October 2012 Market Commentary

Despite data showing that U.S. manufacturing continued to expand pushing GDP growth higher than expected, reducing unemployment, it was concern over the impending “fiscal cliff” which weighed on U.S. markets in October and since the November election.

The fiscal cliff is the combination of the expiration of Bush era tax cuts and a slew of massive spending cuts that are slated to take effect in the New Year. Unless a compromise is reached, many economists expect that the impact of this will be an increased tax burden of about $3,500 per family. This will have devastating consequences for the U.S. economy, likely pushing it back into recession.

With Barrack Obama winning a second term in the White House, the Democrats controlling the Senate and the Republicans in charge of the House of Representatives, many fear that the political gridlock which crippled the president’s first term is likely to continue. Given the ideological differences between the two parties coupled with their unwillingness to compromise, hope for a solution by year end is becoming increasingly unlikely.

Since the election, reaction from the investment markets has been less than favourable with the S&P 500 falling by more than 3% since the election (as of November 12). Bonds have been affected as investors pile into U.S. treasuries, bidding prices up and pushing yields lower. This has had an impact on currency as the U.S. dollar has rallied relative to the Canadian dollar, moving from $0.9936 (USD/CDN) to $1.0016 (USD/CAD) since the election.

While there are other concerns facing the markets, namely the European debt crisis and a slowdown in China, we expect that the short term focus will remain on the fiscal cliff. The fallout will be considerable and felt around the world, likely resulting in extreme volatility, affecting virtually all investors.

With such dire consequences, how can you protect your portfolio? There are a number of ways. The first is to get more defensive by increasing your allocation to bonds. If no deal is reached, equities will selloff very sharply. Should this happen, investors will flock to safe haven assets such as government bonds and to a lesser extent investment grade corporate bonds.

Another way to protect your portfolio would be to add another safe haven asset, namely gold. In periods of extreme uncertainty, gold tends to hold its value very well. For volatile times, you are historically better off holding bullion, rather than gold companies. Where possible, hold the currency hedged version to protect against the impact of currency.

And finally, for more aggressive investors who wish to have some U.S. equity exposure, we would suggest moving from high yielding dividend paying stocks to more growth oriented names. The rationale for this is that one of the tax increases that is expected to survive is with dividends. Currently, the top tax rate on dividends is 15% but is expected to rise to 40% under the new plan. This will likely result in a selloff of dividend payers and a surge in growth stocks as investors look to lessen their tax burden.

Of course, should a deal is reached before year end, it is likely that equities worldwide will enjoy a short term boost until attention returns to the overall condition of the economy and the European debt crisis.

Short of pulling all of your money out of the markets, none of these strategies will fully protect you from the unknown. But by taking a more defensive position in your portfolio, you may be able to help mitigate some of the potential damage.

For the month ending October 31, the best and worst performing funds were: