According to the most recent Bank of America Merrill Lynch fund manager survey, nearly one in five fund managers believes there is a risk arising right here in the U.S. that trumps the eurozone crisis. That risk is the so-called "fiscal cliff" -- the combined effect of expiring tax cuts and automatic government spending cuts that represents 4% of gross domestic product. If Congress is unable to reach an agreement to steer a course away from this cliff, the country will almost certainly dive into the abyss of recession. Even if legislators do reach an agreement, don't expect a smooth, well-telegraphed process. Here's what that means for investors.
Expect U.S. equities to become increasingly volatile throughout the second half of the year as the urgency of an agreement increases. A global macro hedge fund manager I met with last week told me that volatility, as measured by the VIX Index (INDEX: ^VIX ) , is cheap right now. Whether you own individual stocks or index ETFs such as the SPDR S&P 500 ETF (NYSE: SPY ) or the Vanguard S&P 500 ETF (NYSE: VOO ) , you need to be prepared for this. If you're happy with your equity holdings at current valuations, there's no need to panic. If you're looking to increase your equity allocation, volatility could provide the opportunity.
Sure, U.S. Treasury yields have been plumbing historical lows recently, but the longer lawmakers wait to change course, the heavier the flows into "safe-haven" government bonds, which will push yields lower. Barclays recently published a note predicting that the 10-year yield will fall to 1.25% in the third quarter, with the 30-year declining to 2.25% (they're now at 1.5% and 2.6%, respectively). It's virtually impossible to predict what will occur over such a short timeframe, but that scenario certainly sounds plausible. On the balance of probabilities, I'd agree that bond yields are more likely to move lower than higher in the second half -- good news if you trade the Vanguard Extended Duration Treasury ETF (NYSE: EDV ) .
Macro matters! The "risk-on, risk-off" pendulum will find plenty of momentum in the current environment. Individual investors: Keep your long-term goals in mind and use volatility to adjust your portfolio when the opportunity arises.
Politics isn't always a negative for stocks. In fact, our limited-time report shows how "These Stocks Could Skyrocket After the 2012 Presidential Election."