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On May 26th 2012, in my article Money Printing To Bring Forth The Next Risk-On Phase I recommended that investors buy risk assets as the global central banks were embarking on stimulus programs. Since then, S&P500 has rallied 10% and gold is up nearly 11%.

Today, I am advising our clients to get defensive, as the impending fiscal austerity in the U.S. will bring on a risk off state for the foreseeable future.

At the stroke of midnight Dec 31st, as you say goodbye to 2012 and welcome 2013, Washington will also be saying goodbye to some fiscal stimulus measures put into place in recent years and by past administrations and welcoming new measures of austerity.

On Jan. 1, 2013 measures of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws set to change at midnight on December 31, 2012 are:

1. End of last year's temporary payroll tax cuts (resulting in a 2% tax increase for workers).

2. End of certain tax breaks for businesses.

3. Shifts in the alternative minimum tax that would mean a bigger tax bill.

4. End of Bush tax cuts from 2001-2003.

5. Beginning of taxes related to President Obama's health care law.

6. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect. According to Barron's, over 1,000 government programs - including the defense budget and Medicare are in line for "deep, automatic cuts."

This is not trivial!

According to the Congressional Budget Office, the net effect of these tax law changes could result in:

- Loss of $600bn in public savings every year.

- Drop in the country's GDP of 0.5%.

- Rise in unemployment rate to at-least 9.1%.

Basically, a recession would be guaranteed!

And that is why these end of year tax law changes and the impending economic gloom is being termed as going over the "fiscal cliff".

Washington has 3 choices:

1. Let all the tax cuts and stimulus measures expire, which spells doom. This is highly likely if the two parties do not come to any resolutions.

2. Extend all the existing tax cuts which means that the fiscal deficit continues to increase putting the value of the Dollar at risk which could lead to severe inflation.

3. Take a bi-partisan approach to implementing pro-growth measures and get rid of tax cuts and stimulus measures that just create economic largesse.

From an investment perspective this creates risks as well as opportunities, which I would like to break out by time scale.

From Now until Dec. 31, 2012

I do not see lawmakers rushing to negotiate and passing reasonable measures any time soon. They will delay and negotiate till we are at the precipice of the cliff.

This means an increase in uncertainty and volatility which is not good for risk assets. S&P 500 could easily drop to 1300 by year-end! The 100 week moving average is around 1300 and the 200 week is coming in around 1200. These are long term support lines. Investors should look to either trim their long holdings or look to position through inverse ETFs such as SH, DOG or PSQ.

2013

I am not sure how badly the negotiations will go, but one thing is quite certain. Tax breaks on quite a few investments will disappear. The ones at the most risk are:

1. Stock dividends - Most likely dividends will be taxed at the top income tax rate rather than 15%. This is a loser for high dividend paying stocks. Avoid them as the exodus could push their prices down below their fair value.

2. Municipal Bonds - The tax free status of municipal bonds is at risk and they could be taxed at a 28% cap rate. Given the illiquidity of municipal bonds, any mass exodus from munis could result in catastrophic losses for muni bond holders.

The relatively better assets to invest in 2013 could be the high alpha markets. The so called frontier markets did extremely well in 2012 as they are being buoyed by good fundamentals like cheap valuations, good risk-return metrics, steadily increasing foreign capital flows and strong commodity exports to China.

As an example, African Composite mutual fund, NAFCX is up 30% and Asian countries beyond BRICs are also up in 2012 (Philippines+30%, Thailand+30%).


(Click to enlarge)

The second area that could continue to do well is REITs. The policies of the current administration as well as the Fed over the past 4 years have clearly targeted the housing market through QE programs. Consequently, the REITs as measured by VNQ (Vanguard REIT ETF) are up 11% for 2012 and 200% since March 2009. Supporting the housing market also gets the foreclosed bank owned properties off the bank's balance sheets which is healthier for the overall economy as it gets the credit flowing easier. Therefore, I would expect support for the housing market and therefore REITs to continue into 2013.

As a final word, I would advise the readers to adopt a dynamic rebalancing and a risk managed approach to portfolio management rather than a buy, hold and pray approach. Markets these days are affected by a lot of non-economic factors and asset classes can go in and out of favor quite rapidly.

Source: Fiscal Austerity To Bring On The Next Risk-Off Phase