While focus remains with the Eurozone, the Fiscal Cliff beast lurks in the shadows
With weak data being released from countries almost daily, in conjunction with an overall negative backdrop of Euro Zone concern, it is safe to say that the outlook for the world economy is far from positive. With these headline-making statistics and concerns there is still one issue that has stayed relatively silent in comparison but has the potential to fully overshadow any other situations we are witnessing: the US ‘Fiscal Cliff’.
The beast awakens…
Investors and economic spectators will, without doubt, have heard mention of the Fiscal Cliff and its disastrous implications, but the focus still does not appear to be priced into the markets and opinion polls show that until recently, the general public has been largely ignorant to this impending situation. However, with specific deadlines looming for a solution to this crisis the markets will soon need to take note and investors must be fully prepared for what is about to unfold, in order to safeguard their investments and even capitalise on this unique opportunity.
Groundhog day for global markets…
The Fiscal Cliff in essence is a group of tax changes and spending cuts being made by the US Government, which can cause a combined reduction of around 4% of US GDP. Should this go ahead without compromise and restructuring, the impact will likely cause the US to enter a deep recession; an unsupportable situation especially considering recent PMI data from the US shows a number below 50 and therefore a country in ‘contraction’ along with other weak indicators such as the current employment situation and consumer sentiment amongst others. The resulting effect on markets will be a deeper decline than experienced during the US Debt Ceiling Crisis of 2011 and the potential for a replication of the disasters witnessed in the recent Financial Crisis.
High government spend targets in the line of fire…
Taking into account all effects of this impending Fiscal Cliff, we believe the most disastrous impact will be experienced as a result of the spending cuts and the dividend tax increase. As a result of this, our recent research focus has been shifted to two specific sectors: Defence and Healthcare; both of which make up a large amount of the US budget.
No light at the end of the tunnel for Defence…
The defence industry is presenting signs of general weakness in light of upcoming negative impacts such as the potential sequestration in the government budget or any resulting compromise, as well as a reliance on current spending and clear threats of decline owing to the ending of the war in Afghanistan. In general the companies are highly leveraged and the larger companies still commit to large dividend payments. The incestuous nature of the industry means any cuts in US spend is felt throughout the industry leading to many companies being left unable to sustain through these conditions with their current balance sheet structure and company model.
US Health Care window dressed despite underlying issues…
The Health Care industry has shown signs of being in even worse shape as a whole. Key metrics in the industry such as uncompensated treatment figures and covered hospital visits shows pressure in the industry in negative areas. Many companies within this industry are reliant not only on the resulting effect of government hand-outs, but also rely on the smooth running of the industry as it stands and run the risk of a strong decline in company operations should there be any sign of downturn or reduced funding.
PuriCassar proprietary research…
Our research programme has generated a list of target companies that will be significantly weakened by any Fiscal Cliff action, which will be represented in the short term by an immediate reduction in their share price, as well as a long term risk of decline in company operations; thus presenting a strong candidate for a short trade. The companies selected when scenario tested against previous economic situations fell further than the S&P, as well as an industry benchmark. More details of these tests will be made available upon request.
Profiting from the Fiscal Cliff effects…
The most effective positions to hold in light of the upcoming events are short (sell) trades on exposed companies, which either have a weak standing or are a ‘bottle-neck’ in the industry that negative implications will inevitably pass through. Examples of these companies are undiversified defence companies who may not be a necessity when budget cuts begin to take place; healthcare companies which are very much reliant on Medicare and Medicaid supplements and sustained government funding; as well as, of course, highly leveraged companies who do not hold a contingency cash holding. Our scenario testing on a list of five companies that represent these factors showed a potential reduction in price of up to 50% in various Fiscal Cliff based scenarios.
Going long for growth during a downturn…
For investors who prefer not to short securities, there are still companies who will rebound strongly out of this situation. Investors must be willing to take a short term ‘hit’ and a period of uncertainty but will return to an increasingly profitable position through the outcome. The companies to focus on are cash-rich entities, preferably those with a history of M&A activity in the markets. Through past analysis of these types of companies, they have shown the tendency to grow strongly in negative situations due to a diversified portfolio and the ability to acquire strong companies at value prices. Without doubt, it is essential for investors to now begin to plan and reshape portfolios in anticipation of any outcome of US discussions, since we have seen from 2011 and various other scenarios that even the mention of uncertainty can have grave effects on markets and portfolio value. In times of highly fluctuating sentiment, it is essential to plan with a ‘better safe than sorry’ mind-set.
By Nicholas Puri
