Views from the cliff's edge
By Sonita Horvitch | 10/12/12

Editor's note: With the U.S. election over and legislators now deadlocked over fiscal policy, Morningstar convened a U.S. equity roundtable that discussed the outlook for the world's largest stock market.

About the Author
Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

Our panellists:

 Janet Navon, managing director, director of research and member of the U.S. investment team at New-York-based Epoch Investment Partners, Inc. Navon employs a value approach. Epoch's mandates include managing assets for Toronto-based CI Investments Inc. Epoch is responsible for CI American Value and CI American Value Corporate Class.

 Darren McKiernan, vice-president and portfolio manager at Invesco Canada Ltd. Also a value manager, McKiernan is a member of the Trimark global equity team responsible for U.S. equities. He is a co-manager of Trimark Global Fundamental Equity and Trimark Global Fundamental Equity Class. He is lead manager of Trimark Global Dividend Class.

Glenn Fortin, portfolio manager at Beutel Goodman & Co. Ltd., a value-style firm. Fortin is a member of the global team, with his focus on U.S. equities. The team's mandates include Beutel Goodman Global Equity and Beutel Goodman American Equity.

They spoke with moderator and Morningstar columnist Sonita Horvitch, whose three-part series this week continues on Wednesday and concludes on Friday.

Q:The S&P 500 Index had a total year-to-date return to recent close of 13.5% in U.S.-dollar terms. What were the drivers of this?

Navon: In each quarter, they were dramatically different. It was more of a "risk on" in the first quarter. The second quarter was "risk off" and then the third quarter was "risk on" again. In the second quarter, the rush to stocks with dividend yields drove performance very dramatically. The dividend stocks were clearly bond surrogates. During the last 12 months, we saw those sectors that were cheap get cheaper like technology, particularly more mature technology. Sectors like utilities and consumer staples became much more expensive. If you look at U.S. equity-market valuation, as defined by the S&P 500 Index, it's trading at about 14 times earnings, but the differences in valuation within the market are quite extreme.

Fortin: The market is not expensive. It's fairly valued. But the ranges in valuations across the different sectors are more pronounced than we've seen in a long time. We see value in industrials, financials and health care, for example.

U.S. market on pace for a strong 2012
2012 YTD*2011201020092008
S&P 500 Total Return (C$)
S&P 500 Total Return (US$)
*To Nov. 30

McKiernan: The cyclical stocks are generally cheap.

Fortin: Yes.

Navon: There's a dividend yield on the index of a little over 2%. Earnings disappointments have been severely punished lately.

Janet Navon

Fortin: There's a lot of uncertainty globally. If there's any hiccup or blip in an individual company, the market just exits the stock.

Q:What are the main post-election issues?

Fortin: It has brought the U.S. fiscal cliff to the forefront.

McKiernan: Investors are struggling with this. Will the politicians get their act together in time? If I can use a Winston Churchill quote: "We can always count on the Americans to do the right thing, after they have exhausted all the other possibilities." On the flip side, if they don't do anything, the capital markets will force them into doing something and quickly. Sequestration or across-the-board public-sector spending cuts would hit the economy.

Navon: Sequestration was designed to be the mechanism that forced everyone to the table. Both sides of the aisle fear this significantly. Sequestration doesn't need to happen on Jan. 1. It doesn't impact the economy immediately. What does are the elimination of the Bush tax cuts and the increase in the employee-payroll-tax rate. These are Jan. 1 events.

Q:What does this mean for U.S. economic growth?

Navon: The potential drag on GDP is about 3%, if everything goes off the cliff. U.S. GDP growth is currently about 2%, so this is unpalatable. From what we hear in Washington, it looks as if the tax cuts will be extended for at least a few months. There is likely to be a compromise regarding the tax-cuts expiration for the wealthy. The payroll tax holiday will likely be allowed to expire. Based on what we think the compromises will be, there will be an 80-basis-point drag on real U.S. GDP growth (nominal growth adjusted for inflation).

Darren McKiernan

McKiernan: Both sides seem committed to avoiding Armageddon.

Fortin: The news around the fiscal-cliff issues will drive the U.S. equity market. It will be volatile from now until year-end.

Navon: One of the concerns around this uncertainty is that we have seen a real decline in CEOs' capital-spending intentions.

McKiernan: Businesses are using this as a stick to get politicians to move on these fiscal matters. They're hoarding cash. Their balance sheets are strong. You're seeing some U.S. corporations issuing short-term paper below U.S. treasury-bill rates.

Navon: It was like that in the early '80s, which was the last time we thought that we were going down the hole with government debt.

McKiernan: Now, the world is saying that these well capitalized big U.S. multinationals are in better shape from a balance-sheet standpoint than the government.

Fortin: Many companies are better run today than they were three or four years ago, because they have had to be. They have cut costs.

McKiernan: Prior to the financial crisis, back in 2007, companies leveraged their balance sheets and bought back a lot of their own stock. They're not doing that this time. You're seeing dividend payout ratios starting to move higher.

Navon: Corporations are being opportunistic in their share buybacks. We may also see more special dividends from companies as we go into the yearend, with the uncertainty about dividend tax rates going into 2013.

Fortin: In the last few weeks we've had a few announcements. For example, Carnival Corp. CCL announced a special dividend in mid-November.

Q:Further challenges or pluses for the U.S. economy?

McKiernan: Systemically high unemployment, which has been a problem for some time.

Navon: The official unemployment rate is 8.7%. The U.S. housing market has stabilized. Of the job losses, some two million were in construction. The improved housing market and reconstruction after Hurricane Sandy should boost this employment.

Fortin: Generally, we've been seeing opportunities in companies that will benefit substantially from an improvement in the domestic economy. Some major U.S. banks are an example.

Glenn Fortin

Navon: The banks are stronger from a capitalization standpoint. Fewer of them have to shrink to improve their capital ratios. But it will be harder than ever before to make money in the banking business. There is also still some regulatory uncertainty.

Fortin: The banking game has changed. Growth is the question.

McKiernan: Longer-term, the U.S. economy from a demographic standpoint is much healthier than Europe. The U.S. also has good labour flexibility. Americans remain among the most innovative and entrepreneurial-minded people in the developed world. Google Inc. GOOG, which I own, was not around 15 or 20 years ago.

Navon: On the energy front, we have shale oil and shale gas. The latter is even cheaper.

McKiernan: U.S. management teams that I speak to say that this is going to redefine the industrial competitiveness of the United States. This potential low-cost energy source is a plus.

Navon: The United States still remains a major agricultural centre.

Fortin: Finally, we should emphasize that this low-interest-rate environment is not going to change any time soon. The U.S. Federal Reserve Board has made it clear that we have a pretty long runway here. That provides the consumer with some incentive to spend and corporations to continue to try to spend, when the confidence comes back with respect to all the political issues.

Photos: www.paullawrencephotography.com

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