What is the Fiscal Cliff, and How do I Prepare?

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What is the fiscal cliff, and how likely is it to take place in 2013?  How will the fiscal cliff impact consumers and the economy, and how can investors prepare for it?

The term “fiscal cliff” refers to the confluence of several major shifts in taxation and spending policy – all of them austere – that will hit the economy as of January 2013, unless Congress and the President come to a different deal that will head it off.

Remember the famous cartoon scene where Bugs Bunny and Yosemite Sam found themselves on trains heading toward each other at top speed along a length of track in a game of chicken? “I’m not stoppin’ my train!!” yells Bugs.  “Yeah, well I’m not stoppin’ mine!” yells Yosemite Sam.

This is an apt analogy for the high-stakes political gamesmanship surrounding the fiscal cliff.  A similar exercise in game theory is being played out in Congress right now. Except it’s not a cartoon – it’s real life, real money, and real jobs hanging in the balance. It’s political moments like these where my thoughts hearken back to Saturday morning Warner Brothers cartoons I used to watch as a child.

But how much of this is just politics as normal – and how much of it will likely affect consumers and investors whether or not Congress can broker a deal?  What can investors do now to protect their money?

What Will The 2013 Fiscal Cliff Entail?

Unless a deal is struck to avert the fiscal cliff, here is what will happen come the New Year:

  • The “Bush tax cuts,” first passed in 2001 and extended for the last two years because of the weak economy, will expire – resulting in an across the board tax increase for all income tax brackets. Capital gains taxes will also increase from 15 to 20 percent. Income taxes on qualified dividends also increase.
  • The ‘payroll tax holiday’ expires – which will force workers to pay an additional 2 percent of their salaries in Social Security taxes. The average take-home income of nearly all wage-earners, in other words, will fall by 2 percent.
  • Federal unemployment extensions expire – further hitting consumer spending power.
  • The alternative minimum tax exemption returns to the level it was at in 2001.
  • An additional 3.8 percent tax on capital gains on those who earn over $200,000 per year – or $250,000 for married couples – goes into effect.
  • “Sequestration” kicks in. This refers to a broad across-the-board cut of 9-11 percent in most discretionary programs, under the terms of the Budget Control Act. This would mean the mass cancellation or rollback of tens of thousands of federal contracts – and possible large-scale furloughs or layoffs.

Impact on the Economy

According to the Congressional Budget Office, the combined effects of the fiscal cliff elements will be enough to push the struggling U.S. economy back into a nasty recession. The CBO is projecting an economic contraction of about 2.9 percent in the first six months of the fiscal cliff, and 0.5 percent over the full year. Meanwhile, hundreds of thousands of new graduates will enter the workforce – and jobs will not be available for them. The CBO also projects that unemployment will spike to about 9.1 percent over the course of the year.

Now, it is very possible – even likely – that both parties will come to an agreement to avoid the worst elements of the fiscal cliff. But it is almost certain that the overall fiscal policy of the United States, under such a deal, would be less stimulative than it is now. There will be some combination of tax increases on higher-income workers – a condition President Obama is now insisting on as a means of breaking up the Republican coalition – and spending cuts. Their combined effect, whatever form they take, will take billions out of the economy, one way or another.

Defensive Investment Moves: Alternative Ideas to Consider

As a smart investor, what are the best ways to circle the wagons for the next year or two, while still staying invested?

Bonds are an uphill battle: With interest rates still bouncing around record lows, there’s not much upside available in bonds anymore – and plenty of downside. That leaves equities of various stripes.  Here are some things to consider:

  1. Get a jump on the New Year. Sell some winners and pay this year’s rates on capital gains taxes, rather than the higher rates likely in the future. By selling prior to the new year, you are locking in the favorable capital gains tax rates of today, and establishing a higher tax basis in your next investment. Remember – if you sell off losers to offset capital gains tax on winners, you can’t take the capital loss deduction if you buy the same security or a substantially equivalent security back in the next 90 days under the wash-sale rules.
  2. Get in the way of a ‘special dividend.’ Cash-rich companies may decide to “cut a melon” to their shareholders in the form of a special cash dividend before the tax rate goes up.
  3. Look for dividend stocks in general. Dividends historically provide a bit of a safety net during bear markets and recessions. Investors tend to flock to them during tough times, compared to Yes, you may have to pay more than you used to on dividend income. But that’s not an issue in retirement accounts, anyway.
  4. Consider real estate. While many stocks are sensitive to economic swings, real estate is often less tied to the economy (though correlations to stocks have been increasing in recent years). Some observers believe the sector is now experiencing a “serious recovery.” Plus, the battered sector is now attracting significant inflows from hedge funds and other sophisticated investors.
  5. Bet on vices.  When times are tough, people cling to life’s simpler pleasures: Alcohol and tobacco. Tobacco stocks, in particular, are strong income generators. Reynolds American International (RAI), for example, sports a dividend of 5.8 percent against a P/E of 16.78.  In addition, gun manufacturers, like Smith & Wesson (SWHC) and Sturm, Ruger & Co. (RGR) can do very well in recessions, too. And violent crimes are up, which spurs home defense sales. RGR is particularly inviting, with a yield of 3.2 percent and a P/E of around 16. Don’t fall for post-election froth; stick to fundamentals, rather than passing sentiment.
  6. Watch out for defense stocks. Some years back, you could rely on defense spending to increase year after year, regardless of what happened in the economy. That’s not true anymore. The defense industry has been buoyed for years by wars in Iraq and Afghanistan, to include research and development on counter-IED tactics and the development of entirely new vehicle platforms. The so-called “stimulus” also involved another round of military spending. But most military programs face the axe if sequestration happens, or anything like it. That means some planes, ships, vehicles and weapons just won’t be getting built, and existing orders could well be rolled back – at least in the short run.

Beyond Sequestration

There is also an argument on betting on the possibility of a naval arms race between China and the U.S., though, as China moves to assert its force projection capability throughout the Pacific and Indian Ocean and challenge the U.S. supremacy on the high seas. That might lead one to major ship-builders like Northrop Grumman (NOC). This one’s already taken a nasty haircut on sequestration concerns and the Obama reelection. But don’t count them out: There aren’t many other prime contractors that can build a modern nuclear carrier, for example. And they have a 3.2 percent dividend and a P/E of 8.34. Northrop Grumman is a longer-term play that takes you beyond sequestration and into the next economic phase. Remember: when thinking about defense stocks, think about the next conflict, not the last one.

Disclaimer: The views in this piece are held by the writer alone and do not reflect the opinions of NerdWallet.