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Fiscal Cliff Diving

Posted on October 23, 2012

With only two weeks to go before the election and only eight short weeks between the election and year-end, the fiscal cliff could be the most influential macro force on capital markets for the balance of the year. In a recent client meeting, we were asked what the fiscal cliff entailed. We touched upon this briefly in a post on the dysfunctional nature of today’s political decision-making process, and today we will unpack the fiscal cliff in more detail. 

The term “fiscal cliff” was first coined by Ben Bernanke in early 2012, and it refers to a large sum of money that will be withdrawn in some way, shape or form from the economy in 2013. This will occur in the form of tax increases and federal spending cuts. According to numbers published by Morningstar, the total size of the fiscal cliff is estimated to be roughly $718 billion, or 4.6% of our nation’s annual economic output.

2012-10-23_Marching_Towards_Fiscal_Cliff.png 

Nearly 80% of the fiscal cliff comes in the form of tax increases, as broken down in general terms below:

  • Income tax rates rise to a range of 15.0% - 39.6% from 10.0% - 35.0%
  • Capital gains tax rates rise from 15.0% to as high as 23.8%
  • Dividend tax rates rise to from 15.0% to as high as 43.4%
  • Child tax credit falls from $1,000 to $500
  • Estate tax exemption falls to $1M from $5M, top rate rises to 55.0% from 35.0%
  • AMT taxes will apply to roughly 30 million tax payers, up from 4 million
  • Payroll tax holiday expires (additional 2.0% in payroll taxes on first $110K)

Tax policy is one of the hotly debated issues of the upcoming election. Obama and Romney have very different ideas over what tax structures will properly incentivize economic growth and bolster the middle class. Thus, the outcome of Congressional and Presidential elections will have a substantial impact on what to expect in terms of policies that may be implemented to address the list above. 

Tax policy aside, one of the more controversial components of the cliff is the $109 billion in “sequestration” cuts which are mandated by the Budget Control Act of 2011 (the “Act”). The Act was signed into law by President Obama in August of last year as part of a compromise that allowed for an increase in the national debt limit. This bill established what became known as the “super committee”, a group of 6 republicans and 6 democrats tasked with reaching an agreement on how to cut the federal deficit by $1.2 trillion over the next decade. The committee began meeting in early September and was given until mid-January 2012 to enact a plan. As a failsafe, the bill included automatic spending cuts that would go into effect at the beginning of 2013 should the super committee fail to reach an agreement. Wikipedia offers this description:

The agreement also specified an incentive for Congress to act. If Congress failed to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress could grant a $1.2 trillion increase in the debt ceiling but this would trigger across-the-board cuts ("sequestrations").

Similarly, analysis from law firm GreenbergTraurig called the sequestrations an “enforcement mechanism”:

The BCA also includes an enforcement mechanism in the form of an across-the-board “sequestration” of federal funds that strongly encourages Congress to reach a deal identifying at least $1.2 trillion in spending cuts or new revenue. 

In other words, the President was granted the authority to raise the debt ceiling only under the condition that $1.2 trillion was assured to be cut from the deficit over ten years, whether via a plan crafted by the super committee or via the forced sequestrations that are now on deck for over 1,000 government programs. 

But now these spending cuts are being called into question, and many are proposing that they be delayed or perhaps eliminated altogether. While a more intentional approach to cutting the deficit would obviously be preferable, it seems ironic to us that we should now be attempting to reach compromises on compromises. The fact is that the super committee failed to reach a deal. If our elected officials can simply discard the consequences that they laid out for themselves just one year ago, then perhaps the threat of the sequestrations was never much of an “enforcement mechanism” in the first place. While we don’t envy the shoes our elected officials currently have to fill (they don’t have an easy job), the level of dysfunction being shown through the implementation of the Budget Control Act is alarming.

If nothing is done and all the scheduled tax increases and spending cuts go into effect on January 1st, the Congressional Budget Office estimates that the economy will contract slightly in 2013. Other estimates (including ours) show a much deeper recession would be likely. However, it is widely expected that Congress will work after the elections to do something to address the cliff. What this will look like is anyone’s guess, but it will probably be a combination of allowing certain components to take affect while “kicking the can” on others. The ultimate result is likely to be a drastic reduction in the size of the  cliff towards something closer to $200 billion.

In addition to anticipating what actual changes are likely to be implemented in the post-election aftermath, perhaps equally as important will be anticipating the path taken to achieve those ends. A prolonged and heated Congressional debate over what should be done is likely to extend the timeline and feed the high levels of uncertainty already present amongst business owners and capital market participants. A recent CNBC article highlighted the issue this way:

Some 72 percent of respondents believe investors have yet to price in the ramifications-a view that is spreading across Wall Street as time winds down for a solution. Andrew Garthwaite, global equity strategist at Credit Suisse, said in a note, "So ironically the fear of the fiscal cliff may be as damaging to growth as the actuality of fiscal policy."

Meanwhile, former Treasury Secretary Larry Summers anticipates fairly swift action on the part of Congress, but only once they’re feeling an adequate level of urgency:

“I've been watching Washington for a long time, and one of the things you learn is that sometimes when the need is sufficiently great, the transition from inconceivable to inevitable can actually be fairly quick.”

In summary, we don’t expect the US to walk headlong over the fiscal cliff, but we do anticipate the uncertainty surrounding what will be done and when to weigh on risk appetites in the meantime. Indeed, the fear itself (not the actual event) is often the greatest threat to investment results. We are therefore remaining underweight our long-term targets in risk assets until we gain more clarity or believe risk is adequately priced into the markets.

Contributor: David Houle,CFA

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