One of the joys of the long Thanksgiving weekend is the beautiful fall weather. Cool crisp air, the smell of smoke drifting out from fireplaces and the last leaves falling from the trees. Among the maples and other hardwoods that have been lit up with color for the last month, one of my favorite trees is the decision tree. As all of us pundits debate the fiscal cliff, I have been studying the decision tree of outcomes, looking for insight into how to position my portfolio for protection against most of the projections.
Outcome 1: President Obama and Congress at an impasse, and the Budget Control Act measures go into effect. This is the best outcome for the country long-term, although of course it will cause a recession in 2013. Many say "we can't let this happen" – but neither could we let the fed funds rate go to 20% in 1981. After that economic shock stopped inflation dead in its tracks, the U.S. economy went on a 20-year boom that rivaled any of our best expansions. Right now, I am carrying a high cash balance and avoiding cyclicals to position for this outcome.
Outcome 2: A deal is put in place to raise tax rates and cut some expenditures. This is the most likely outcome, but it will not be more than a budgetary Band-Aid. The deficit is running over $1 trillion, and the tax revenue increase will be at best $80 billion to $100 billion. So, after all the Sturm und Drang, we will still have a trillion dollar deficit to grapple with. The Federal Reserve has been funding the deficit, so it will by necessity continue to do so. Years of prospective debt monetization means inflation will accelerate sooner or later. To protect against this probability, I own a fair amount of gold via SPDR Gold Shares (GLD), and my equity holdings are skewed toward inflation-resistant businesses. Consumer staples with pricing power are the best inflation hedges, and real estate is usually a good bet, too.
Sadly, the fiscal cliff negotiation is distracting us from the larger issue that will remain unresolved come Jan. 1. Roger Arnold made the point eloquently in his column, The Fiscal Cliff and the Fiscal Multiplier, that the U.S. is rapidly approaching the point of no return on our federal debt burden. Since the U.S. will never formally default, the most likely long-term outcome seems to be a period of currency devaluation. The balance of this decade appears to be shaping up to play out similarly to the second half of the 1970s. Studying what worked then could provide insight into what will work in the years ahead.