The Fiscal Cliff Could Punish These ETFs

One of the most used market buzz terms in recent months has been "fiscal cliff." That is the ominous scenario in which tax cuts expire and are met with tax increases and spending reductions. While it has been painfully obvious for years that Uncle Sam needs to spend less money, the spending cuts could be muted by the fiscal cliff's other issues. Positive momentum gained from spending reductions will take a while to have a material impact on the broader economy and that ebullience will almost certainly be initially thwarted by the negativity that comes with the expiration of tax cuts and the introduction of tax hikes. Or if one chooses to explain the concept of the fiscal cliff to a second-grader, the adjectives awful, bad and terrible will suffice. If the fiscal cliff is not addressed by the end of the year, the U.S. could lose $600 billion in economic output, enough to send the world's largest economy back into a recession. Hopefully, that will not happen, but if the fiscal cliff does come to pass, these ETFs could be in for some selling pressure. Consumer Discretionary Select Sector SPDR XLY Marquee U.S. economic data points have been volatile to say the least in 2012. One batch is encouraging while another is concerning and that pattern has repeated itself throughout the year. Still, the U.S. consumer has been surprisingly resilient, enabling discretionary ETFs such as XLY to stellar year-to-date returns. XLY, the largest discretionary ETF, is up 19 percent while the SPDR S&P Retail ETF XRT is up 18.1 percent. The Market Vectors Retail ETF RTH has gained over 21 percent. This trio and rival funds are vulnerable in a fiscal cliff scenario, though. A $600 billion hit to GDP is roughly four percent of total U.S. economic output. Combine that with the fact that the U.S. consumer is the single most important driver of GDP and it is easy to see why discretionary and retail ETFs could falter if the fiscal cliff is not avoided. iShares Dow Jones U.S. Aerospace & Defense Index Fund ITA Or the PowerShares Aerospace & Defense Portfolio PPA. Things could change after Election Day, but at the moment, there appears to be some bipartisan support for reducing defense spending. Lower defense spending is not a good thing for ETFs that hold stocks like Boeing BA, Lockheed Martin LMT and General Dynamics GD, which ITA and PPA do. ITA and PPA are up eight percent and 10.3 percent, respectively, this year. That sounds good, but the returns are somewhat ominous when considering the S&P is up nearly 14 percent. iShares iBoxx $ High Yield Corporate Bond Fund HYG Or the SPDR Barclays Capital High Yield Bond ETF JNK. The two largest junk bond ETFs combine for over $29.2 billion in assets under management. HYG, JNK and comparable funds have been prime beneficiaries of the Federal Reserve's low interest rate policies, which has arguably forced investors to take on more risk in order to gain yield. While junk bond ETFs have performed well this year, there have been signs as of late the group is ready for a pullback and some analysts have cautioned chasing capital appreciation in these ETFs at current levels is risky. Add to that the likelihood the fiscal cliff will take a bit of risk appetite and send bond investors running to investment grade fare, and HYG and JNK look vulnerable, too. PowerShares DB Base Metals Fund DBB The PowerShares DB Base Metals Fund does not grab a lot of press, though it should be noted the fund is by no means small or thinly traded. DBB has $328.6 million in AUM and average daily volume of almost 226,350 shares. This is the problem with DBB assuming the fiscal cliff arrives. The fund is evenly divided among aluminum, copper and zinc futures contracts. Simply put, demand for those metals will suffer in a recession, plaguing DBB in the process. For more on ETFs, click here.