As children, we were all (wrongly) told that Columbus tempted fate and risked sailing off of the edge of the world as he tried to find a new route to India. Today, investors face more risk than Columbus, as the world of investments is flat with cliffs on every side. You may know of the American fiscal cliff, but there are plenty of other cliffs out there for your portfolio to sail off of.
America's not the only one looking for better policy.
An American overview
To put the other dangers in perspective, let's review the key facts about our own fiscal cliff. Tax cuts made in 2001 and 2003 will expire. The payroll tax cut, originally passed in 2010 and extended in 2011, will also expire. Automatic budget cuts will slash $1.2 trillion in spending over nine years.
For investors, this means that capital-gains taxes will increase from 15% to 20%, while the 15% dividend tax rate will change to the investor's income tax rate. And companies that count the government as a large percentage of revenue could encounter trouble as the Department of Defense reduces its budget by 10% and discretionary programs cut their budgets by 8%. This includes companies like defense contractor Lockheed Martin (NYSE: LMT ) , for which the government accounts for 82% of sales, and IT, intelligence, and health care provider SAIC (NYSE: SAI ) , which counts on the government for more than 90% of its revenue.
All these cuts are predicted to shrink GDP by 0.5% next year and push the unemployment rate back above 9%. Any solution has been put on hold, with politicians much more interested in the upcoming election. Even with the seemingly drastic short-term consequences, analysts have put the odds that an agreement will not be reached between 15% and 35%. That may not seem like high odds, but the expected outcome is severe enough to fear any chance that it will occur.
Now let's compare this issue to events around the world.
Japan's budget bickering
While Japan may have been the first to try near-zero central-bank rates and quantitative-easing policies, it's following America with its own version of a debt ceiling debate. As the Financial Times reports, "Japanese politicians are at loggerheads over a bill that would allow the government to borrow the 38.3tn yen ($479bn) it needs to finance this year's deficit." The parliament has until the end of November to come to an agreement in order not to run out of money.
Failure to pass legislation would contract Japan's GDP by nearly 8% in the last quarter of 2012. The uncertainty of the situation has also raised the cost of borrowing for Japan's longer-term bonds, and for the country with one of the highest levels of debt to GDP, small upticks in borrowing costs can quickly add straw to the camel's back.
For companies with plenty of business in Japan, such a contraction in GDP could hurt profit over the next few quarters. Take, for example, Adobe (Nasdaq: ADBE ) , which takes in 20% of its revenue from Asia. Expensive software purchases could easily be pushed off into the future if businesses want to crimp costs during a slowdown.
An uneasy Europe
Greece, although a small part of the European Union, still weighs on the solvency of the economic partnership. It's currently working to delay its deadline to meet a budget surplus from the end of 2014 to 2016. Even with such an extension, Greece has to find cuts worth 13.5 billion euros ($17.4 billion), or about 5.8% of its GDP. It's looking at measures many may find riot-worthy, such as raising the retirement age from 65 to 67 and putting 25,000 of the roughly 700,000 public workers into a special reserve -- most likely a stop on the way to being let go.
Greece's ability to pull through and survive as part of the union is important, even though it only represents 1.7% of the E.U.'s GDP, because the exit of a single country would cast doubt on the group as a whole. It would also dampen hopes that a bigger nation that requires assistance -- e.g., Spain, which makes up more than 8% of the E.U.'s GDP -- can pull through and remain a member.
These conditions squeeze profits all around Europe, especially at banks like the Spanish Banco Santander (NYSE: SAN ) . In its most recent quarter, the bank's profit fell 94% from billions to millions. The bank's bad loans in its Spanish market climbed past 6.3%, up from 5.1% a year earlier, and it forecasts this number could rise to more than 7% in 2014.
What wins in a flat investing world
When surrounded by threats, protect yourself with long-term quality investments. Look at businesses with distinct competitive advantages, with large profit margins and a varied customer base. Think companies like Starbucks (Nasdaq: SBUX ) , Google, Coca-Cola, or McDonald's. Starbucks, at a relatively attractive price right now, represents a company with double-digit profit margins, a growing global footprint, a diversifying customer base, significant brand power, commitment to quality, and a scale that is difficult to replicate. Even when you're sailing off the edge of the world, doesn't a coffee sound good?
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