The general election season is finally upon us, and investors should begin shifting their focus from theoretical discussions about the impending fiscal cliff of potential tax hikes and spending cuts to more concrete action plans of what to do about it.

From an investment standpoint, there is little evidence that a bad outcome is currently baked into the market. Were the fiscal drag to actually happen stocks would likely suffer a significant decline, along with other risky assets like commodities and high yield bonds, when the markets open on Jan. 2 and soon thereafter.

The odds still favor a last-minute compromise. However, even if avoided and that compromise appears, the fiscal cliff poses two challenges for investors: volatility is likely to rise on the lingering uncertainty, and that uncertainty may exert some modest drag on Q4 economic growth. With that in mind, I would advocate that investors, if they haven’t already done so, adopt a moderately defensive posture.

Make no mistake, the fiscal cliff is a big deal:

  • It poses a potential threat to the economic recovery. While exact estimates differ, the economic impact is likely to be over $600 billion, or roughly 4% of GDP.
  • It would hit at a time when the economy is still in the midst of a fragile recovery, with US GDP growing by 1.7%.
  • Finally, it will hit the economy where it is most vulnerable: consumer spending. Should the fiscal cliff hit on schedule, it is likely to lead to at least a modest economic contraction next year.

As of today, I don’t believe that this is discounted into the price of stocks or other risky assets. Investors are talking about it, but most people believe it will be avoided and are therefore doing little to change their asset allocation mix.

The view that investors put a small probability on the fiscal cliff actually happening is reinforced by consensus economic views. The Congressional Budget Office estimates that should the fiscal cliff occur on schedule, the economy will contract by 0.50% next year. The consensus view – that the economy will grow by 2.1% in 2013 – suggests Wall Street economists assign a very low probability of this actually happening.

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