While President Barack Obama and the beloved members of Congress are focused on the November elections, the looming “fiscal cliff” is of paramount importance to the economy.
As part of a grand bargain between both major parties and the president to raise the federal debt ceiling, the Budget Control Act of 2011 — signed into law by President Obama in August 2011 — a mandatory set of budget cuts, together with the expiration of tax cuts enacted when George W. Bush was president, and then extended in 2010, “will push the U.S. into a recession in the first half of 2013,” according to KBW analyst Fred Cannon, unless Congress and the president once again kick the can down the road.
Since the only thing that matters to most members of Congress is the subsequent election cycle, it would seem most likely that another bill will be passed to prevent the federal spending cuts and to extend the tax cuts once again, but one never knows. The bitterness between the parties, together with the election results, could indeed push us over the so-called fiscal cliff.
For income-seeking investors, TheStreet recently covered the significant tax implications that will affect investors unless Congress extends the tax cuts, as well as several choices to maximize dividend income under various scenarios.
KBW’s “base-case economic outlook” assumes that Congress and the president will take the necessary actions to avoid the “fiscal cliff,” but Cannon said that even under that “even if the ‘fiscal cliff’ is addressed by Congress, we believe that the December debate on the issue will be negative for consumer confidence and will slow spending.” After that, assuming that we don’t fall off the “fiscal cliff,” KBW expects the economy to “[reaccelerate] in 2013, ending the year with 2.2 percent (gross domestic product) growth and the unemployment rate at 7.3 percent.”
“Under the ‘fiscal cliff’ alternative scenario, we would expect the U.S. to fall into a recession in the first half of 2013, with negative GDP growth and the year ending with the unemployment rate at 9.1 percent,” Cannon said, adding that “interest rates stay low under both scenarios, but in the ‘fiscal cliff’ alternative, we would expect the 10-year Treasury yield to drop below 1 percent early in 2013.”
For financial stocks, KBW compared the looming “fiscal cliff” to “the summer of 2011, when Congress nearly allowed the U.S. to default and S&P downgraded U.S. debt. Overall, financials underperformed the market during that time period, with the underperformance led by capital market firms, large-cap banks, and life insurance. Conversely, diversified financials, P&C insurance, and real estate firms outperformed the market.”
Cannon expects “similar performance of financials during the December debate over the ‘fiscal cliff,’” but sees “key differences” this time around, “as the impact of significantly increasing taxes on dividends, payrolls, and high-income families will be factored into stocks during this debate.”
After such a beautiful run for financial stocks this year, we could be headed into some pretty rough waters heading into the end of the year, with downward price pressure for the simple reason that money managers being paid based on calendar-year results will want to lock in their gains.
Under the “fiscal cliff” scenario, the financial stocks that KBW expects to underperform what would probably be a lousy overall market include Goldman Sachs, Morgan Stanley, State Street, Bank of New York Mellon, and “most regional banks,” along with certain asset managers, life insurance companies, and credit card lenders Capital One, and American Express, which have both seen solid returns this year.
Financial sectors that KBW would expect to outperform under the “fiscal cliff” scenario include “health-care REITs, triple net REITs, and self-storage REITs,” payment processors Visa and MasterCard, private label card lender, processor and rewards program marketer Alliance Data Systems, and among regional banks, U.S. Bancorp, and M&T Bank.
KBW analyst Sanjay Sakhrani said that “we believe that American Express is likely more exposed to an adverse ‘fiscal cliff’ scenario, as higher-net-worth individuals could see an increase in their tax rates, which could result in lower discretionary spending,” and that “if there were a meaningful deterioration in the unemployment situation, we would expect Capital One to underperform given its higher exposure to subprime borrowers.”
If unemployment were to rise “significantly,” Sakhrani said, “we would prefer to own MasterCard/Visa due to their international exposure and lack of significant credit risk and capital management. Of the card issuers,” and that he would favor Discover Financial Services “due to its relatively strong core cardholder base (and lower exposure to subprime) as well as its positioning for multiple avenues of asset growth,” and ADS, “due to its ability to gain share in the private label card space, potential for more companies to utilize Epsilon to increase their market efficiency particularly with the convergence of commerce, payments, and marketing, and exposure to Canada and Brazil in its loyalty segment.”
Bancorp is an obvious choice for outperforming in a “fiscal cliff” scenario recession, as the company sailed through the credit crisis, and is the strongest and most consistent earner among the nation’s largest bank holding companies, with an operating return on average assets (ROA) of 1.59 percent for the 12-month period ended June 30, according to Thomson Reuters Bank Insight. Over the same period, the company’s return on average equity (ROE) was 14.79 percent.
Following M&T Bancorp’s agreement to acquire the troubled Hudson City Bancorp for about $3.7 billion in stock and cash, or roughly 80 percent of Hudson City’s tangible book value, KBW analyst Brian Klock reiterated his “market perform” rating for M&T, saying the bank “has proven to be an effective and efficient acquirer and has proved, in our view, to be disciplined in pricing and diligent in achieving projected cost savings.”
M&T’s ROA for the 12-month period ended June 30 was 0.97 percent, while the company’s ROE was 8.16 percent, according to Thomson Reuters Bank insight. Klock estimates that the company will earn $6.75 a share this year, followed by earmnings per share of $7.50 in 2013.
—By TheStreet.com’s Philip van Doorn
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