Now that the 2012 presidential election is in the record books, investors can start focusing on a much bigger issue - the fiscal cliff. The looming automatic spending cuts and tax increases could have a dramatic effect on the U.S. economy and could possibly push the nation back into recession. Overall, without action from Congress, 2013 and beyond could be quite a bumpy ride. For investors, it may make sense to prepare ones portfolio for any impending doom and gloom.
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Big Time Spending Cuts
Back in 2011, The Budget Control Act was passed under a partisan stalemate, in which democrats and republicans could not agree on how to reduce the deficit. Under the agreement, a series of automatic spending cuts and tax increases were created in order to provide motivation, as well as create a line in the sand to bring the sides together to solve the deficit problem.
If Congress and President Obama don't act by January 1, then more than $600 billion in automatic spending cuts will hit the economy. Not to mention that there will be higher taxes starting in 2013. Economists agree that tax hikes and budget cuts will likely cause Americans to pull back on spending and significantly slow down the overall economy. The average household would have to pay an extra $3,400 in taxes next year as income rates rise 3 to 5%. According to nonpartisan think-tank, the Congressional Budget Office (CBO), the U.S. economy would contract by 0.5% in 2013, if the government fails to prevent going over the fiscal cliff. Currently, economists predict the U.S. will see far below the 2% GDP growth for the year.
The situation gets worse when it comes to unemployment. The CBO estimates that the U.S. unemployment rate will surge up to 9.1%, if a deal isn't reached. Unemployment currently stands at 7.9% and the jump would be the highest rate since July 1991.
Careful Portfolio Planning
Given the severity of the fiscal cliff, it's easy to understand why all three of the major stock market indexes have fallen about 5% since President Obama's reelection. The expiration of the Bush tax cuts for dividends, capital gains and carried interest are a prime concern for investors as well as any contraction in the already fragile economic recovery. However, blindly dumping dividend-focused funds like the iShares Dow Jones Select Dividend Index (ARCA:DVY) or other assets isn't necessarily the best way to play the cliff. Yet, there are some ways to prepare a portfolio just in case Congress decides to leap.
While U.S. debt loads are the heart of the fiscal cliff, treasury bonds remain a "safe-haven" for many investors in times of trouble. As investors have dumped stocks since the election, inflows into Treasury bond funds have grown. The $4.7 billion iShares Barclays 7-10 Year Treasury (ARCA:IEF) allows investors to bet on a basket of intermediate-term government bonds. The fund's 23 holdings provide a 1.59% yield for a rock bottom expense ratio of just 0.15%. Likewise, shorter-termed government bonds could be a good bet and the SPDR Barclays Capital 1-3 Month T-Bill (ARCA:BIL) is a good way to play those bonds.
If we do go over the cliff and the current tax rates expire at the end of the year, federal-tax-free municipal bonds will become more attractive as investors will be able to keep more income. The Market Vectors Intermediate Muni ETF (ARCA:ITM) can provide investors with a basket of tax-free muni bonds from across the nation. The ETF has an overall four-star rating from Morningstar (Nasdaq:MORN) and yields 2.4%. Similarly, the Van Eck-sponsored Market Vectors High-Yield Muni ETF (ARCA:HYD) could be used to get more "oomph," as it bets on the muni equivalent of junk bonds. HYD yields a tax-free 4.97%.
Finally, when it comes to safe-haven assets, precious metals like gold and silver remain a top draw for investors. No matter the outcome - deal or not - precious metals can serve as a buoy for portfolios in times of trouble. The obvious play in gold is the behemoth SPDR Gold Shares (ARCA:GLD) at nearly $73 billion in assets. Perhaps a better bet could be the ETFS Physical PM Basket Shares (ARCA:GLTR). The fund allows investors to own a basket of gold, silver, platinum and palladium stocks under one ticker.
The Bottom Line
Going over the pending fiscal cliff could be a scary proposition for American citizens and investors. The automatic spending cuts and tax increases could further damage America's already-fragile recovery. For investors, it's never too late or too early to prepare for the possibility. The previous picks, along with cash alternatives like the PIMCO Enhanced Short Maturity ETF (ARCA:MINT), make good choices.
At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.