Financial survival in a time of fiscal peril

Advisers are asking investors to exercise restraint, develop a plan and stick with it over the long term. By Paul Sullivan
 20 Oct 2012 09:08

 BEST STRATEGY'Sit down with yourself or your adviser and figure out what you're trying to accomplish over the rest of your life. Develop a plan with as few moving parts as possible and then stick to that plan,' advises John Taft, head of RBC Wealth Management. - PHOTO: REUTERS

BETWEEN now and the end of the year, investors who are paying even the slightest bit of attention to the news will hear the term "fiscal cliff" repeated so often that it will surely either strike fear into their hearts or numb them to possible risks ahead.

For some, it may sound like the warning they wished they had received ahead of the 2008 crash, or a signal that it is time to retrench. For others who have their money in cash or bonds, the chatter may confirm their worst fears about living in an uncertain time and persuade them to wait longer to invest in stocks. It should do neither.

The phrase itself refers to a confluence of tax increases and spending cuts that will happen automatically on Jan 1, 2013, if the US Congress and president do not come to an agreement to avert them. Think of skid marks ahead of a precipice.

If the government does not hit the brakes and all the provisions that make up the fiscal cliff come to pass, however, the impact on gross domestic product will be to reduce it 4 per cent, according to the Congressional Budget Office. The non-partisan Tax Policy Center made the impact more personal: 90 per cent of Americans will see their taxes rise, with an average increase of US$3,500. The US economy will slide back into recession.

As if this were not scary enough, the news from other major economies is not encouraging. China appears to be slowing down just as its leaders are distracted by the once-a-decade leadership change. While events in Europe are not making headlines as they did last year, the debt situation there is not vastly improved. And don't forget the numerous flash points of the Middle East and the peril they could pose to global energy markets.

What should investors do? Neeti Bhalla, head of the tactical asset allocation team at Goldman Sachs, said that they need to learn to live with uncertainty for quite some time.

"We won't have an answer to the fiscal situation after the election," Ms Bhalla said. "We won't have an answer to the European crisis after they come up with some fiscal union. We won't have an answer to China after they transfer power. The issues everyone is concerned about don't have a finite end to them."

That's the bad news. The good news is no analyst interviewed for this article thought the government would drive over the fiscal cliff, since many of the expiring provisions have bipartisan support.
"Our belief is Congress is going to punt," said Thorne Perkin, a managing director at Papamarkou Wellner Asset Management, which advises very wealthy investors. "They will turn the fiscal cliff into a fiscal hill and do some form of compromise people can live with. I don't think anyone wants to go through the full shock."

But even a hill implies some pain to an economy that is not experiencing strong growth right now.
There are two complementary schools of thought on getting through the turmoil of the next six months. Both involve restraint and planning. The first requires investors to return to their plan.

What advisers are asking is not that investors necessarily take big risks in the face of the fiscal cliff - after all, really bad economic things could still come to pass at the beginning of 2013. But they are asking that they return to a normal asset allocation and get back to being broadly diversified.
This sounds simple. But it may not be for investors who have been putting their money in cash, whose value is eroded by inflation, and low-yielding US Treasury bonds.

"The people we are advising have been overallocated to asset classes that they consider to be safe and conservative - cash and fixed income," said John Taft, head of RBC Wealth Management in the US. "Cash has the certainty that your purchasing power will be eroded by the rate of inflation. Bonds have the risk that when and if monetary policy tightens, rates will go up and they'll be exposed to principal loss."

Bond interest rates move in the opposite direction of bond prices, so a one percentage point increase in rates on new bonds would result in about a 15 per cent loss in the price of a previously issued bond on the open market.

For those who are skittish and want to cling to their cash and low-yielding bonds, G Scott Clemons, chief investment strategist at Brown Brothers Harriman, advises a mental accounting fudge. He has told clients to have enough money in cash to pay expenses for a period of years that makes them comfortable and put the rest into an investment plan meant to increase the value of the portfolio for years after that.

"If an investor has set aside three years of spending needs, she's bought three years of time horizon for the rest of the portfolio," he said.

For those with more gumption, who think the fiscal cliff will lead to buying opportunities when falling asset values prompt sell-offs, recommendations vary.

One favourite is dividend-paying stocks, which may seem counter-intuitive since the tax rate on dividends could increase to as high as 43.4 per cent from the current 15 per cent.

But Barbara Reinhard, chief investment strategist at Credit Suisse Private Bank, sees two reasons to favour dividend stocks: First, the stocks themselves are inexpensive relative to their historical earnings, and second, companies that are paying and increasing dividends now are strong and often diversified, so they are best positioned to weather any volatility over the next few months.

Ms Reinhard said that all else being equal, an increase in both the dividend and capital gains rate to 20 per cent would be preferable to having capital gains taxed at 20 per cent and dividends taxed as income, which could go as high as 43.4 per cent for the highest earners.

She and other analysts were not worried about the impact of an increase on most investors. Mr Taft estimated that a third of dividend-paying stocks were owned by foreign investors and another third were owned in pension funds or retirement accounts that did not pay taxes.

For the other third, particularly those who depend on the dividend for income, the increased taxes will be a hit.

Defensive portfolio
There are other hedging strategies for people worried about volatility. Harry Clark, chairman and chief executive of Clark Capital Management, which oversees US$3 billion for smaller investors, said his firm had purchased a combination of exchange-traded funds and notes to cap any loss for clients at about 10 per cent. "We don't worry about a massive decline," he said. "But there are other ways to make a portfolio defensive, like buying companies in the materials, energy, consumer essentials and utilities spaces."

The thinking here is that if the worst happens, there are still some essential things, such as soap and gas, that people will need to buy. "I think the biggest risk is in the bond market," Mr Clark said. "That's the next disaster waiting to happen. They're going to drop like a rock when rates go up."
For those with the deepest risk appetite - or deepest wallets - the best strategy is one that allows them to look beyond all the noise the fiscal cliff will create. Real estate and private equity come to mind. Mr Perkin said that he was putting together a group to invest in a unique way in the oil boom in North Dakota: lodging.

"Every oil company in the world is going gaga over the Bakken oil fields," he said. "The problem is there is zero infrastructure: terrible roads, no restaurants, nowhere to stay, the airport is awful, no hospitals or schools, nothing."

Despite all that, he said, he has a group of clients investing US$60 million into a hotel project with another US$40 million of investments planned.

This is not without risks beyond the lack of liquidity in the deal. If the price of oil drops below US$60 a barrel, the demand for Bakken crude could slow, he said. But right now, he said, clients like investments that appear uncorrelated with the market volatility the fiscal cliff could cause.
For most investors, even those with many millions of dollars, the best strategy may be to take a similarly long view without as much risk.

"Most investors are best served by the following strategy, and I say this with 100 per cent conviction," Mr Taft said. "Sit down with yourself or your adviser and figure out what you're trying to accomplish over the rest of your life. Develop a plan with as few moving parts as possible and then stick to that plan."

"Individual investors are notoriously bad about making tactical, short-term changes to their portfolios," he added. "That's basic advice, but it's the best advice there is." - NYT