Now that the election is behind us, we can all get back to worrying about that other looming crisis that has been dominating the airwaves – not who will be the next American Idol winner -- but whether or not our economy will fall off the fiscal cliff. The mix of expiring tax cuts and spending reductions scheduled to occur at the end of this year could take a hefty chunk out of economic growth in 2013. But even if we dive full-force off the cliff on January 1, there are some sectors of the economy that should hold up better than others and that could help cushion the blow for investors' portfolios.
A huge point of concern among investors is that the lowered tax rate on dividends currently in effect will be revoked at year-end, along with a slew of other temporary tax breaks. Right now, the tax rate on dividends is capped at 15%. If no action is taken to extend this benefit, the tax rate will revert back to ordinary income rates, which can be as high as 39.6%. This could potentially lead to dividend-producing stocks temporarily falling out of favor in the market.
But even if dividend tax rates do go up, it would be foolish -- with a lower-case "f" -- to ditch dividend payers now. History has shown that stocks that pay out dividends typically outperform those that don't, even in periods of higher taxes. According to data from S&P Capital IQ, from 1980 through July of 2012, dividend-paying stocks returned an annualized 12.1% compared to a 10.7% gain for non-dividend payers. But in times of higher taxes, specifically from 1980 through 2002 before the current lowered tax rates on dividends went into effect, dividend-producers churned out a 14.4% annualized showing versus just 11.3% for non-payers. So if history is any guide, even higher tax rates on dividends won't be enough to stop dividend stocks from shining.
Investors who want to cash in on the dividend trend have some great, inexpensive options. Two first-rate exchange-traded funds that fish in these waters include Vanguard Dividend Appreciation (NYSEMKT:VIG) and SPDR S&P Dividend ETF (NYSEMKT:SDY). With price tags of just 0.13% and 0.35%, respectively, these funds are an easy way to get exposure to a well-diversified portfolio of attractively priced large-cap dividend stocks.
While the entire economy would feel the brunt of a nosedive off the fiscal cliff, some corners of the market would be more adversely affected than others. Obviously the defense industry, which is due to bear the majority of the scheduled budget cuts, would be especially hard hit. Other sectors like consumer discretionary and health care could also take a hit as Americans cut back on purchases of higher-end luxury items and delay treatment on pricier health care services.
But in a worst-case fiscal cliff scenario, defensive consumer stocks should hold up relatively well. They won't be entirely insulated from a drop in consumer spending, but since Americans are less likely to cut back on things like toilet paper and milk than they are on leather handbags and luxury vehicles, consumer staples stocks have a head start on their competitors in difficult economic times. To benefit, check out a fund like Vanguard Consumer Staples ETF (NYSEMKT:VDC), which tracks the performance of more than 100 defensive consumer names.
If a deal is not reached to avert the worst of the coming fiscal cliff, stocks and other risk assets will be feeling the heat. Bonds, on the other hand, are likely to be the beneficiary of a newly weakened economy and investor fear. Of course, Treasuries don't look terribly attractive given record low yields. To sniff out the best bargains in the bond sector, investors should look to municipal bonds. If taxes do go up, muni bonds, whose income payments are exempt from federal taxes and in some cases state and local taxes, are likely to see a spike in popularity.
If you are a higher-tax-bracket investor who would benefit the most from the tax-exempt feature of municipal bonds, give a second look to moderate duration funds such as iShares S&P National AMT-Free Muni Bond Fund (NYSEMKT:MUB) or Market Vectors Intermediate Muni Bond ETF (NYSEMKT:ITM). Just keep in mind that you should always own such funds in taxable accounts, not in a tax-favored vehicle like a 401(k) or IRA since you would lose the favorable tax treatment muni bonds enjoy.
In the end, odds are good that lawmakers will come to some sort of agreement to extend at least some of the tax cuts in question and delay some of the spending cuts. While such a deal will almost assuredly leave parties on both sides of the aisle unsatisfied, it will likely avoid the worst of the cliff. But I'm betting that at least a few tax cuts will be allowed to expire and some reductions in spending will be instituted. So while the best move is to leave your long-term asset allocation largely unchanged, making a few adjustments at the margins to prepare for higher taxes and a more challenging fiscal environment probably can't hurt.