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When Barack Obama won re-election to the White House back in early November, the consensus was that a "Fiscal Cliff" deal was all but certain.
As we see now, that "simple" deal hasn't been quite so simple.
America may be headed over "The Cliff." But you don't have to take the plunge, too.
In our Dec. 7 issue, we detailed several moves investors could make to fend off, or at least blunt, the effects of the Fiscal Cliff.
And given how things have played out down in Washington, we thought it was worth going over those moves a second time.
To fully understand what we're talking about, it's first worth reviewing the predicted fallout from the Fiscal Cliff, a mix of spending cuts and tax increases that many fear will toss the U.S. economy back into recession.
As we mentioned before, Permanent Wealth Investor Editor Martin Hutchinson has a surprisingly contrarian take on the escalating tempest.
Martin says there's been so much fear-mongering and political obfuscation that most Americans have lost sight of what's really at stake here.
"Bill, it's all such rubbish," the former global merchant banker told me. "As I said to you when we first started talking about what's become known as the Fiscal Cliff, it makes a lot of sense just to go over" the cliff.
Washington wants American consumers to believe this whole debate is about dodging the pain – forever. That phony sales pitch is what Martin is referencing with his "rubbish" comment.
"Some of our leaders want us to believe this debate is about avoiding the pain of higher taxes, another recession, a spike in unemployment, an inability of businesses to grow and hire," Martin said. "The truth is that there's no way to avoid the fallout from the fiscal mess this country now faces. We can either accept the pain now, or be forced to face it later. And if we wait, the pain will be far more excruciating than most Americans can even imagine."
Let's look at what Martin means – by reviewing a simplified version of a study by the Congressional Budget Office (CBO) – the agency that provides nonpartisan budgetary analyses to our elected lawmakers.
The term "Fiscal Cliff" was coined to describe what will happen if a package of Bush Administration tax reductions is permitted to expire, even as a series of spending cuts take effect. The implication is that the U.S. economy will be shocked into recession – pushed over the "Fiscal Cliff." What the term doesn't convey is that there would be an accompanying reduction in the U.S. deficit of some significance.
What the CBO did was to create two scenarios – a "baseline" scenario in which the country is toppled over the cliff, and an "alternate" view in which Washington "rescues" (term is mine) America with late-in-the-game compromises.
The results may surprise you, since they run counter to the spin we're getting from Washington.
Under the alternate, or rescue, scenario, Washington dodges the Fiscal Cliff, most likely avoiding a near-term recession. Taxes and other revenue remain around the historical norm of about 18% of U.S. gross domestic product (GDP). But public debt rises from 69% of GDP in 2011 to 100% by 2021 and to roughly 190% by 2035.
U.S. debt as a percentage of GDP hasn't been that high since it peaked at 109% just after World War II. If we do see such a spike, you can bet it will impact the nation's ability to grow and create jobs. In fact, a 2010 study conducted by economists Kenneth S. Rogoff of Harvard and Carmen M. Reinhart of the University of Maryland found that for countries with debt-to-GDP ratios "above 90%, median growth rates fall by 1%, and average growth falls considerably more."
Compare that to the CBO's baseline projection, the Nightmare on Main Street scenario that the Beltway SpinMeisters want us to believe should be avoided at all costs.
By implementing the required spending cuts and letting the tax reductions expire, taxpayers would feel a bigger bite and overall federal revenue would rise to 24% of GDP. The higher revenue coupled with the lower spending would lower U.S. debt, interest payments and federal budget deficits.
Deficits would fall from 8.5% of GDP in 2011 to 1.2% in 2021. According to the CBO's calculations, the accumulated deficit for the 2013-2022 period would be slashed from $10 trillion to $2.3 trillion – a reduction of $7.7 trillion.
The bottom line under the CBO forecast: We'd probably see the economy slow to near-zero growth in the first half of the New Year, with a rebound to 2% or more in the second six months. In the long run, however, the big cuts in debt issued each year, as well as the reduction in interest payments and the worrisome yearly budget shortfalls, would lead to much higher growth. Such fiscal strength would give this country the economic muscle needed to better compete with such emerging economic leaders as China.
"I agree that we'd probably have a mild recession in the near term – but it would be a mild one because we no longer face a financial crisis," Martin said. "And having a mild recession in the near term because we've taken such pro-active steps to clean up the economy is much preferable to harsher ones that will increase in both frequency and intensity down the road if we let U.S. debt become an even greater imbalance."
Even better: Slashing debt will finally solve the job-creation problem that's been plaguing this country for half a decade.
"By reducing debt, you're reducing what the government sucks out of the U.S. economy – which is very good for small businesses," he said.
So if you believe the two sides will fail to get together, resulting in an impasse that shoves the country over the Fiscal Cliff, what should you do to get ready? While most investors are panicking, you can celebrate the U.S. economy's good fortune – and your own as well, by making these three moves:
- Take Stock of U.S. Stocks: In general, U.S. stocks will likely take it on the chin. That doesn't mean you should dump stocks and run, however. It means the broad market indices will do poorly, so careful stock-picking will carry the day over set-it-and-forget it indexing. Financially sound companies with solid dividends will also stay in style.
- Act on the Twin Catalysts for U.S. Treasury Bonds: A reduction in debt will be good for the country's credit rating. And that upbeat outlook for America's finances will make U.S. bonds look even more attractive than the offerings of our debt-ridden counterparts overseas. At the same time, the deficit-reduction efforts will result in the U.S. government issuing less debt, reducing supply. The increase in demand coupled with the drop in supply should supercharge U.S. Treasury prices. Martin recommends the iShares Barclays 20+ Year U.S. Treasury Bond Exchange Traded Fund (NYSE: TLT).
- Capitalize on the King of Currencies: Martin says the big winner will be the U.S. dollar. It makes complete sense: If we clean up our act so that there's more confidence in our economy, it follows that there will be a renewed confidence in our currency, as well. Expect the dollar to rally big against other currencies for that reason alone. Plus, the greenback has a correlation coefficient with the U.S. Standard & Poor's 500 Index of negative 0.79, meaning it moves almost perfectly opposite the direction of this key U.S. stock index (and that inverse correlation has been increasing, according to researchers with the Bespoke Investment Group). So if the S&P 500 were to fall, as Martin predicts, the dollar will rally by almost the same magnitude. To capitalize on a projected dollar rally, Martin has two suggestions – depending on how speculative you wish to be. His first suggestion is the PowerShares U.S. Dollar Index Bullish Fund (NYSE:UUP). Although this unleveraged fund tends to trade in a tight range in normal markets, during times of panic, it can make big moves – and quite quickly, too. It shot from $22.50 to $27 in late 2008 and from $22.75 to $25.75 in a rally in early 2010. For a more-speculative play, take a look at the triple-leveraged PowerShares DB 3X Long U.S. Dollar Index Futures ETN (NYSE: UUPT).
- Consider Correlations: If U.S. stocks, as measured by the U.S. Standard & Poor's 500 Index, do fall as expected, look for investments that are "negatively correlated" both as a hedge and to profit. In the last six months, the only sector that is actually negatively correlated to broader stocks is the semiconductor sector (-0.21). And if you believe the U.S. dollar will continue to rally – as we discussed above – look for investment sectors that are positively correlated with the greenback. Those sectors are semiconductors, transports and utilities.
"A shove over the Fiscal Cliff will create a lot of market hysteria, but those who believe that's the ultimate outcome and position themselves ahead of time will do quite nicely if that happens," Martin concluded. "And, speaking frankly, I hope that's what happens. It would certainly fix a lot of the problems the economy faces and would increase the odds for higher growth going forward. Now if we can only get them to do something about the regulatory environment, too …"
[Editor's Note: In upcoming issues of Private Briefing, we're going to offer special research reports on "Fiscal Cliff" stocks as well as our experts' top investment plays for 2013. Make sure to stay tuned.]