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Fiscal Cliff’s Implications for Investments – The Witching Hour

Mike Temple
calender-icon Posted on October 15, 2012

As the elections grow nearer, so does the fiscal cliff – the point early next year where tax hikes, debt limits and spending cuts will presumably converge.

  • The debt ceiling. There appears to be an agreement, at least among key senators and congressmen, that the issue will be addressed after the election. The Federal Reserve and the Treasury also agree that we won’t have to deal with this problem prior to the first quarter of 2013. With this provision, the matter will be debated by the newly elected congressmen and senators in place, while outgoing congressmen will not have to deal with it and take extreme positions if they want to get a new term.
  • Sequestration (expected cuts in programs), for which there has never been an agreement. This would cut rather indiscriminately across different segments of the budget, and amounts to about a trillion dollars over ten years, which is a fairly small number on an annual basis. The major source of cuts is going to be defense; the rest should be on discretionary spending. Both parties are eager to address this because neither is happy with how the cuts affect their particular interests. Sequestration would be a drag on GDP but might not be, in our mind, the largest source of concern for the market.
  • Bush-era tax cuts expiration.  We believe the expiration of Bush’s tax cuts would have the most potentially negative impact. This would lead to higher tax rates on all constituents, most notably on dividends and capital gains. We think it could have a profound effect on financial markets   equity markets in particular   as investors have been reallocating large portions of their equity holdings toward income-generating large cap equities. We think the increase in capital-gain taxes would hurt all those interested in buying risky assets.

We foresee the possibility of fairly substantial sell-offs as a result of the re-institution of the tax regime prior to the Bush tax cuts, so that is the key risk for financial markets, in our opinion.

A Sell-off in U.S. Treasuries Could Drag the Corporate Bond Market Down With It

We think that a political agreement over less government spending would support U.S. Treasuries longer-term for more fundamental reasons, showing the world that U.S. budget deficits should not spiral out of control. However, if the current deficit spending ultimately intersects with better and faster economic activity at some point in the future, igniting inflation concerns, Treasury yields and prices could come under substantial pressure.

I think there is the risk that a sell-off in Treasuries could drag down the corporate bond market. With spreads so low particularly in Investment Grade credit, if you see a sharp rise in 10-year yields, while there may be some modest spread compression on corporate bonds as the economy improves, the increase in U.S. Treasury yields could overwhelm this positive spread action.

The high-yield segment could be relatively more protected because of its lower duration. To minimize the risk from a U.S. Treasury sell-off under these conditions, we believe the focus should be on the shorter part of the yield curve where there is some room for spread compression, albeit from low levels.

What Can investors Do in This Environment?

Of course, the most important thing investors have to grapple with is their risk tolerance and time horizon. Volatility may persist amid all the uncertainty, related to politics and other forces. So if you have a shorter time horizon, it is important to reduce your exposure to investments that are fully priced right now. On the one hand, if the world normalizes over the next couple of years, the greatest risk is that soaring interest rates will pressure very high-quality fixed income securities. In this case, portfolios focused on U.S. Treasuries and mortgages are going to have a real hard time. Conversely, if the world continues to struggle economically, we could see pressure on risky assets and equities.

What investors should try to do is avoid these two extreme scenarios (tail risks). In the current economic scenario, there is a strong case for highly active management – the world of passive investment strategies and of high-quality fixed income doesn’t really make a lot of sense.


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