Jan. 1, 2013, is less than 60 days away and many are wondering how the so-called "fiscal cliff" will play out. Could this scenario be as severe as economists and investors believe? What steps, if any, will Congress take to avert disaster?
Last August, when Congress and the White House agreed to raise the debt ceiling by $1 trillion, the agreement called for cuts of $1.2 trillion in federal spending. Since no agreement was made on which cuts would take place, $1.2 trillion in automatic cuts are set to begin in 2013.
One thing is for certain: If nothing is done, then we will see massive tax hikes, billions of automatic federal spending cuts through 2021 and the possibility of another recession.
But before I tell you the best way to protect your investments, let's take a look at five potential "fiscal cliff" scenarios:
1. Congress kicks the can down the road (again)
This is probably the most likely scenario. With mid-term elections coming in 2014, legislators may opt to "pass the buck." A short-term, stopgap deal similar to others we have seen in the past is a high possibility. Each time the United States has come close to reaching its debt ceiling, Congress has been able to pass last-minute legislation to prevent the country from defaulting on its debt. In this scenario, the debt ceiling would be raised and a "down payment" might be made on longer-term liabilities.
2. Congress doesn't make a deal
This seemed almost improbable a few months ago, but here we stand facing another possibility of the United States defaulting on its debt. We could "go over the cliff" as 2012 comes to an end, and if that happens, then there is a strong possibility Congress could vote to reinstate some of the spending levels and tax breaks in order to calm the global financial markets. In other words, with these newly reinstated tax breaks, Congress will have annulled the $1.2 trillion spending cuts the country needs to control its debt.
3. Middle ground is reached and both parties compromise
This would occur if Republicans and Democrats decide to give and take. Though compromise may leave neither side completely satisfied, it may avert some of the mess that the fiscal cliff could create in 2013. Some potential compromises could include:
- Short-term provisions like the payroll tax holiday increase for small business expense deductions, assorted tax credits and some of the tax breaks for education may be phased out.
- The Bush-era tax cuts may be preserved for the middle-class and then raised for those making $1 million or more per year.
- Estate taxes, and taxes for capital gains and dividends may be raised.
- Defense cuts may get postponed.
You get the picture. Each side of the political aisle would have to give something up in order to gain and prevent financial chaos.
4. The "ultimate bargain"
The potential for an "ultimate bargain" between Congress and the White House is a long shot at best. The task of cutting $4 trillion by the mid-2020s seems almost impossible considering that both sides have been unable to reach an agreement on just $1.2 trillion in cuts. There seems to be too much of a gridlock for this scenario to play out, but strange things have happened...
5. Congress agrees on a down payment
If legislators agree on a down payment of deficit cuts to buy time and avert disaster, then this could be approved by a fast-tracked simple majority vote. If Congress fails to take further steps to cut the deficit in 2013, then certain tax breaks will disappear and cuts would hit certain social welfare programs, though not Social Security.
Based on these potential scenarios, what's an investor to do?
Here are four steps to prepare yourself and your portfolio...
Close out your riskiest positions, load up on cash and hedge what you cannot afford to lose
Cash is not a dirty four-letter word. Cash on hand could save you during tough times. It'll come in handy when the next market sell-off comes. After all, you should be buying when everyone else is selling.
You can also use inverse ETFs to protect downside risk and buy put options to hedge against losses. Think of these two investments in the same way you should approach any kind of insurance: Skip paying premiums if you can afford to take the loss. If you can't afford to lose, then insure your portfolio.
Rebalance your portfolio to be more defensive
Companies that offer recession-proof products around the globe should continue to thrive as well. With 70-80% of the world's population living in developing countries, emerging markets have been growth areas for many consumer-staples companies. With the increase in global consumption, these companies have great opportunities to increase their market volumes and accelerate their earnings growth rates.
Add more gold
Even central banks are bullish on gold. European central banks have become net buyers of gold for the first time in more than two decades, the latest sign of how the turbulence in the currency and debt markets has revolutionized the bullion market.
Physical gold, gold ETFs and gold-mining stocks could see prices soar if the crisis spreads and the globalhits another recession.
Have an offensive game plan
Action to Take --> Whatever happens in Washington, now is the time to consider these four steps in order to lower your taxes and protect your hard-earned money, especially if you're trying to build a reliable retirement portfolio.