Global Macro Fiscal Cliff Portfolio

Includes: AZO, DLTR, TGT, WMT
by: Lamarcus R. Coleman

The Fiscal Cliff is undoubtedly the catalyst driving the majority of investors' decision making. Should we go over the fiscal cliff, the Bush tax cuts would expire, income taxes would appreciate, massive automated spending cuts would take place, amongst other forms of coercive fiscal reform. I, personally, feel that Congress will lack true bipartisanship, but will muster up enough to kick the can down the road and avoid the fiscal cliff. Many are not as optimistic as I am. The macroeconomic environment will be greatly affected if the fiscal cliff scenario plays out. Europe is already back in recession. Asia is experiencing a slowdown as a result of the lagging global economy.

For those who believe that the worst is yet to come I recommend positioning your portfolio from a macro viewpoint. Inclusive to this is hedging. Yes, if you believe the worst, which right now is the fiscal cliff, is inevitable, think like a prop trader or hedge fund. You may be thinking that hedge funds have under performed the market as of late. On a broad index basis that's true, however, not all funds have struggled to come to grips with the new economic environment. In fact, 13% of hedge funds have outperformed the broad market.

In thinking like a fund manager, your primary responsibility is to account for everything that could possibly happen, evaluate the risk-reward paradigm, and invest accordingly. Do your research, generate ideas that are supported by facts not intuition, and make risk conscious decisions based on your work, and lastly hedge against the risk.

If we go over the fiscal cliff how will the markets be affected? I know the stock market would go down, but how would the market specifically be affected? What would happen to the USD? How would interest rates be affected? What sectors in the stock market would outperform the overall benchmark? How would bonds respond? Would commodities fall, or rise off of some random speculation? These are just a few of the questions that I would be asking regardless of the outcome of the fiscal cliff, but more so if I was extremely bearish going into December.

The currency markets are primarily driven by changes in interest rates. In real-estate it's location, location, location. Well, in the currency markets it's interest rates, interest rates, interest rates. A country's currency is affected by political events, GDP, of which consumption is 2/3rds, and other factors, but interest rates are key. If the fiscal cliff materialized the USD would fall in my opinion. Our country has been financing economic growth through foreign stimulus. What this means is that a large part of our debt is owned by foreign nations. This debt factored into our GDP, our economic growth, thus the dramatic removal of the debt would in-turn remove the synthetic portion of our economic growth.

This is why economists predict that should the fiscal cliff come to pass, our country would fall back into recession. Exports and imports would decline as well. This is bearish for the dollar. I recommend looking for carry trade opportunities as one way to play the scenario should it play out. A key consideration is the rest of the globe. Even if we went off the cliff, would the dollar still be the best option relatively speaking? What safe havens would exist, JPY? AUD? CAD? CHF?

Interest rates are already low, but the big issue is that an automatic freeze on spending would occur. This means that no new debt would be issued and the debt outstanding could possibly no longer receive interest payments, for the time being. This would raise the risk of owning our bonds, thus bond prices would fall. Of more urgent concern is how the Fed would stimulate us out of this situation. If interest rates are already at record lows, there isn't any further room to reduce rates to stimulate the economy. I would go long interest rate futures and short bonds.

The stock market would take a major hit. This is in large part due to the certain reduction in consumption. With high unemployment, which I predict would go even higher should we go over the cliff, investors would hold on to their funds and even begin moving into cash. Normally, you would see a massive move into bonds, but with the potential freeze on interest rate payments, bonds would be plummeting, hence the move to cash. At this point I would venture to say that [[GLD]] or gold would be the most sought after asset. Investors tend to purchase gold in times of uncertainty.

Gold and the USD have an asymmetrical relationship. Meaning that, a change in gold does little, if anything to the USD. However, a change in the USD will have a more material affect on gold prices. The defense, consumer discretionary, and technology sectors would be amongst the biggest losers. The hospital stocks, dollar stores, and consumer staples would do okay, relatively speaking. I would go long the VIX and short Nasdaq Futures against it.

I like Dollar Tree (NASDAQ:DLTR) in the dollar store industry. The stock had outperformed the S&P until October. The selloff presents a great buying opportunity. The stock bottomed earlier this month at $37.74 and is up 10% since then. With an inevitable increase in taxes and unemployment and slow down in spending, individuals are going to save every penny they can. I would short Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) as they have already had to cope with the loss of market share to the dollar stores.

I would also go long Autozone (NYSE:AZO). Auto sales would be a big decliner in the way of spending. People will hold on to their vehicles a little longer, or at least until unemployment comes down a bit more, and they become accustomed to the new environment post cliff. Autozone has underperformed the broad market in recent times as we've experienced a better economic position than in later years. The stock is trading above its 100 day moving average. If we went over the cliff, the stock would outperform the broad index.

Commodities would also suffer. Copper in particular would decline. The reason that this would occur is because business manufacturing activity on a global scale would decline further, adding to the global slowdown, and thus decreasing the need for copper. Mind you that copper is a leading resource for manufacturing activity. If activity slows down further, investors and speculators would take a more prominent short position on the metal. One strategy that may be feasible is to borrow some other currency pegged higher than the USD at that time, convert it into USD, and buy gold.

The reason that this strategy may be a viable technique to hedge against the cliff is that the dollar may decline, and should decline in value, giving premiums to other currencies. These currencies would be then be able to be converted into more dollars at less cost in their domestic currency, and thus would have more purchasing power when buying gold. Gold tends to perform well in times of economic woe. Of primary concern to implementing this strategy would be one's position on the USD, whether it would go up or down should we go over the cliff. In a stronger recovery or better global economic condition, whether the dollar would fall should the fiscal cliff materialize would not be a question. However, in an environment in which the global economy is suffering, the dollar just may be the best performer in relative terms. There may not be any other option available in the currency market as a safe haven.

Investors, before making hedging decisions should definitely determine in which direction they believe the USD is going. In recent news, it has been projected that GDP would decline by 1.4% should we go over the cliff. Unemployment benefits offered by the federal government could also expire, leaving 2 million individuals with no job or benefits. According to the C.B.O, the unemployment rate would hit 9.1%. This would definitely weigh on consumer sentiment which in recent times has not shown a significant decline. Consumer sentiment, which is currently at a five year high, will translate into consumer spending, and thus GDP. The White House estimates that consumers could spend 200 billion less next year if we go over the cliff. These factors, and others are major considerations to investing and hedging in the currency and commodity markets in the coming months.

The cliff has not occurred, but remains at the forefront of every investor and portfolio manager's mind. Not all asset classes and investments will underperform. Some under performers are obvious across the macro environment. The best investors during a plunge into the abyss will be those that actively and accurately hedge. A fiscal cliff portfolio, to mitigate risk, and have any attempt at outperforming relatively speaking should have long and short positions. The issue is finding the opportunities.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DLTR, AZO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.