2.) Bungee jump. In this outcome, we are faced with a Republican sweep of the presidency, House and Senate. While there is no deal in the lame-duck session, lawmakers announce a plan to reverse tax increases in January and the debt ceiling would be raised ahead of a full budget deal. In this case, we’d likely see market volatility during December and January until a new plan is put in place. As per the previous scenario the net impact on markets is likely to be muted, though this is highly dependent upon the final budget, tax and spending measures put in place. The wildcard here is the ability of the new government to implement real structural reforms; failure to do so would likely result in a sell-off of risky assets and outperformance from higher quality investments like Treasuries.
3.) Sky dive. In this final scenario, Obama wins the election and Washington remains partisan and divided. In this scenario we could sky dive off the cliff. While there is a possible income tax deal in early January, prepare for politicians to wrangle over the debt ceiling. This scenario would cause anxiety throughout the end of the year and into 2013, and the Fed might be required to step in to continue supporting the economy and markets. For fixed income investors, this scenario would likely result in continued low interest rates and sluggish growth. Longer duration investments could excel, along with any segment of the market that the Fed stepped in to purchase. Higher risk asset classes would likely under-perform, and investors looking for yield would likely be better served in lower risk investments such as investment grade debt and municipal bonds
No matter what happens with the fiscal cliff, we are likely to see relatively low interest rates over the near term. Investors looking to increase yield by moving into credit and other higher risk segments of the bond market should think about the cliff and its potential impact on their portfolio. But no matter which outcome you think is most likely, remember to vote.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.