Wells Fargo analysts view the "fiscal cliff" as one of the "more immediate risks to the economy and financial markets." They cited a combination of federal tax increases and automatic spending cuts that can result in an economic slowdown or even a new recession.
In its just-published Wells Fargo Structured Products Monthly, the firm's analysts offer their view on the fiscal cliff’s potential effect on each securitization sector and how this impacts relative value.
Analysts said that Congress and the Obama administration are now working toward a solution to the fiscal cliff. But, if the policy outcome from these negotiations is not positive for economic improvement, there might be longer-lasting harm to financial markets and the economy, Wells Fargo analysts said.
Relative value opportunities in fiscal cliff scenarios will track risk-on/risk-off trading environments, analysts said. Looking at the fiscal cliff, for instance, would probably drive risk aversion higher among buyers (risk-off) and a spread widening in more credit-sensitive sectors. Spread volatility will probably rise, and there would likely be less liquidity, Wells Fargo analysts said. If the fiscal cliff were averted, then a further rise in investor risk-taking can result in better returns in higher-beta or credit-sensitive sectors.
In terms of CLOs, the Congress and the President are now negotiating to stop the implementation of a combination of spending cuts and tax cut expirations. If no deal is reached, the Wells' economics group has projected that going over the “fiscal cliff” will result in a roughly 4% hit to 2013 GDP.
Analysts examined three scenarios: no deal, a temporary resolution and a “grand bargain” that offers a long-term fix. Wells Fargo also looked at how CLO spreads performed in two related negotiations.
Under the temporary solution scenario, analysts suggest purchasing senior notes and CLO equity. Senior notes offer protection and prices might drop more than needed. Volatility, particularly a selloff in the loan market, benefits CLO equity holders since managers are able to purchase at discounted prices. Wells analysts said that a prudent manager buys loans that trade at spreads pushed artificially wider by risk-off moves. In the “grand bargain” scenario, they suggested that buyers purchase 'BBB' and 'BB' tranches. These notes should outperform in a risk-on move and can benefit from CLO calls when the loan market rallies. Conversely, CLO equity distributions might be pressured by a loan market rally.
Within RMBS. the threat of the “fiscal cliff,” or any variation of fiscal tightening, still pervades over the MBS markets. However, analysts think that it is hard to structure trading strategies around any probability handicapping such as the chance of continuing current fiscal policies considering the outcome's uncertain and binary nature. With this in mind, analysts think that buyers should stay conservative with regard to valuations and focus on maximizing carry in this low-yield environment. Even though they might experience fluctuations from near-term yearend pressure, analysts are staying constructive on the basis and like major production and down-in coupons, select loan balance and LTV payup stories and shorter-duration hybrid ARMs, as carry plays across either a stable or tighter fiscal scenario.
A sequestration or "falling off the fiscal cliff” scenario would have the most severe implications for CMBS, analysts said. Cuts to defense spending could reach close to $1 trillion in the next 10 years. Commercial space leased by defense contractors experiencing cancelled contracts most likely would be vacated or downsized, which can lead to increased vacancies in markets with high exposure to defense contractors. Wells analysts anticipate that federal programs such as “Operation Twist” and quantitative easing would continue under this scenario. The search for yield in a continued low-rate environment would push more investors into high-risk products and credit classes of CMBS, countering any spread volatility due to a short-term recession effect.
In a short-term solution scenario, Congress would reach a temporary agreement to avoid going off the fiscal cliff and would postpone any decisions on the deficit to the new Congress. The lack of action and leadership by Washington’s leaders could further increase the crisis of confidence and could result in a downgrade of U.S. debt. Another U.S. debt downgrade will likely result in a risk-off. In this case, analysts expect 'AAA' agency CMBS spreads would be the least volatile, followed by private-label senior 'AAA' CMBS spreads. Higher-beta more credit-oriented CMBS might experience considerable spread volatility, they said.
In consumer ABS. Wells Fargo analysts think that the effects of the fiscal cliff would likely be noticeable. However, they do not expect long-lasting harm to consumer ABS unless the policy outcome from Washington is adverse to economic growth.
The pricing of recent new-issue transactions does not seem to reflect ABS investor worries about the fiscal cliff. Some of the potential effects include lower new-issue volume, potentially wider spreads, specifically in nonbenchmark sectors, potential rating reviews on FFELP student loan ABS, weaker credit performance in an economic slowdown, credit trends helped by robust structural protections, a safe haven in credit cards and prime autos and relative value opportunities if spreads widen meaningfully.
Analysts now handicap the outcomes at a 50% chance the economy goes over the fiscal cliff without relief from Washington and a 50% chance that a continuing resolution is passed to postpone it for the next Congress.