Q&A: Bracing For a Fiscal Cliff Fall

Dec 7 2012 | 10:48am ET

Scott Warner's area of expertise is U.S. equities and, by extension, all events affecting U.S. equities. Events like presidential elections, looming tax hikes and spending cuts, and Washington gridlock, the sum total of which is known as the "fiscal cliff."

With the U.S. apparently poised to plunge over that cliff if the re-elected President Barack Obama can't strike a deal with Congressional Republicans, Warner, director of long/short equity strategies at the Pacific Alternative Asset Management Co., took time to discuss his role at the $8 billion fund of hedge funds and the potential ramifications of the U.S. political stalemate with FINalternatives Senior Reporter Mary Campbell.

Tell me about your role at PAAMCO.
I am a sector specialist and portfolio manager at PAAMCO, responsible for our U.S. long/short equity portfolio. The majority of our managers are fundamentally-driven and, as a large allocator to long/short equity, we talk to many different managers, giving me a little bit of a sense of what people are talking about and thinking about.
This year in general has been fairly good for the long/short equity strategy. Certainly, a nice return in the broader market is helpful, but also the drop in correlation and volatility over the year has been a more supportive environment for the strategy in general. As a case in point, for October, our portfolio was up about 1% against a Standard & Poor's 500 Index that was down about 2%.

How did managers respond to the election campaign, and what is their outlook now the election is over?

As we got closer to the election and the polls continued to narrow between the two candidates, the distribution of potential outcomes got a lot wider. As such, we saw a number of managers in our portfolio take down their overall gross exposure—particularly managers that have heavy allocations to what we call the "battlefield" sectors, namely financials and healthcare. One of our financials-focused managers had dramatically cut in the couple of days prior to the election, knowing that whoever won, it was going to increase volatility in financials.

What strikes me is that, although we now know who the winners of the election are, the outcome of the election really won't be decided until the cliff is addressed. The fact that we have a Republican House of Representatives and a Democratic president, well, we know what that is, but we don't know how well they'll compromise to work together to address these issues. The market volatility and reaction suggests a negative view or expectation about their ability to truly reach compromise, and I think it's going to be the headline-driven market as we get closer to the end of the year.

What threat does the “fiscal cliff” pose?

If a compromise is not reached by Dec. 31, some of the Bush tax cuts will expire immediately. A lot of that impacts how dividends are taxed, so it does have a lot of ramifications that could have an immediate consequence to the economy. If you look at the worst-case scenario—which is basically, you come to a stalemate and the Bush cuts roll off—a lot of sell-side economists expect about a 2% fiscal drag in 2013, with a worst-case of a 3.5% drag on gross domestic product which, in their minds, would most assuredly cast the U.S. into a recession.

How do managers position for this, given the uncertainty surrounding the outcome of negotiations between the president and the House?

One of the things that managers typically do is try to find a probabilistic framework to think about how their portfolio will react, depending on which outcome comes to fruition. And as we get closer and have more clarity and certainty, those probabilities will shift and managers will adjust their positioning accordingly. One of the key issues that has led managers to de-risk their portfolios to a degree is the fact that corporations themselves are being held hostage in these negotiations. Depending on what the final resolution is, how they think about spending and hiring or what to do with the cash on the corporate balance sheet, all of those things are very much in flux. Depending on what happens to dividend tax rates, companies may actually be incentivized to make special dividends that are effective in 2012, as opposed to 2013.

I think one of the things that I found really interesting, the day after the election, was AT&T's announcement that they were going to increase their CAPEX spending by a pretty darn significant amount. If you recall, AT&T tried to acquire T-Mobile earlier this year and the Obama administration blocked that merger. Once President Obama was declared the victor, AT&T realized that this same government is intact for the next four years, so I think they moved to Plan B: "Okay, if we can't buy T-Mobile, we need to upgrade our network infrastructure and we'll choose to compete in a different way."

My sense is that many corporations are waiting for clarity both on the election as well as the fiscal cliff and at this point have a Plan A and a Plan B in place. If AT&T was any indication, I think that other companies are in a similar situation where they're waiting to see where the dust settles and set their strategies accordingly.

As someone who follows this situation closely, do you have any sense of how the fiscal cliff negotiations will play out?

I hope there's significantly more cooperation than what we saw last year with regard to the debt ceiling. That said, I think investors collectively were incredibly underwhelmed by the outcome last year and are tempering any hope or expectation that a positive resolution will be reached. Fool me once, shame on you, and, as George Bush said, "You don't fool me a second time." [Laughs.] It's one of those things where I think everyone realizes the importance of reaching a constructive compromise and yet are fearful of the gridlock that we've seen in Washington, in which despite everyone's best intentions we will end up with a negative outcome. While the truly worst-case scenario is perhaps not the most likely outcome, the severity of that outcome is so tremendous that it has people on edge.

Generally speaking, did investors feel that a President Mitt Romney would have had more luck dealing with a Republican Congress?

Yes. I think the consensus view is that if Romney had won, the chance of going off the fiscal cliff would have been reduced dramatically.

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