Look Out Below! The Fiscal Cliff Steepens

by: Russ Koesterich, CFA

We are now less than six weeks from the election and if the polls are to be believed, the next government will be like the current one — divided and partisan – only more so. If that is the case, the looming threat of the fiscal cliff may be even more ominous – especially given a worrying trend in recent economic data. I believe that investors should consider adopting a more defensive posture.

Investors seem to be taking it for granted that there will be a last minute reprieve from the fiscal cliff. As such, expectations for economic growth in 2013 may be too optimistic. For example, headlines recently have fixated on an improving housing market. However, while the housing recovery is real, it is still modest and unlikely to provide a big boost to growth.

What many have missed is that leading indicators and personal consumption are pointing to slower growth. The Chicago Fed National Activity Index (CFNAI), the leading indicator that has historically had the best record of predicting next quarter’s gross domestic product (GDP), recently took a nasty turn for the worse. The last reading plunged to its worst level since 2009, consistent with GDP growth of less than 1%, or what economists describe as stall speed. The collapse in the CFNAI is mirrored by other measures, including the Institute for Supply Management (ISM) New Orders component, another useful barometer of near-term GDP.

There has also been a modest decline in personal consumption, a big driver of US growth. As of the end of August, personal consumption was growing at just 3.3% year-over-year, half the long-term average and the slowest rate of consumption since 2010. Most of the recent economic data points to slower growth in the third quarter and potentially the fourth.

What’s an investor to do? In the equity space, they should consider increasing their exposure to minimum volatility funds, which should help provide some downside cushion, while also offering the prospect of better risk-adjusted returns over the long term. I would also be very cautious on market segments that are dependent on consumer spending, like retailers and restaurants.

In fixed income, high yield enjoyed a big run over the summer. As a result, spreads on the 10-year Treasury appear tight, particularly given the recent slippage in leading indicators. I would bring down high-yield exposure to no more than a benchmark weight and increase exposure to municipals and investment grade debt, both of which are less sensitive to growth. Finally, investors should be cautious on more cyclical commodities, particularly industrial metal, which will not respond well if growth continues to slow.

As I outlined in my book, The Ten Trillion Dollar Gamble, the long-term drivers of the deficit are entitlement spending and a relatively narrow tax base. Unfortunately, the fiscal cliff does nothing to address either of these issues. What it does do is impose a significant headwind on the economy at a time when the recovery is still fragile. The result is the worst of both worlds – no long-term reform coupled with short-term policy, which may push us back into a recession. So contemplating the biggest fiscal drag in the post-World War II period – potentially $600 billion or roughly 4% of GDP – especially when the economy is showing signs of softening, is a very dangerous scenario.

Source: Bloomberg

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