Here's the background of the current situation: In the fall of 2011, a gridlocked Congress established a mandated across-the-board cut of between $300 billion and $600 billion in federal spending to go into effect next year unless a deal is struck by the end of this year to cut the budget and/or raise taxes.
Given the bitter congressional gridlock, and economists' warnings that such a sudden cut in federal spending could throw the country back into recession, investors are understandably worried about their portfolios.
But a solution may bring a new set of issues. So they also have to worry about how any deal, should one be struck between the two parties, would affect markets and their existing investments.
Most political observers agree that the two least likely scenarios for year's end are a so-called grand bargain in which taxes get raised on the wealthy and cuts get made in social programs and other areas of the budget in a smooth reform that spreads the pain among all or most Americans; or an alternative where both parties stonewall and just let the country fall off the cliff.
Republicans initially took that strategy with the debt ceiling deadline in 2011, but after losing congressional seats, not to mention the presidential race, in an election where exit polls indicated that the economy was utmost on voters' minds, they are unlikely to do the same thing in this crisis, observers said. Some kind of compromise is thus likely, though it may take some time for the two sides to arrive at one.
Given that, what can advisors do to protect clients in these next uncertain weeks and months?
FASTEN YOUR SEAT BELTS
Dave Roda, southeast regional chief investment officer at Wells Fargo Private Bank, tells Bank Investment Consultant that he does not expect Congress and the White House to reach a deal on the "fiscal cliff" before the December 31 deadline, but he is confident they won't let the country fall off the cliff. "They'll pass something to kick the can down the road past the president's second inauguration and let the new Congress deal with it," he predicts. At that point, he expects "some kind of a deal that will involve higher taxes on dividends, capital gains and the top income bracket."
In the meantime, he says investors and their advisors should be prepared for a period of significantly higher market volatility. With that in mind, Roda says he is recommending reducing the amount of risk in portfolios, while doing "staged buying" whenever markets are down and present opportunities.
He's also "trying to capture a large share of cash flow" by investing in dividend-paying stocks — especially those like technology companies, industrials and consumer cyclicals — that are in a position to raise dividends. For the next couple of months, with the fiscal cliff being the "crisis of the moment," Roda says his bank is dollar-cost averaging. As for clients who provide the appropriate documentation, the bank is also offering options-based puts to mitigate downside risk.
In the case of investors with smaller portfolios, Roda urges advisors to make sure their clients have enough liquid assets to be able to "get through the next 18 months without being forced to sell when markets are down" just to meet their living expenses.
Hal Ratner, CIO Europe and head of capital markets at Morningstar, says that things are a "little bit dicey right now." While he says it is "hard to imagine" elected officials allowing the economy to go over the cliff, which would cause a "catastrophic" global recession, he also notes that "We do think there's going to be a game of chicken going on, a little like the 2011 debt ceiling standoff."
In that environment, he suggests, "Just sitting tight on your investments is a reasonable strategy, especially for long-term investors."
Ratner, like Roda, doesn't expect a resolution by year's end, but rather sometime in the middle or end of the first quarter of 2013, after the new Congress is seated and the president has been sworn in to a second term of office.
His colleague at Morningstar, investment management division economist Francisco Torralba, says that given the likely market volatility until a compromise is agreed on, reducing portfolio risk is probably a good idea.