Last summer, I wrote here about the impending fiscal cliff (“Fiscal Cliffhanger”, July 28, 2012) and explored the issues surrounding America’s steadily escalating policy uncertainty which had already begun to impact economic growth.And now with just about five weeks left before year-end when the raft of potentially crippling US tax hikes are brought to bear on the fragile economic recovery, practically all that can be heard on the financial news channels is commentators elaborating on what progress is being in made on the fiscal cliff and how it will impact the markets.Last Monday, for example global stock markets came back to life with the S&P 500 stock index posting its largest gain in two months on the news headline of: “An improving outlook for averting the fiscal cliff.”For those who have somehow been able to escape watching the financial news and are not yet aware of the details, the ‘cliff’ concern is about a huge swath of American tax increases and spending cuts amounting to approximately $600 billion scheduled to drain out of business coffers and citizens’ wallets at the beginning of next year.The ultimate question is ‘pay me now or pay me later’ as policymakers wrangle about how to start paying back for irresponsible government programmes and an inability to simply balance a budget.As it happened, in November Americans signed up for another four years of approximately the same cast of characters as the last ones; but now the world’s largest economy has to at least think about paying the piper after four years of waltzing around in circles to the tune of an extra $4 trillion in debt.Out of the entire package, the potential tax increases are the most ominous part of the cliff. Approximately half the tab or $305 billion is comprised of expiring ‘Bush tax cuts’.During his second term as president, George W. Bush gave Americans a generous basket of tax breaks which was just must meant to carry us through the tough years from 2008 to 2010. However, the tax breaks there subsequently extended until the end of this year.Besides the expiring Bush tax cuts, other components of the cliff include $93 billion in payroll taxes coming back online and new taxes to pay for the Affordable Care Act (“ObamaCare” healthcare plan).On the spending side, if no compromise is reached by year-end, the government will also be forced to automatically reduce spending by about $110 billion to meet the $1.2 trillion spending reduction target required over the next ten years.Half of the spending cuts must come from the defence budget with the other half coming from all of the other programs.Business leaders are growing very concerned; all in, the $600 billion bill could potentially lop up to 4% off of the US growth rate and throw the country into a steep recession.The good news, if there is any, is that the cliff is front and centre with political and business leaders acknowledging a sense of urgency to make a deal.In recent days, a team of 17 CEO’s representing some of America’s largest corporation have recently banded together under the ‘Fix the Debt’ banner with the newly formed coalition actively writing letters to legislators urging a speedy resolution.In terms of investment strategy, two trends are apparent and we feel both could result in better returns. The first point is that not all parts of the global economy will necessarily be highly impacted by the outcome of the cliff negotiations.The second point is that regardless of the outcome, volatility is likely to stay elevated in the weeks or possibly months ahead providing some nice buying opportunities for longer term investors.On the first point, a few sectors of the broader economy still seem to be working despite the economic slowdown which has already begun.Even though businesses are clearly pulling back on spending, the American consumer is still buying, at least selectively.As highlighted in my recent piece on housing for example, (“Real Estate Rebound is a Bright Spot in the US Economy”, October 27, 2012), the home building sector and other related industries continue to make progress.Just this past week, housing starts were reported to have climbed to a four-year high while building permits for single family units reached their highest level since July 2008.All-time low mortgage interest rates appear to have trumped fiscal cliff concerns at least in the eyes of many home buyers. Another sector likely to be less affected by policy change is the healthcare sector which benefits from the resurrection of the ‘ObamaCare’ plan.More people will be allowed into the system under this legislation in addition to the increased volumes of health services already being demanded by an ageing US population. US ‘baby boomers’ are scheduled to start their golden years en masse this decade.On the second point, another likely trend over the next few months is increased market volatility. The VIX Index, a standard measure of stock market volatility, increased from 15 to 19 shortly after the US election, signalling wider day-to-day swing in asset prices.While the big price moves we have seen in risk markets lately can be concerning to those fully invested, market swings and sector rotating can also spell opportunity for patient, long term investors with some cash.In recent trading days, for example, high-dividend paying stocks were pummeled as investors grew overly concerned that the American government would raise taxes on dividends from their presently low rate of 15%, back up to ordinary income tax rates approaching 40%.High quality, dividend-paying stocks including relatively stable electric utility and telecommunications companies actually fell as much or more than the overall market.But looking through the noise, we believe it unlikely that the highest tax brackets would be reached immediately, if at all. More likely, the dividend tax rate may push to 24% (23.8% is highest rate even Senate Democrats are suggesting).Furthermore, many dividend-paying securities are held in tax-exempt accounts anyway so would not be affected by a higher bracket.Most offshore holders are clipped at a relatively high 30% rate already and so would generally not be hurt in terms of net dividend income although price swings in securities related to American tax policy would affect the holders’ market values.Traditionally, more defensive sectors paying high dividends tend to hold up better in a down market but recently this changed. After the dust settles, however, one has to consider the possibility that profitable companies paying income streams amounting to over two or three times the rate offered on increasingly shaky sovereign debt (even after a modest bump in the dividend tax) might again find favour in the market.And finally, taking a longer term approach, we feel some intrinsic value may be found in more cyclical companies exposed to business spending. Many companies which make or transport items such machine tools, heavy equipment, commodities and computers are trading at historically low valuations.Clearly, concern about new tax policy has left businesses confused about the new rules and caused them to cut back on capital spending.However, after whatever plan of genius is finally decided upon in Washington, the uncertainly will soon be gone and some businesses may find themselves underinvested.It is not unusual to see spending occur immediately after the resolution a major issue which prompts additional ‘catch up’ investment.So-called ‘pent up demand’ which is already occurring in the auto and housing sector could eventually work itself back into the industrial and manufacturing sectors ultimately pushing valuations back up to more normalised levels.Bryan Dooley, CFA is a senior portfolio and fund manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further informationThis communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.