Fiscal Cliff Update: The Election Is Over. Now What?

The recent presidential and legislative elections did not change the players negotiating our country’s budget issues. Barack Obama, a Democrat, is still President and the House of Representatives is still Republican. Our divided government must face the budget issues that they have kicked the can on multiple times already, but now with the added pressure of avoiding the fiscal cliff. We see three scenarios:

1) The parties kick the can farther down the road. The fiscal cliff deadline is pushed into 2013. Government tells us it’s “not fair” for a lame duck session to make such important decisions for America.

2) The parties reach a grand bargain. Revenue is raised by potentially increasing capital gains and estate taxes, reducing deductions for the wealthy (e.g., a phase-out on mortgage and charitable deductions), and changing the income ranges on tax brackets, as opposed to changing rates. At the same time, future liabilities are reduced by fundamental reform to entitlement programs. One potential reform would be to phase out Medicare benefits for higher net worth individuals; these types of agreements are unlikely to impact current recipients of benefits or those very near retirement age, but those in their 40s and early 50s could be affected.

3) The parties fail to reach any type of agreement, and the tax hikes and spending cuts of the fiscal cliff go into effect, with big headlines and with lots of finger-pointing in Washington. The debate rages well into 2013, with the eventual outcome uncertain.

Of these outcomes we think that the first scenario is the most likely. We believe that the second scenario would be the best for the markets and the economy in both the short and long runs. And, we think there is very little chance of the third outcome; allowing the fiscal cliff to impact the economy would jeopardize the already anemic recovery. Politicians like getting reelected and we believe it is unlikely, but not impossible, that our elected officials would knowingly cause their constituents, and maybe more importantly, their donors, to suffer unnecessarily.

We are not alone in our view. Most major investment managers, Wall Street bankers and hedge fund managers agree that the United States is unlikely to head over the fiscal cliff. As a result, the markets are reflecting only a very small probability of the economic impact of the government not reaching some type of agreement. While most investors are relatively sure that some sort of agreement will be reached, when evidence surfaces that increases the probability that agreement may not be reached (e.g., reading the tea leaves of the President and the Speaker of the House), the markets react strongly. As a result, we expect there to be considerable volatility in the equity and credit markets between now and the end of the year. The volatility is short-term in nature and totally unpredictable. We believe that markets will fall on days when an agreement looks out of sight and rise on days when a grand bargain looks possible. While it might seem like a good time to be active with your portfolio, trying to time the ups and downs is not possible.

Managing markets like these requires effective diversification. On days when agreement seems difficult to achieve, Treasuries have rallied, while equities rallied on days when agreement seemed possible. Also, keep in mind that most people are investing for the long term; even if we head over the fiscal cliff and the stock market goes with it, the intermediate-term outlook is for a pickup in growth. In fact, we believe that due to improvements in housing, manufacturing, energy production and exports, the United States could see surprisingly strong growth at the end of 2013, or the beginning of 2014. Trying to time your investments to protect yourself from the volatility of the fiscal cliff, while still hoping to capture the upside of a continued U.S. recovery, is a losing game; it just doesn’t work. It doesn’t work for institutional investors, for hedge fund managers, for the wealthiest families. Short-term market timing works once in a while for people who are lucky. We never bet on being lucky; instead, we bet on having a tested investment approach, rooted in historical experience and academic research.

In times of volatility, the key is to control what you can: taxes and portfolio costs. We can help clients plan for higher taxes and our investment team is helping take control by cutting overall portfolio costs for our clients. We believe in building all-weather portfolios. In August, we proactively added both purchasing power protection strategies and risk/volatility dampening strategies to most portfolios in an effort to further diversify portfolios for multiple economic scenarios. For instance, we added fixed income securities, which generally perform well in a low-inflation and recessionary environment, and we added purchasing power protection strategies to take advantage of current inflation levels and to hedge against the potential of high inflation, which may occur if the solution to the fiscal cliff ends up being more monetary easing.

If there’s a silver lining to the fiscal cliff, it’s that any solution to it has to involve the beginnings of a solution to the long-term budget issues.

We’ll be here for discussion; please continue to visit our website for the latest news from Wealth Enhancement Group.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. 

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