4 Reasons To Be Concerned About The Fiscal Cliff

Includes: IXJ, KXI
by: Russ Koesterich, CFA

Despite all the headlines lately warning about the pending fiscal cliff, I have yet to meet an investor who doesn't expect Washington to arrive at a last minute deal later this year to avert the tax hikes and spending cuts set to take effect in January 2013.

Just look at recent economic forecasts: The consensus expects U.S. gross domestic product growth, for instance, to modestly accelerate in 2013 and isn't discounting in a high likelihood of either tax hikes or spending cuts. And I have to admit that I too believe the most likely scenario is another 11th hour compromise that, at the very least, postpones the bulk of the tax hikes and spending cuts.

Investors, however, including me, may be being too complacent given how serious a threat the fiscal cliff is to both the economy and the U.S. equity market. Here are just four reasons why we all should perhaps be more worried.

  1. The Size of the Fiscal Cliff: Potential exact estimates differ, but by most accounts, the total size is in excess of $600 billion, which equates to more than 4% of GDP. The tax hikes alone account to more than 3% of GDP. The last time the United States experienced a tax hike this large as a percentage of GDP was 1968; a recession quickly followed in 1969.

  2. The Timing of the Fiscal Cliff: A large tax increase coupled with spending cuts would be challenging under any conditions, but it will be particularly problematic given the troubled nature of the recovery. The consensus view of economists is that U.S. GDP will grow approximately 1.8% in the second quarter, with little improvement in the back half of the year. This growth level is significantly below the long-term average of approximately 3.25%

  3. Where the Fiscal Cliff Would Hit: The fiscal drag is set to hit the economy where it's most vulnerable: Disposable income. As fiscal stimulus and transfer payments have begun to expire, income growth has decelerated. Personal income growth was up less than 3% in May and at half the level of early 2011. Should the fiscal drag hit, this will further lower disposable income by raising taxes and reducing transfer payments such as extended unemployment benefits. This would also occur against a backdrop in which retail sales are already decelerating: June was the third month in a row in which retail sales less food and autos declined on a monthly basis.

  4. Early Action Ahead of the Fiscal Cliff: While the economic impact of the fiscal cliff isn't set to hit until January, individuals and businesses in particular may be acting early. In the absence of near-term clarity, individuals may be cutting back on discretionary spending and businesses may be delaying hiring or capital spending plans.

The good news is that Washington appears aware of the risk, and there are a number of efforts underway to reach a resolution prior to the November election. But the bad news is that while most policymakers want to avoid falling off the fiscal cliff, there's little agreement on how to do so.

The bottom line: If we're still stuck at an impasse come fall, investors should consider positioning their portfolios for a higher probability of a recession in 2013 by opting for:

  1. Less equity exposure.

  2. A higher allocation to defensive sectors like consumer staples and healthcare, accessible through the iShares S&P Global Consumer Staples Sector Index Fund (NYSEARCA:KXI) and the iShares S&P Global Healthcare Sector Index Fund (NYSEARCA:IXJ).

  3. Less credit exposure in the fixed income section of their portfolios.

  4. A smaller allocation to commodities.

  5. A higher weight to dollar-denominated assets.

Source: Bloomberg

Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.

Narrowly focused investments typically exhibit higher volatility.

Health care companies are subject to extensive government regulation and their profitability can be affected by restrictions on government reimbursement for medical expenses, rising costs of medical products and services, pricing pressure, and malpractice or other litigation.

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