As the beneficiaries of significant flows over the year, maybe it’s time to exercise some caution in this space. These portfolios face a ‘double whammy’ from the fiscal cliff as returns could be hit by a number of its features while firms could be forced to operate in an adverse economic climate.
Barack Obama last night won a second term as president after seeing off strong competition from Republican rival Mitt Romney.
But regardless of who is in the White House, what won’t change is the challenges thrown up by the fiscal cliff – a series of expiring tax cuts and government spending reductions coming into force at the start of 2013 – in the first few months of the presidency.
Dividends falling off the cliff
How the cliff is dealt with by Obama will be especially important for those invested in US equity income. I was speaking with Rathbones research director Elizabeth Savage and she raised some interesting points about where the impact could fall.
Several of the Bush-era tax cuts due to expire next year will affect US equity income funds. Capital gains tax would increase from 15% to 20% and the tax applied to dividend income would jump from 15% to 43% for top-rate taxpayers.
Valuations of the bigger US dividend payers, which are starting to look “quite stretched”, could be damaged by the tax rises. In the consumer defensives space, for example, Colgate is on 20 times earnings, Coca-Cola on 19 times and Heinz on 16 times, making them expensive by historical standards.
Furthermore, the combined impact of all the planned tax increases and federal spending cuts could shave as much as 4% off of the US’ GDP – threatening to send the world’s largest economy back into recession and worsen business conditions.
Savage said: “There’s valuation risk over the short term but over the long term there’s also GDP risk. Unless the economy picks up and these companies are able to grow their dividends, then there’s a risk there.”
Investors flocked to US equity income
What’s more concerning about the possible risk to US equity income is this is an area investors have channelled a lot of money this year. Funds in this space took $11bn in net inflows from global investors in the first seven months of 2012, compared with the $13bn that has flowed out of US equities as a whole.
In the UK, meanwhile, the amount of money run in the IMA Global Equity Income sector reached £5.76bn in September – and the average fund in this sector has increased its exposure to North America over the year from under one-quarter to more than almost one-third, according to FE Analytics.
Should policymakers fail to solve the fiscal cliff, US equity income funds could see their holdings’ dividends hit by increased tax, valuations falling from their expensive levels to price in the tax rises’ impact and a deterioration in operating conditions as the macroeconomic climate sours.
Keeping an eye on fiscal cliff
US policymakers are unlikely to let the economy face the full cliff. They are expected to implement a short-term solution at the start of the year – essentially kicking the can down the road by extending the tax cuts and delaying spending cuts – before working on a more permanent resolution later in the year.
But this scenario is far from guaranteed. At a recent event attended by Savage and a number of fund managers and policymakers, an audience survey assigned a 17% probability of the US going off the fiscal cliff, which she described as “quite high”.
Hargreaves Lansdown investment analyst Richard Troue said: “There is this cloud hanging over US equity income at the moment but we really don’t know what will be decided.
“If the US doesn’t do anything about, these investors might have to look for other sources of income. It certainly could present a problem. I think this is something to keep an eye on.”
It’s difficult to say pulling back from US equity income would be a good course of action. Although the fiscal cliff is one of the leading risks out there at the moment, some degree of solution is widely anticipated.
But this will come with a great deal of brinkmanship and compromise. Over the next few months, investors need to pay close attention to how the president plans to tackle the government’s deficit while working around the cliff – because US equity income seems to be most exposed to its fallout.