Thoughts on the “Fiscal Cliff” from the Coldstream Investment Strategy Group

With the elections over, the media has turned its attention to negotiations between the U.S. House, Senate and Administration over tax policy and spending programs to avert what has been dubbed the “fiscal cliff” facing our country.  One of our research resources, Strategas Research Partners, provides a list below of the various tax extensions, programs and spending cuts set to change in 2013 if action isn’t taken between now and year end. Investors have clearly been nervous about the outcome of these negotiations; the S&P 500 stock market index has fallen (as of November 16^th) more than 6% from its early October level, with the NASDAQ composite and small cap stocks down even more.

We wanted to share with you our team’s thinking about the fiscal cliff and what steps we have taken in client portfolios or might consider taking in light of the issues being debated in Washington. Like other market participants we don’t know what will be agreed to regarding all of the various spending programs and tax policies. But we think there are some likely outcomes:

1. With major issues such as entitlement reform on the table we are confident that a “grand bargain” that fully addresses all spending and tax issues will not be completed by 12/31/12.
2. We expect the parties to agree to a general framework, make some preliminary changes, but “kick the can down the road” on the real substantive issues by year end. The point is we don’t expect the markets to have complete resolution until later in 2013.
3. The fiscal cliff is a symptom of the larger problem of U.S. government finances being out of balance. Even with a resolution of the fiscal cliff, we foresee that economic growth for a number of years will be slowed by higher taxes and lower federal government spending.
4. We also expect that putting the nation’s finances on a more sustainable path will lead to more spending, investing and hiring by companies (large and small) that should add to economic growth.
5. Along with the positive effects of an emerging housing recovery, very accommodative monetary policy and the net effects of the two prior points (3 & 4) we see the economy continuing to grow at around 2% per year.
6. If leaders in Washington were not able to resolve these issues and all of the changes were allowed to take effect in 2013 (in other words we went off the fiscal cliff) we believe the economy would experience a recession in 2013 and the market would drop from current levels.

What steps have we taken in client portfolios?

1. We have been taking into account these fiscal issues for more than a year in assessing economic growth prospects and market return and risk potential.
2. We have maintained well diversified, conservative balanced portfolios for clients expecting some volatility in markets. Specifically, we have emphasized alternative investments that we believe dampen portfolio volatility. We have also invested in some structured notes that provide exposure to risk assets (such as small cap and emerging market stocks) but do so with downside protection.
3. We continue to believe that the return/risk prospects over the next number of years for stocks are much better than longer maturity investment grade bonds. To this end we have focused on high quality stocks with above average dividends and higher yielding investments such as Master Limited Partnerships, corporate high yield and emerging market bonds.

Looking Forward.

1. As markets experience volatility over these negotiations we will look to be opportunistic in purchasing risk assets that we see as being reasonably valued such as high quality U.S. stocks.
2. If policymakers allow the economy to go over the fiscal cliff and the prospect of a recession increases we are prepared to be more defensive in seeking to protect client capital.
3. In terms of client specific tax issues, such as the pros and cons of harvesting long term gains this year, please contact your relationship manager.