As 2012 is coming closer to the end, investors cannot help but be concerned about the fiscal cliff, the prospect of drastic spending cuts and tax increases as the 2001 Bush fiscal package expires. How should investors prepare their portfolio for this prospect?
It depends on how the fiscal cliff is addressed. The table below summarizes two scenarios and their impact on the economy and financial assets in 2013. The first scenario assumes that the Bush package is renewed; the economy continues to grow in the first part of 2003, but slows down towards the end. Investors who find this scenario most likely should trim their positions into bond funds like iShares Barclays 20+ Year Treasury (TLT) Bond Fund and stay with index funds that invest in stocks like SPDR (SPY); they may also want to increase their exposure into cyclical ETFs like Market Vectors Retail (RTH).
The second scenario assumes that Bush fiscal package expires. Economy falls into a recession in early 2013, but recovers towards the end. Investors who find this scenario likely should stay with bond funds like TLT, but trim their exposure to stocks, especially to those paying high dividends. As I wrote in an article I co-authored for Barron's some time ago, this is a risky strategy under this scenario, as an automatic rise in dividend taxes will make these stocks less appealing.
Two Scenarios for the Fiscal Cliff and Their Impact on the Economy and on Different Asset Categories
Scenario 1: Bush fiscal package is renewed
Scenario 2: Bush fiscal package expires
State of the Economy in 2013
The economy continues to grow in the early 2013. However, the US government debt risks another downgrade by major credit agencies; long-term interest rates edge higher. The economy falls into a recession in the end of the year.
Economy falls into a recession in early 2013; interest rates edge lower, driven by a weaker economy, an accommodating FED, and the re-affirming of current grading of US government debt by credit agencies-though there is little room for further rate decline towards zero.
Cyclical stocks rally in the first quarter of 2013, and falter into the second and third quarter, as concerns over an impending recession caused by rising interest rates mount.
Non-cyclical stocks, especially those paying high dividends also rally.
Cyclical stocks falter earlier in the year but rally towards the end.
Non-cyclical stocks, especially those paying high-dividend decline as tax on dividends may rise.
Commodities rally early in the year, but falter towards the end, as higher interest rates take their toll on the economy.
Commodities falter early in the year, and rally later as interest rates continue to fall.