. We also expect that, at some point, a reversion to the mean is likely. But we think the key issue is how much longer profits stay at high levels and then how fast they revert to the historical averages.

From that standpoint, we think there are several key factors that are supporting margins now and are likely to continue to do so in the foreseeable future.

  • Globalization means many companies have moved labor from the U.S. to China or countries in Southeast Asia, and have made major cuts in labor costs as a result.
  • Automation in manufacturing has increased significantly, aiding productivity and boosting margins.
  • Companies in general are not hiring or investing in expansion because of concerns about future government policies and economic growth; their focus is on protecting their current business.

We do not expect a substantial decline in margins as long as the U.S. economy continues its slow pace of growth. Companies generally are not spending on hiring, inventory or expansion, and instead are protecting existing margins. When economic growth picks up and companies begin to generate more revenue, we expect corporate spending also will increase and margins then could revert closer to historical levels.

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Nov. 13, 2012, and are subject to change due to market conditions or other factors.

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