Markets have been buffeted by the ongoing European saga that has driven markets both higher and lower as investors have tried to gauge the success of the European experiment. The markets’ schizophrenia has manifested itself in a series of “risk on” followed by “risk off” sessions as sentiment has swung widely. In its wake, the era of buy and hold has died and a new form of guerilla investing seems to have taken hold.
Don’t look for the dust to settle on markets any time soon as the U.S. election drags on and slower global growth undermines exports, the strongest pillar in an otherwise mediocre American recovery. A fear factor is emerging about an approaching fiscal cliff for the U.S. economy. The fiscal cliff is expected to arrive at the beginning of 2013, when the Bush-era tax cuts are set to expire and $1 trillion in spending cuts are set to kick in.
The impact of reduced government spending, coupled with slumping consumption when the Bush-era tax cuts are enacted, will result in a drag on economic activity of somewhere between two and five percent. And with the U.S. economy barely growing at two percent, failure to avert a fiscal cliff could quickly tip the world's largest economy into recession.
U.S. Federal Reserve chairman Ben Bernanke has been warning Congress for months now that the removal of tax cuts, combined with government spending cuts, would create a sudden shock that the U.S. economy would not be able to handle. “The size of the fiscal cliff is such that there is, I think, absolutely no chance that the Federal Reserve could or would have the ability whatsoever to offset that effect on the economy,” Mr. Bernanke said.
But despite the dire warnings, Congress is deeply divided and unlikely to take decisive action before the year end. The situation is creating a panic as economists fret that the same bitterly partisan battles that were fought over the debt ceiling last year may once again be played out over the fiscal cliff. That contentious debate over the U.S. debt ceiling led Standard and Poor's to downgrade the debt of the U.S.—a very real prospect once again as the fiscal cliff looms ever larger.
By the end of this year, the U.S. will once again hit its debt ceiling triggering more acrimonious debate and possibly triggering another downgrade. Bill Gross, the founder and co-chief investment officer of the world's largest bond company PIMCO, recently warned that the U.S. could be headed toward a credit rating downgrade if it does not tackle its deficit.
With Washington deeply divided, an election cycle in full swing and Europe's troubles heating up again, look for consumers and businesses to pull back as the year end approaches. Many big commitments such as house and car purchases are likely to be delayed until the outcome is clear and the fiscal fog is lifted.
With a possible one-two punch in the offing, investors should adopt a more defensive stance over the next few months. Trying to understand industry dynamics as well as the outlook for supply and demand is one thing investors can manage, but trying to game the actions of politicians on two continents is a mug’s game. For most investors, a hefty cash weighting and a few good dividend paying companies is the way to wait out the market volatility in the months ahead.
