Keep your portfolio from going over the cliff

Kevin Fusco, The Daily Record Newswire

There were more than enough focal points this election season to grip headlines and compete for investor attention, but the one that may provide the most post-election strife, and have the biggest effect on portfolios, is the so-called fiscal cliff.

Much has been made of how we ended up in such a quagmire, and enough pundits have debated the merits of flying off the cliff versus slamming on the brakes, but what remains for investors is how they should position their portfolios for each scenario.

The first of these scenarios is the most unlikely, and would see a lame-duck Congress pass some form of sweeping fiscal resolution before the January deadline. Under this scenario, and assuming an uncanny amount of cooperation between the White House and Congress, the financial markets would likely react favorably as the cliff would be avoided totally.

In addition, this scenario would mitigate concerns of a recession in 2013 and should bolster spending by both consumers and corporations. Fixed-income markets would likely see yields rise as investors fled safer alternatives for more risky asset classes.

In our opinion, portfolios with less Treasurys exposure, more credit-sensitive offerings, and traditional equity market exposure would stand to perform admirably, while “safe haven” investments like government-backed securities and non-correlated asset classes, such as commodities, could suffer.

A more likely outcome is that Congress and President Barack Obama will reach some form of compromise. This compromise, while not sweeping reform, will probably be centered on extending the Bush-era tax cuts for a short time until the administration has time to address a longer-term solution.

Many believe such a compromise would allow the markets to continue their current course by kicking the proverbial can down the road. Most investors agree that it is vital to address the fiscal issues expeditiously, but not so fast as to plunge the economy into recession.

Investing under the compromise scenario should be centered on a balanced approach. Assuming that the compromise staves off a recession in 2013, investors will not need to jettison risk assets, but at the same time, uncertainty over the timeline for sweeping reform could heighten volatility enough that requires some allocation to relatively risk averse holdings as well.

This balance is generally achieved easily by developing an objective-based asset allocation framework. It is important to remember, though, that asset allocation alone does not protect against losses, so investors must also employ a dedicated rebalancing regimen that takes into account the short-term market movements that sudden volatility may bring.

In what is generally accepted as the direst scenario, yet still a distinct possibility, Congress fails to act prior to the January deadline, thus leading to the automatic spending cuts and tax hikes that most investors fear. This scenario, based on many economists’ projections, would almost surely plunge the U.S. economy into recession if Congress does not act very swiftly.
While it is widely believed that even if this scenario did come to fruition, Congress would try to lessen the full impact of such spending cuts and tax increases by acting as quickly as possible, the perception that the economy went “over the cliff” would cause at least some panic in the financial markets, and volatility would rise.

The effects of the “over the cliff” scenario would present the most challenges for investors, if for no other reason than the uncertainty it will cause.

Leading up to the end-of-year deadline, many investors will shed positions with low cost bases in order to avoid an increase in capital gains tax rates, while others load up on Treasurys in a flight to perceived safety. Market volatility will likely accompany the last few weeks of 2012 and at least the first few of 2013, and it would not be strange to see investor appetites for risky assets wane.

But, it is important to keep in mind that being defensive does not mean running away from risk. Investors can apply a defensive overlay to their portfolio by blending fixed-income holdings to maximize yield in lower credit quality offerings, while targeting higher-quality corporate offerings that avoid the momentum trappings of Treasurys.

Also, defensive sectors, such as utilities and consumer staples, in the equity markets may offer the potential for return without having to abandon stocks all together.

Which scenario investors will inevitably be faced with in the post-election landscape is still uncertain, but those who plan accordingly, and have addressed the likelihood of each option, will hopefully be able to avoid some of the pitfalls brought by having to react rather than re-evaluate.

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Kevin Fusco is senior vice president of Fusco Financial Associates Inc. of Towson. He can be reached at 410-296-5400, extension 109, or Kevin.Fusco@LPL.com.

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