Policy, U.S.

The Looming U.S. Fiscal Cliff

April 25th, 2012 | By Nick Sargen

After a period of unusual calm, financial markets have become more volatile of late in the wake of a disappointing March employment report and renewed tensions in Europe. However, there is a prominent issue on the horizon that has not yet captured the markets’ attention -- namely, the prospect of a $500 billion fiscal shock that could occur next year if Congress and the President do not alter scheduled tax hikes and spending cuts.

This issue is certain to attract investor interest as the November elections approach, as the outcome will have a critical bearing on the course that is pursued. While we are not making any changes to our investment portfolios until the outcome is clearer, we are examining the most likely possibilities and assessing their implications.

“The Looming Fiscal Meter Strike”

My interest in this topic was heightened by a recent commentary (April 16, 2012) by Jim Glassman, a friend and first rate economist with JPMorgan Chase & Co. In describing the situation, Jim uses the metaphor a fiscal meteor shower that is speeding to the economy and which will strike on January 1, 2013 if Congress and the President do nothing to divert its path:

“Left unchecked, the blow to the economy – amounting to about a $500 billion shock, or at least 3 percent of GDP – almost certainly would drive it into recession. The convergence of expiring tax cuts, waning fiscal stimulus spending, draconian (sequestration-related) spending cuts to defense outlays, and new taxes to pay for expanded healthcare coverage, along with the perennial need to index the Alternative Minimum Tax code for inflation and postpone steep cuts in payments to doctors for Medicare services, is pure happenstance. It is the result of divided government in recent years that has resulted in temporary actions to support the economy.”

While most investors are aware of some, if not all, of these pending developments, they have been very restrained thus far. However, Federal Reserve policy makers have begun to take note of the situation, and they included an explicit discussion in the March FOMC minutes. As a result, market commentators are beginning to pay more attention to it, as well.

Considering that few economic forecasters are predicting a recession in 2013, Glassman asks why they are relatively sanguine about this predicament. His answer is that forecasters are assuming that the government (even a divided government) will act rationally and find some way around some of the draconian spending cuts and tax increases: “After all, allowing tax relief to ‘sunset’ would be a nightmare for both Democrats and Republicans, let alone for the economy.” At the same time, it is far from clear what type of compromise will be reached, and the outcome could dictate the direction of the stock market later this year and into 2013.

Below is a list of pending actions – what Glassman calls “The Fiscal Meteor Shower” -- that could occur without new legislation:

  • Expiration of the Bush Tax Cuts -- $150 billion in 2013 ($200-$250 billion thereafter)
  • Expiration of the AMT patch -- $90 billion annually
  • Expiration of the 2010 Tax Act -- $100 billion
  • Sequestered Spending Cuts -- $100 billion
  • 2009 Stimulus Spending Rolling Over -- $25 billion
  • Cuts in Medicare payments to doctors -- $20 billion
  • Obama Healthcare Tax Increases -- $40 billion

Will the Day of Reckoning Be Postponed?

Investors have not reacted to these developments thus far, mainly because they assume action will be taken to extend expiring deadlines and to soften the blow from abrupt changes in spending after the election. After all, it is in neither side’s interest to create conditions for an abrupt decline in demand that could send the economy into a tailspin. That said, it is also clear there are fundamental differences between the two parties on how to proceed.

The most important issue for the markets will be whether the Bush tax cuts are allowed to expire if President Obama is re-elected, or whether a major overhaul of the federal government occurs if Governor Romney wins the presidency and the Republican Party gains control over both houses of Congress. If the tax cuts lapse, the impact on the stock market could be significant, because the top federal dividend tax rate would rise from 15% to 43.4% in 2013, while the tax rate on capital gains would increase from 15% to 20%. Most experts presume some form of compromise will be reached to lessen the disparity in tax rates, but this also presumes politicians will do the right thing.

Should the current political stalemate be maintained, there is also a specter of a replay of the budgetary impasse that occurred last August that resulted in Standard & Poors downgrading U.S. treasury debt. This time, the outcome could be more problematic, as both Moody's and Fitch have indicated they will reassess the U.S. credit rating after the elections.

The most favorable outcome, to be sure, would be an agreement to reform the entitlement programs – especially Medicare and Medicaid – to make them actuarially sound: According to the Congressional Budget Office, projected outlays for these programs and Social Security will reach 18.4% of GDP – the historic average outlays for all government programs – by 2050 without any modifications to these programs. In order to achieve such an agreement, it is widely acknowledged that entitlement reform needs to be paired with reform of the tax code that would broaden the tax base and enable marginal tax rates to be lowered. This is the essence of the Simpson-Bowles proposal that was commissioned by President Obama.

Unfortunately, while the solution to the nation’s long-term fiscal imbalance is widely understood by experts, the two parties have lacked willingness to compromise, and it is unclear they will do so in the future.

Investment Implications

Knowing all of this, the logical question is “what should a rational investor do?” My answer: Nothing right now, because it is hard to handicap the election outcome, and even more difficult to know what type of compromise will be reached.

In addition, investors need to assess what news is priced into markets, especially for high dividend paying stocks. Based on HOLT’s analysis, the derived market discount rate currently is elevated, but not super-high. If no tax increase is priced in and one occurs, HOLT estimates the downside for the broad market could be in the vicinity of 10%, with high dividend paying stocks faring somewhat worse.

If this assessment is correct, the question boils down to whether an investor is prepared to tolerate a 10%-15% principal hit to a dividend portfolio in the event the Bush tax cuts are allowed to lapse. We are not altering our investment strategy at this time for the reasons stated, but we will be monitoring political developments closely because the stakes are high.