Fiscal Cliff: Braced For Impact?

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Fiscal Cliff

Lather, Rinse, Repeat.

As if you didn’t have enough to keep you up at night. The European Union’s economy is sliding. Though its recent past imbalance of trade and competitiveness has diminished, the accompanying enormous debt obligations continue to snowball, month after month. James Mirrlees, a Nobel economics laureate, may have said it best when he told Bloomberg Television that Greece is a mess. Just before our Thanksgiving holiday (11/20/12), European finance ministers and the International Monetary Fund discussed allocating 15 billion euros ($19 billion) through 2014 for Greece and sought an elusive formula for putting its debt on a sustainable path.

Portugal, Spain, and Italy continue to struggle. And Moody’s stripped France of its AAA credit rating, citing its exposure to shocks from the Eurozone periphery. Investors want to believe Eurozone policymakers can resolve the debt crisis. But the risk of a prolonged recession is rising.

And here’s something totally different: Speculation is rising that some European countries may use their gold holdings as collateral against their debt to lower their borrowing costs. No, that’s not an excerpt from a Greek tragedy. Or is it?

Fiscal Cliff: What, Me Worry?

Europe’s economic cliff may make our fiscal cliff look like stepping off of a curb. But the ramifications are still grim.

In the U.S., among other changes if there’s no congressional action:

  • Income tax rates will go up for all taxpayers
  • The capital-gains tax rate will increase to 20%
  • Dividend income will be taxed as ordinary income
  • The estate tax will revert to a top rate of 55%, with an exemption amount of $1 million
  • The payroll tax cut expires
  • $55 billion in automatic defense spending cuts kick in

And almost all economists agree that the U.S. will fall back into recession, due to the headwinds these factors would create for GDP.

Ben Bernanke urged Congress again, to strike a budget deal. Failure to do so would impose heavy costs on the economy. Bernanke said Congress also needs to reduce the federal debt over the long run to ensure economic growth and stability. After the last debt standoff in the summer of 2011, Standard & Poor’s downgraded the government’s credit rating on long-term securities − first-ever downgrade of U.S. government debt. The stock and bond markets reacted violently. What? Me Worry?

 

No one is sure that the Fed will be able to cushion the economy from the fiscal cliff beyond the bond purchase program it’s already conducting, to try to lower long-term borrowing rates and stimulate spending. The minutes of the Fed’s last policy meeting suggest that it may unveil a bond buying program in December to try to drive down long-term rates. The new purchases would replace a bond-buying program that expires at year’s end. It seems that all Bernanke has left is a bond-buying hammer, making everything look like a nail.

Not all agree. Some Fed policymakers questioned whether additional bond buying would be needed. Two of them worried that keeping rates too low for too long could drive up inflation.

Brace Yourself

So what does this mean for investors? It’s not a new story. The answer is as old as Modern Portfolio Theory itself. Investors have been told time and time again that diversification is the key to successful portfolio management.

But here’s the twist: As stocks and bonds have become more correlated, unfortunately, achieving diversification through traditional asset classes has proven to be more challenging over the last 13 years or so.

Fifty years ago, diversification meant making sure investors held some allocation to both the US Equities and some type of Fixed Income. Later, investors added small and mid-sized company equities, corporate bonds, high yield bonds, and finally international equities – first with Developed Markets, then with Emerging Markets.

Adding some alternative asset classes to a portfolio provides additional diversification during a time when equities of all kinds have been very highly correlated to one another.

There was a time when the alternative asset classes were available only to high-net-worth investors. That, however, has changed. Today, accessing these investments can happen through mutual funds, exchange-traded funds (ETFs), and other types of retail products. So if you haven’t yet allocated at least 10% to 20%  away from traditional stocks and bonds, brace yourself.