If you are like me, you can’t wait until you don’t have to hear the term “fiscal cliff” 100 times per day anymore. Let’s take a look at how a prudent investor might react (or not react) to this political uncertainty and what might be in store for investors in 2013. But first of all, if you feel pressure to make significant changes to your investment portfolio ahead of the fiscal cliff, you would probably benefit from 1) a new investment strategy, 2) a different way of thinking about your investments or 3) both of the above.
The term “fiscal cliff” refers to the expiration of the Bush-era tax cuts and the automatic federal spending cuts that Congress agreed to in the summer of 2011. All told, the slated spending cuts and tax increases amount to about $600 billion, or 4% of U.S. GDP. It is not widely understood that if we go over the fiscal cliff our national finances would actually be bolstered in the short term. Tax revenue would increase and spending would decrease, thus improving our budget deficit and decreasing the rate at which our national debt is piling up (now $15 trillion and rising). The concern is that in the medium and longer term this abrupt change in policy would damage our economy and could, in the estimation of the Congressional Budget Office, send the country into recession in 2013.
So far the U.S. stock market does not seem to be particularly worried about the fiscal cliff. As of this writing the Dow Jones Industrial Average is up 7.7% so far in 2012 and the S&P 500 Index is up 12.8%. Markets are basically at the same levels as three months ago, despite the fact that we are just days away from the “cliff.” Why are markets so blasé? Well, no one can say for sure, but perhaps it is because we have seen a similar movie before-in the summer of 2011 with the messy, bitter negotiation in Washington to raise the federal debt ceiling and the subsequent one-notch downgrade of our sovereign credit rating from AAA to AA+. Investors were rattled by those events and sent the stock market down by more than 20% over a 10-week period. (Although, to be fair, troubling developments in Europe’s debt crisis conspired against global equity markets during that time span as well.) However, once the dust had settled and the Democrats and Republicans reached an interim agreement, markets recovered their losses fairly quickly over the following months.
The political theatre we will see over the coming weeks will likely cause some market volatility. If this happens, investors should stick to their long-term investment plans and ignore the short-term noise. Trying to game political outcomes is not likely to be a successful strategy in the long run. Instead, if markets do get choppy, investors should be looking for opportunities to add to their high-quality (but unduly punished) holdings.
Oddly, there is one potentially very positive outcome to the fiscal cliff negotiations that the press does not seem to have picked up on: that if an agreement is reached, corporate purse strings across the country will be yanked open and companies will be able to move ahead smartly with their capital expenditure, hiring and expansion plans in the new year. Right now companies are basically sitting on their hands as they watch and wait for Washington to get this matter settled. However, anything resembling an agreement will set spending wheels in motion and we could see a sudden release of the pent-up demand that has accumulated in recent months. Right now there is much political and economic uncertainty weighing on consumers and businesses alike. If, in two months from now, there is less uncertainty, our economy and our markets may begin 2013 riding a nice tailwind.