The buzz-word on Wall Street the day after the election was ‘uncertainty.’ While investors now know that President Obama has been re-elected, two significant sources of uncertainty in today’s marketplace remain: the so-called fiscal cliff and the debt ceiling. In a market where political and economic uncertainty continues to prevail, investors will be best served to consider the scenarios that could play out for various economic events.
THE FISCAL CLIFF
When the lame duck Congress begins on November 12, politicians will begin working on addressing the fiscal cliff. The tightening impacts of the fiscal cliff include the expiration of the Bush-era tax cuts, the expiration of the payroll tax cuts, sequestration, emergency unemployment insurance benefits expiring, depreciation incentives expiring, the Alternative Minimum Tax fix not being patched and Medicare payments to doctors not being extended. Politicians in Washington will need to make decisions as to whether they wish to kick the can down the road, cross the political divide and make comprises, or allow for the full force of the fiscal cliff to come to fruition, potentially causing a serious shock to the US and global economy. The resolution of the fiscal cliff has the potential for a couple of scenarios.
KICK THE CAN (BEST CASE SCENARIO FOR 2013 GDP GROWTH)
If politicians extend these measures for the short term to avoid the fiscal cliff in early 2013 and there is no resulting fiscal drag, economists estimate that US GDP in 2013 will register at 2.7%. While this is a plausible scenario and one that would result in the best short-term growth prospects, it may not pass muster with Congress. In addition, another round of can kicking the can may push eventual resolution into future years, but may not bode well for bolstering faith that Congress can work together to solve the big issues that were a central tenant of the Presidential debates.
MEASURED COMPROMISE (BASE CASE SCENARIO FOR 2013 GDP GROWTH)
It seems more probable that President Obama will look for Democrats to cross the aisle with Republicans and work on a resolution before the end of the year. While the ambitions might exist to do so, having both parties come together for a broad-based resolution may be difficult. More likely, some compromise will take place, which will generate a certain amount of belt tightening. For example, it seems likely that the payroll tax, which is worth approximately $120 billion, will be allowed to expire because it has not been popular with either party. Thus, economists estimate that 0.7% will be knocked off of GDP as a result of these measures, bringing growth next year to a slower 2.0%.
NO AGREEMENT TO AVERT THE CLIFF (WORST CASE SCENARIO FOR 2013 GDP GROWTH)
If Democrats and Republicans fail to compromise, the fiscal drag may reach 1.7%, bringing US GDP down to 1.0% in 2013. However, economists are forecasting that GDP could fall as low as -1.1% should the full impact of the fiscal cliff be felt. This would imply that the US would fall back into a recession, which would impact global growth and have serious domino effects to security markets.
The base case scenario braces for some impact to GDP growth, but nothing catastrophic. From a political point of view, this implies more of a status quo environment. In other words, while 2013 may see more productive discussions on the long-term fiscal condition of the US and the role of taxes and entitlements, investors may need to be prepared for ongoing uncertainty. At the same time, investors will need to contend with the evolving political situations in the Eurozone and questions about Chinese growth prospects. Should economic prospects worsen, central banks are standing ready to prime the pump with additional liquidity; however, we really question their effectiveness at this stage.
THE DEBT CEILING
While most headlines have focused on the impending fiscal cliff, the US faces another debt ceiling debate in short order. Estimates vary for when the current ceiling of $16.4 trillion will be breached, but based on tax receipts and expenditures it seems likely that it could occur between January and March 2013. While the Treasury department does have some leeway to manipulate their spending, which they did in 2011, this will only serve as a band-aid until a long-term resolution is reached. In August 2011, markets were whipsawed as politicians debated whether to allow the debt ceiling to be increased without cutting spending. Washington may have learned from this experience that inaction increases uneasiness in an environment that is already characterized as uncertain. Even so, global investors may continue to look unkindly at this kind of behavior from the world’s largest economy.
With a renewed debt debate and the potential lack of commitment to aggressively reduce spending or plan for future austerity when it may be more palatable for the economy absorb, gold stands to benefit as it has served as a buffer against uncertainty and its value cannot be debased. In addition, with the potential for a long-term inflationary environment due to continued large-scale government spending, investors may wish to allocate a portion of their portfolio to real return assets such as real estate, energy, and agriculture investments.
While some of the political uncertainty has eased now that we know the US will have another four years of Democratic leadership, investors still need to contend with the remaining elements of uncertainty driven by Washington. First and foremost, politicians will need to tackle the fiscal cliff and, shortly thereafter, address the debt ceiling. President Obama will likely be driven to address the fiscal cliff in short order, but there is the potential for the solution to include only minor adjustments to the fiscal situation or something far less benign.
Unless one is a day-trader, the vast majority of investment decisions do not pay off immediately. To expect immediate investment gratification with a long-term strategy is imprudent and unrealistic. Often, a long-term investment strategy will look wrong in short-term periods, only to be right in the medium to long-term. Investors must keep top of mind that a long-term strategy of the old days (five or more years ago) was underpinned by a downward trend in interest rates, which created ease in borrowing. Today, that trend is bottoming (bottomed in some places like Europe). Periods of change, such as these, are typically marked by heightened volatility. Volatile periods of change are not unique to the investment world. This means that a long-term investor has to identify the likely long-term path of the new macroeconomic environment.
Most informed investors have come to, in our opinion, the correct conclusion that setting and forgetting a portfolio is no longer the best investment strategy. Currently, when looking at the long-term investment horizon, it is hard not to see the mountains in the foreground. Therefore, long-term investors must adopt a strategy that is more nimble to deal with the volatility that comes with a change of macroeconomic trend. To achieve long-term financial goals, wealth and purchasing power must constantly be carried forward. In the current environment, to carry wealth forward, investors must be prepared to protect their wealth from the many and varied risks we did not have to face five or ten years ago. Investors must prepare portfolios for the looming economic storm that sits between today and the long-term.
Addressing risk in all facets of life is the same, and always requires some form of caution. Caution in the investing world means a lowering of risk exposure (depending on the risks). Our role as investment fiduciaries to our clients requires us to act in the best interest of clients. To that end, we look at the macroeconomic picture, evaluate likely outcomes, and put in place the best mix of investments for our long-term view. This may not provide immediate investment gratification, and it will not always beat random market benchmarks, but it will keep your portfolio from getting wet from the storm in the long-term.
Do you have an investment strategy that seeks to protect your portfolio against volatile economic conditions? Call me to schedule a free review of your current investment portfolio – 913.402.6099.
John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals. For more information, visit http://www.chladekwealth.com.