US Fiscal Cliff: PIMCO's Post-Election Forecast

(November 9, 2012) – What does the Presidential election outcome mean for the United States economy’s ‘fiscal cliff’?

Pacific Investment Company Corporation (PIMCO) aims to answer that question in a newly published paper by the asset manager’s Libby Cantrill and Josh Thimons. Even though the election results are only just final, market participants are pondering this area of uncertainty, PIMCO believes. (The so-called cliff is the point when a wave of taxes that had been temporarily repealed to try and stimulate the global economy, along with an array of other measures, should come into force adding pressure to the US’ financial prosperity.)

“We wrote recently that our base case for a fiscal cliff resolution—regardless of the election outcome—was a short-term, ‘mini’ deal that largely kicked the can down the road on the majority of the key items,” the whitepaper says. That mini-deal, according to the authors, would reflect about 1.5% of GDP in fiscal contraction in 2013 (vs. nearly 5% without a deal).

“While this remains our base case, we can afford to have a more nuanced view now that the election outcome is known, including our opinion that there is now a greater likelihood of so-called tail events related to the fiscal cliff resolution, which will have implications for markets and for our positioning,” the authors write.

For more stories like this, sign up for the CIO Alert newsletter. 

PIMCO’s prediction? A compromise on the Bush tax cuts for the upper income earners and sequestration and on the across-the-board spending cuts agreed to as part of the debt ceiling resolution in summer 2011. “In addition, we believe that coupled with a mini deal, there will likely be a commitment or (optimistically) a process established for broader structural reform in 2013,” the paper notes.

Another, less likely effect of the election on the US fiscal cliff, as outlined by PIMCO, is inaction. The paper explains: “Because without a meaningful shift in the composition in either chamber of Congress and the White House, the players who are negotiating the fiscal cliff deal are largely the same ones who have come close to driving our country to the brink in other, similar negotiations.”

PIMCO’s assertions about the status of the US fiscal cliff follow related findings from a monthly fund manager survey conducted by Bank of America Merrill Lynch. Almost three quarters of respondents to the survey said they did not believe that the fiscal cliff was substantially priced into global equities and macroeconomic data. Alice Leedale, market strategist at asset manager RWC, said: “As we enter Q4, the big elephant in the room (or a donkey if you are a Democrat) is the US fiscal cliff, but the market has so far been focusing elsewhere. The first October regional manufacturing surveys will be released this week, and continued weakness following September’s disappointments will suggest that the fiscal cliff is not being ignored in this sector of the economy, and is indeed weighing on business sentiment and investment spending.”

(November 9,2012) — Issuance of bonds by companies deemed to be relatively risky has hit record levels as investors have snapped up the higher returns available for taking a bet on these firms, data released today has shown.

Some $341.6 billion has been issued in global high yield debt so far this year, according to data monitor Thomson Reuters. This has already broken the previous annual record set in 2010, when high yield issuers raised $322.9 billion.

Investors searching for income to boost their portfolios have been increasingly turning to high yield bond funds as equity markets have failed to rise and returns from government-issued bonds have hit rock-bottom.

Mark Holman, managing partner at Twenty Four Asset Management, told aiCIO: “The year 2012 has seen investors flock to the high yield bond sector in record volumes which has assisted the sector in generating 19% returns so far this year in Europe. But with income likely to remain the financial markets’ most scarce commodity in the quarters ahead there is little reason to question investors’ rationale. Base rates are anchored and gilts yields are at record lows, coupled with a low default rate and unconventional policy action from central banks, the investment case for the asset class has been compelling.”

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

Issuance surged in the second half of the year, according to Thomson Reuters. By the end of June high yield issuance trailed 2011 levels, but drew up and surpassed that in the next three months.

European issuers have raised $61.4 billion in the global high yield markets this year, also an all-time annual record, but the overall percentage European issuers make up on the global scale has fallen, showing the spurt the asset class has had in the US and other markets.

High yield mutual funds in Europe have seen bumper inflows, according to Lipper – the retail fund flow monitor at Thomson Reuters. Net sales for the year hit €39.9 billion in October, with €7.6 billion arriving in that month. Assets in these funds topped €180 billion; three years ago this total was €62.8 billion.

However, Holman warned: “Investors will need to be increasingly selective about which companies they invest in as high yield corporates (particularly in Europe) are facing a challenging environment which will put pressure on earnings and therefore push key risk metrics such as net debt to ebitda in the wrong direction. The result of this is likely to be downward rating pressure in 2013. But with the yield on the sterling high yield index still in excess of 8% for an average maturity of just six years and a BB3 credit rating, the sector is likely to remain well supported.”

All types of corporate debt have seen a boost in 2012 as other asset classes have failed to deliver the high returns institutional investors need to make good their deficits or meet specific investment targets.

Year-to-date, the MSCI World Index has made 7.96%. By the end of September, Euro-denominated high yield bonds were returning 5.8% more than German government-issued bunds, according to Alliance Bernstein. The fund manager said that historical out-performance by this asset was 2.8%.