Most of the discussion surrounding the fiscal cliff involves the potential worst-case scenario: i.e., what happens if we go “over the cliff”? This kind of talk is misleading, since it assumes the fiscal cliff is a binary event that involves either a timely resolution or a total failure.
In reality, the potential set of outcomes is rather wide given that Congress is more likely to kick the can down the road than it is to arrive at any sort of a “grand bargain.”
Investors therefore might want to take a closer look at just exactly what constitutes a best- and worst-case scenario from the fiscal cliff negotiations.
Even Under the Best-Case Scenario, Government Policy Still Will Be Contractionary
Assuming that a grand bargain doesn’t in fact occur — and given the rancor in Washington, such a deal is a low-probability outcome — the final result of the fiscal cliff is likely to be a compromise. Unfortunately for the markets, this compromise is likely to have a contractionary effect on the economy because it likely will involve some taxes and spending cuts.
As a result, even a best-case outcome (picture a bipartisan group of smiling lawmakers signing an agreement prior to Dec. 31) leaves the U.S. economy in a worse position in 2013 than it was in 2012. Given that the United States is already in a slow-growth environment, this indicates there will be little in the way of economic headwinds to boost corporate revenues in 2012.
Again, that’s the best-case scenario.
The Worst-Case Scenario Also Isn’t as Extreme as Reports Suggest
The headlines surrounding the worst-case outcome are equally misleading. The terms “cliff” and (especially) “over the cliff” assume that a catastrophe will occur on Jan. 1 if an agreement isn’t reached in time. But this isn’t Y2K … or even the end of the Mayan calendar.
Instead, it’s a problem with an incremental impact that will be spread out over the full year. And if Congress does come to a solution at a later date, it can put laws into effect retroactively — thereby forestalling the economic impact of a delayed agreement.
Markets Shrugging off the Headlines for Now
In short, the possible outcomes of this fiscal debate — while contractionary on the whole — aren’t necessarily as black-and-white as media reporting would indicate.
The market itself is telling us as much, the S&P 500 trading near its high for the year, high-yield bonds continuing to rally, and Treasuries not benefiting from any significant flight to quality. The recent weakness in gold, together with a VIX in the 16s, also isn’t indicating a market that’s on the edge of its seat.
What Should Investors Do?
Rather than trying to handicap the market impact of the debate ahead of the results, the best bet is to prepare for a countertrend play on any move that comes after a deal.
News related to the United States going “over” the cliff will likely give investors the chance to pick up cheap shares in companies likely to deliver organic growth in a sluggish economy, such as an Apple (NASDAQ:AAPL) or a Qualcomm (NASDAQ:QCOM).
Conversely, any rally associated with a resolution will be an outstanding opportunity to let the rally play out, then bet against domestic-oriented market segments more likely to struggle in a no-growth environment. Prime candidates for such a trade include the Financial Select Sector SPDR (NYSE:XLF), the SPDR S&P Retail ETF (NYSE:XRT), or iShares Russell 2000 Index Fund (NYSE:IWM).
The Bottom Line
The fiscal cliff is fairly straightforward, but the basic misunderstandings of the potential outcomes among rank-and-file investors are sure to create volatility in the weeks ahead. If that’s the case, this is one of those times when it likely will pay off handsomely to move in the opposite direction of the crowd.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.