The election is over, and voters have opted to keep the status quo: a divided U.S. government.
That could have big implications in the months ahead for investors in a broad swath of assets, from stocks and bonds to the dollar, say financial advisers and market strategists.
The single biggest factor in the markets right now is the looming “fiscal cliff.” If lawmakers don’t come to an agreement, tax increases totaling $532 billion for 2013 will kick in on Jan. 1, along with about $136 billion in spending cuts.
According to the Congressional Budget Office, that could cause the economy to contract by 0.5 percentage point next year, with unemployment jumping to 9.1% from 7.9% in October.
The mere possibility of such an outcome unnerved the stock market in the days after the election.
Associated Press President Barack Obama Getty Images House Speaker John Boehner Getty Images Senate Majority Leader Harry Reid
President Barack Obama and congressional leaders have expressed confidence that they will strike an agreement, even if it means pushing back the deadline a few months to give themselves more time. But their track record isn’t encouraging: In 2010 and 2011, Congress waited until the last minute to avoid a tax rise and a breach of the U.S. debt ceiling, respectively—roiling markets in the process.
Some wealth managers expect the worst. “We’re advising our clients to assume the changes will go into effect on Jan. 1,” says Aaron Gurwitz, chief investment officer of Barclays’s wealth- and investment-management division, who recommends clients hold some long-term bonds for safety.
Even if the fiscal cliff is averted, investors will need to keep close watch on Washington in 2013. Presidential policies like the Affordable Care Act and financial regulation will continue to be implemented, having big ramifications for health-care companies and banks.
With that in mind, here is how to prepare for the impending congressional showdown and other upcoming challenges in the months ahead.
Forget the historical analyses showing that stocks outperform during Democratic presidencies and underperform during Republican ones. Such comparisons fail to account for the possibility of a fiscal-cliff showdown that could last well into the holidays.
The approaching deadline could bring market volatility similar to what unfolded during the debt-ceiling debate in the summer of 2011, says Lew Altfest, chief investment officer of Altfest Personal Wealth Management in New York. The Standard & Poor’s 500-stock index fell 3.6% in July 2011, leading up to the debt deal—then plunged anew after S&P downgraded the U.S. because of the increasingly unstable political situation here. Stocks recovered after that.
An ominous sign: This past week, the S&P 500 dropped 3.6% in just the two days following the election.
“It’s almost a prerequisite that politicians are going to be extreme on both ends before a deal,” Mr. Altfest says.
But market volatility could present opportunities for investors. Right now, the S&P 500’s price/earnings ratio based on earnings estimates for the next 12 months stands at about 12.8, according to FactSet—in line with the index’s five-year average ratio of 12.9. So any downdraft in the weeks leading up to an agreement could create bargains.
For more risk-averse stock investors, Craig Johnson, technical market strategist at investment bank Piper Jaffray, recommends large, dividend-paying companies such as AT&T and Walt Disney. Such companies tend to have stable earnings and balance sheets, he says. AT&T has a forward price/earnings ratio of 10, and Disney has a forward P/E of 13, compared with 14 for the S&P 500.
An extended period of volatility also could depress Treasury yields further, which in turn could prompt bond investors to switch to dividend stocks in search of better yields, he says. The $12 billion Vanguard Dividend Appreciation exchange-traded fund, for example, has a 2.1% dividend yield, about half a point higher than the 10-year Treasury. The fund invests in companies that have boosted their dividend for at least 10 consecutive years, among other attributes, and has an expense ratio of 0.13%, or $13 for every $1,000 invested.
The dividend tax will rise next year to rates as high as 39.6% from the current 15% unless lawmakers act. But an analysis by Fidelity Investments found little impact on dividend stocks’ performance when the dividend-tax cuts were implemented in 2003. That suggests their subsequent rise also might have little effect, according to Fidelity.
Longer term, certain sectors could do especially well as the Obama administration carries out its policies in his second term, says Daniel Clifton, head of policy research at investment-research firm Strategas. Among the potential winners, he says: some health-care companies such as hospitals, Medicaid health-maintenance organizations and medical-technology companies, which will benefit as the Affordable Care Act continues to be implemented. On Wednesday and Thursday, for example, the Health Care Select Sector SPDR ETF dropped only 1.6%.
The $23 billion Vanguard Health Care Fund carries a “gold” rating from investment-research firm Morningstar, in part for its low 0.35% expense ratio and stellar performance. In the past five years, it has returned an average of 5.5% annually, beating 60% of its sector peers. Since launching in 1984, it has been the best-performing U.S. stock mutual fund that Morningstar tracks.
Mr. Obama also has supported infrastructure programs and more stringent carbon-emission limits, which could help construction and alternative-energy companies, Mr. Clifton says. Companies that could benefit include $5 billion Jacobs Engineering Group and $29 billion NextEra Energy, he says. Jacobs has a forward P/E of 11 while NextEra has a forward P/E of 12, compared with 14 for the S&P 500.
As if Treasury yields weren’t low enough already, strategists warn that they could fall even further if lawmakers don’t avert the fiscal cliff soon. The 10-year Treasury yield, which moves in the opposite direction of price, fell to 1.63% from 1.74% in the two days after the election.
Investors who rely on bonds for income thus face a tough choice: Make less money on their bonds or venture into riskier ones in search of plumper yields.
High-yield, or “junk,” bonds—those rated below triple-B by S&P and Baa by Moody’s Investors Service—could be especially dicey. Investors tend to dump riskier assets in times of stress.
Consider the summer of 2011, when Congress waited to the last minute to raise the debt ceiling and S&P cut the credit rating of the U.S. by one notch. In August and September that year, the Bank of America Merrill Lynch High Yield Master II index dropped 9%.
Investors willing to take the plunge into junk would be better off with short-term bonds, says Carl Kaufman, portfolio manager of the $2.7 billion Osterweis Strategic Income Fund. They usually are less volatile, because investors have to wait only a year or two before getting their money back. Such bonds can yield from 3% to 5%, or two to three times the 10-year Treasury.
Sam Katzman, chief investment officer at Constellation Wealth Advisors in New York, prefers the $288 million RiverPark Short Term High Yield Fund, whose portfolio of corporate junk bonds has an average effective duration of 0.4 year and has returned 3.8% this year. Another option: the $1.1 billion Wells Fargo Advantage Short-Term High Yield Bond Fund, which has the longest track record among short-term high-yield bond funds and has returned 5.8% this year.
Investors also should consider bonds from emerging-market nations denominated in dollars, says Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management in Kansas City, Mo. The bonds offer higher yields than Treasurys, and the economies of many developing nations are improving. Fitch Ratings on Tuesday raised Turkey’s credit rating, for instance, to triple-B minus from double-B plus. A 10-year Turkish government bond yields 7.55%.
Buying individual emerging-market bonds is difficult and pricey, so investors are better off sticking with a mutual fund or ETF, advisers say. The $6.2 billion iShares J.P. Morgan USD Emerging Market Bond ETF, which owns the debt of Brazil, Russia and Mexico, among others, has a yield of 3.3% and has returned 15.1% this year, compared with the 1.7% yield and 4.4% return of Barclays Aggregate Bond Index, which tracks the U.S. investment-grade bond market. The ETF has an annual fee of 0.60%.
If the current tax rates expire at the end of the year or lawmakers strike a fiscal deal that sends tax rates higher, federal-tax-free municipal bonds might become more attractive, strategists say. That is because investors will be able to keep more income relative to taxable bonds like ones issued by companies and the U.S. government.
The safest bets are municipal bonds rated triple-A by S&P and Moody’s, says David Kotok, chief investment officer at Vineland, N.J.-based Cumberland Advisors, which oversees about $2.2 billion. Their top-shelf rating should offer investors a haven as the fiscal cliff approaches, he says.
Triple-A munis already have higher after-tax yields than Treasurys. The 10-year bonds of Utah and Delaware, for instance, now yield 1.63%, equivalent to a federally taxable yield of 2.51%, according to Municipal Market Monitor.
U.S. Bank’s Mr. Heckman says bonds in states hit hardest by the housing bust could be a good, albeit riskier, bet. Essential-services revenue bonds—think water and sewer utilities—in places like Florida and Arizona offer higher yields than similar bonds in other states, Mr. Heckman says, even as the housing markets in those states improve. For added safety, investors should stick with bonds rated double-A and higher, he says.
Fiscal uncertainty is already helping the dollar, which is traditionally seen as a haven. The Wall Street Journal Dollar Index, which measures the strength of the greenback against a basket of seven currencies, rallied 0.1% in the two days following the election.
“The fiscal cliff is closer, and that seemed to hit investors with much more impact than anyone had expected,” says Andrew Wilkinson, chief economic strategist at institutional trading firm Miller Tabak in New York. “The dollar’s rise will continue until we hear something constructive on discussions.”
Investors who own U.S. stocks and bonds already have U.S. dollar exposure. Those wishing to make an additional bet on the dollar strength could use the $866 million PowerShares DB U.S. Dollar Index Bullish ETF, which invests in a basket of six currencies including the euro and the yen and is the most heavily traded currency ETF. It has returned 2.5% over the past year, and has an expense ratio of 0.75%.
If the fiscal cliff does get resolved soon, however, the dollar could weaken. In that case, investors might want to consider riskier emerging-market currencies like the Mexican peso, Korea’s won and Taiwan’s dollar, says Alan Ruskin, a currency strategist at Deutsche Bank in New York, because their economies should benefit from better global growth.
The largest currency funds with emerging-market exposure include the $7.1 billion Pimco Emerging Markets Currency Fund, which has returned 6.4% so far this year and charges an annual fee of 1.25%, and the J.P. Morgan International Currency Income Fund, which has returned 3.1% and has net expenses of 0.84%.
A word of caution: Investors worried about a falling dollar should be careful with gold, says Michael Haigh, head of commodities research at Société Générale in New York. Gold has risen 10.2% so far this year, and has more than doubled during the past five years.
The precious metal is viewed primarily as an alternative currency—especially when central banks are printing money—and typically gains in value when the dollar is weak. But if politicians successfully negotiate the fiscal cliff, the U.S. economy could be stronger than expected—and that could strengthen the dollar.
The bottom line, says Mr. Haigh: While gold might tick up a little bit in the next few months on fiscal-cliff uncertainty, it “may have had its last hurrah.”
Write to Joe Light at email@example.com and Ben Levisohn at firstname.lastname@example.org
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