The Pessimist’s Guide to Surviving the Fiscal Cliff

Whatever the budget deal, it probably won't be able to prevent sluggish growth and the risk of rising inflation.

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House Speaker John Boehner makes remarks on Capitol Hill in Washington on Nov. 7, 2012. Boehner discussed the looming fiscal cliff and called on President Obama to work with House Republicans

Optimism has been growing that Democrats and Republicans will be able to reach a budget deal that brings the deficit down to a sustainable level while avoiding a recession. A lot of investors appear to be skeptical, though, judging by the fact that the Dow has declined 473 points since President Obama won re-election. I’m skeptical too. A compromise may be achieved that avoids the drastic spending cuts and sizable tax increases scheduled for next year. But it’s hard to see how the economy will be able to achieve better than sluggish growth, accompanied by the risk of rising inflation. The problem is the math.

If a country runs a deficit (as a percentage of GDP) that is equal to its growth rate, the debt level will remain constant. This year U.S. GDP will be a little less than $16 trillion, and its historical growth rate is 3.25%. That works out to what we might call a “safe” deficit of $520 billion, or even $600 billion if you allow for a little inflation. Last year, however, the U.S. deficit was $1.1 trillion — or roughly $500 billion too much.

That gap could be closed by ending all tax cuts, tax breaks and stimulus payments for everyone, according to the Tax Policy Center. But two-thirds of the burden would fall on the middle class — something both political parties want to avoid. All the proposed tax increases on the wealthy, however, even combined with the end of the payroll-tax cut, would raise only $295 billion. So unless there were spending cuts twice as big as the ones currently scheduled, the deficit would still be too large.

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Some people have proposed forgetting about the deficit until the economy is growing robustly. But there is a limit to how much more debt the U.S. can safely take on. The National Bureau of Economic Research calculates that debt greater than 90% of GDP slows economic growth. And at the current rate, within four years the U.S. will surpass the 90% mark (not even counting the debt in the Social Security Trust Fund). Conclusion: The economy will be slowed either by spending cuts and tax hikes or by the growing drag caused by excessive borrowing.

In addition, any compromise that fails to bring the deficit down quickly will force the Federal Reserve to continue easy-money policies that could eventually translate into inflation. The overall result could be an economic climate like that of the late 1970s: a combination of stagnation and inflation. Whatever your political views, if you share my concerns about potential stagflation, you’ll want to minimize the risks for your savings and investments.

One striking development is that buying a home is a significantly better deal than renting for the first time in more than a decade. Not only is it cheaper on a monthly basis, but also prices are now below the norm. And if there is an upsurge in inflation at some point, real estate is one of the best hedges available.

By contrast, bonds are extremely risky. Yields on high-quality long-term issues are now at their lowest level in more than half a century. With yields only half a percentage point above today’s 2% inflation, Treasury bonds provide little real return. Since bond prices move in the opposite direction of interest rates, they have soared as rates have fallen and would tumble if rates were to go back up again because of economic recovery.

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For conservative investors, high-yield stocks are an attractive choice. In a market where capital gains are hard to come by, dividends provide steady returns. And income stocks can raise their dividends over time, whereas bond interest is usually fixed. Although share prices for such stocks may lag if taxes on dividends are raised, the dividends themselves needn’t suffer. Companies that sell consumer staples — such as soaps, paper goods and personal-care products — are usually able to maintain their sales in sluggish economies and also increase the prices of their products to keep pace with inflation.

Another defensive group consists of the largest pharmaceutical companies. Although Obamacare may control pricing for their most lucrative products, giant drug companies have enormous leeway to adjust their sales forces, marketing expenses and R&D investments to the realities of the new health care system. Whatever decrease in profitability they suffer will probably be offset by new customers: the 30 million people who will gain coverage over the coming decade.

Energy stocks are another promising group. Soaring natural-gas production has hurt some oil producers, which is an argument for owning a diverse mix of oil and gas stocks. But overall, the industry is strongly positioned for the future, since worldwide demand is projected to grow rapidly, especially in developing countries. Moreover, energy stocks are normally solid hedges against resurgent inflation.

Finally, there’s a case for investing money internationally, in case the value of the dollar starts to fall. The same sorts of stock — consumer staples, pharmaceuticals and health care, energy — would be attractive. Over the next five years, it will be hard for the U.S. to get its budget back onto an even keel. Defensive investing for income and inflation protection figures to be the best way to preserve assets while all those problems are getting worked out.