Policy

U.S. Election Post Mortem: How Much a Threat Is the Fiscal Cliff?

November 9th, 2012 | By Nick Sargen

Highlights

  • The U.S. equity market has reacted negatively to the outcome of the U.S. elections, ostensibly amid concerns the two political parties will struggle to reach a compromise over pending cutbacks in government spending and increased taxes. Such an outcome would heighten the risk of a U.S. recession and a downgrade of U.S. Treasuries by the rating agencies.
  • My own take is more sanguine for two reasons: (1) the long-term solution to the U.S. budgetary problems are well known and entail a combination of entitlement and tax reforms; and (2) politicians of both parties have greater incentives to compromise now than they did in the summer of 2011.
  • That said, the period of low market volatility may be ending, as the deliberations over the budgetary outcome are likely to be contentious. Also, businesses are likely to hold back on capital spending until the resolution is known.

The Fiscal Cliff Redux

Like other investment management firms we have had a lively debate at Fort Washington about the consequences of the so-called "fiscal cliff", in which pending tax hikes and spending cuts could pose a drag on the U.S. economy equivalent to as much as 5% of GDP. Considering how extensively this issue has been discussed in the media and how little the markets have reacted, I wondered at times if it would be a non-event similar to the debate over Y-2K at the beginning of the millennium. Therefore, I find the stock market sell-off after the elections to be noteworthy, as it has been greater than I expected.

My take is that the 2013 budget deliberations are likely to be a source of market volatility, but I do not foresee dire consequences for the economy or markets. One of the main reasons I am sanguine is that the long-term solution to the U.S. budgetary problems is well-known. It was laid out by President Obama's Deficit Commission headed by Alan Simpson and Erskine Bowles, and has been reaffirmed by the Congressional Budget Office (CBO) and other nonpartisan groups that have studied the issue. The solution entails a combination of cutbacks in discretionary spending along with reforms of the entitlement programs (mainly Medicare and Medicaid) and the tax code to broaden the tax base. With the U.S. economy experiencing a lackluster recovery, the ideal solution is to tackle these issues over an extended period rather than all at once. The U.S. fiscal problems, in short, are manageable provided politicians are willing to compromise on these issues.


Prospects for a Compromise

The main uncertainty in the debate over the fiscal cliff is whether leaders of both political parties are now prepared to find an acceptable compromise. In the summer of 2011, President Obama and House Speaker Boehner reportedly were close to agreeing on measures that would curtail the projected deficits over the next 10 years by approximately $4 trillion. In the end, however, both parties backed away from the "Grand Bargain," and instead agreed on partial measures that would set in after the 2012 elections.

With the election now over, the question remains whether the two parties can reach a more substantive agreement that will set the country on the road to long-term deficit reduction without increasing the risk of a recession in the coming year. The post-election sell-off suggests investors are understandably nervous considering what is at stake: President Obama campaigned on allowing the Bush tax cuts to expire for families with incomes in excess of $250,000, as well as increasing tax rates for dividend payments, capital gains and excise taxes.

But there are also indications the two sides understand what is at stake and are willing to sit down and discuss the various options. For example, House Speaker Boehner has indicated he is willing to consider ways to increase tax revenues by reforming the tax code to make it more efficient, but that he does not favor increasing tax rates. President Obama, for his part, has called for the leadership of both parties to meet with him to lay down a working agenda for the lame duck negotiations.

My bottom line is that both sides have more to lose from appearing intransigent than they do from being willing to compromise. This is very different from the circumstances that prevailed before the election.


Assessing Risks

This does not mean that one should be complacent about the potential risks involved in this high stakes game. The biggest risk is the possibility that the two sides cannot reach a compromise and there is a repeat of the budget debacle of 2011. If so, the likely outcome would be a double-digit equity market sell-off. In my opinion, however, the more probable outcome is that a compromise is reached, but it may fall short of investors' expectations or that of the rating agencies. The market consequences in that event would be adverse, but less severe than without a compromise.

Finally, I am also cognizant of how the business community may react. Whereas consumer confidence has improved in recent months alongside gains in residential housing and the stock market, CEOs have become less confident about the economic outlook because of concerns about the tax and regulatory environment. Consequently, if these concerns are not allayed, businesses could continue to hold back on capital spending and hiring, and thereby contribute to a lackluster recovery.