Federal Reserve Chairman Ben Bernanke has used the term “fiscal cliff” to describe several big fiscal events set to occur in the U.S. at the end of this year and in early 2013. Among them are the following:
- The expiration of the Bush-era tax cuts at the end of 2012, which would raise the current tax rate on ordinary income from a maximum rate of 35% to 39.6%, on long term capital gains from 15% to 20%, and on qualified dividends from 15% to 39.6%
- The expiration of the 2% reduction of the Social Security portion of the Federal Insurance Contribution Act (FICA)
- The expiration of fiscal stimulus measures such as the extended unemployment benefits
- Spending cuts scheduled to be triggered automatically in January 2013 as a result of the failure of the deficit reduction super committee last year (if effected, the cuts will be applied equally only to the non-entitlement programs that represent 38% of the U.S. budget)
If all of the tax cuts and stimulus measures were allowed to expire and the automatic spending cuts were enacted, the U.S. would be taking a hit of about $600 billion, or about 4% of gross domestic product (GDP), which could easily put the economy into recession. To put our precarious position in perspective, our cumulative deficits from 2002 to 2012 equal $7.24 trillion, of which $5.1 trillion has been accumulated in the last four years. A significant portion (60+%) of the impact of letting the Bush tax cuts expire would be allocated to taxpayers in four lower tax brackets. According to Fidelity, there are four possible scenarios that might come into play, as outlined below:
Scenario 1: Punt
A likely scenario is that Congress and the President agree to punt the issue into 2013. If this occurs, the tax cuts will not expire, tax increases won’t take effect, and spending cuts will be delayed until after the presidential inauguration and the new Congress arrives in 2013.
Scenario 2: Modest Compromise
Another possibility is that Congress and the White House reach compromises on some tax and spending provisions, with the election significantly impacting what those compromises might be.
Scenario 3: Over the Cliff
A less-likely scenario is that Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures. The economy goes over the cliff.
Scenario 4: Grand Bargain
The chance of a grand bargain taking place after the election and before the end of the year is a long shot. In this scenario, Congress and the White House would reach a deal addressing tax, spending, and fiscal issues for the medium to long term.
On a YTD basis thru September 30th, the S&P 500 and Barclay’s Aggregate are up 16.44% and 3.99%, respectively. There is still a lot of uncertainty about the direction of the market and whether the “fiscal cliff” might push the U.S. economy into recession. The 2012 quarterly forecast for GDP growth, on a quarter over quarter basis, has steadily declined but probably not by enough to put the economy at risk of recession. When you hear doomsday reports in the evening news, take them with a grain of salt; recessions are very difficult to predict accurately.
There is a chance that the dollar could weaken relative to other currencies if the U.S. economy continues to slow down more than anticipated. While this would hurt domestic stocks, international exposure will serve as an offset because the two classes are negatively correlated. Multi-national exposure in large cap domestic stocks also tempers the impact of a weak dollar. Keep in mind that, while the election is very important, the reality is that the President gets far too much credit – and blame — for shifts in financial markets. While some people might think the President has an influence rating of up to 25% in financial markets, in reality it is closer to 10% or less. The Fed Chairman has far more influence on a global basis.
Gridlock is Good!
Many think this will be the most important presidential election in a generation. We have all heard that there are three things you do not discuss with others: sex, religion, and politics. In some families just the hint of politics is enough to send parents and children scampering to find the keys to their cars. There is no quicker way to mess up a good family get together than to bring up politics.
Gridlock may sound bureaucratic and ineffective but sometimes it can be good. Gridlock can’t force people to get along, but it does cause them to work together to accomplish and meet the needs of the country as a whole. It has checks and balances. Some may remember going to the go-cart track. You put the pedal to the metal and take-off like a rocket but it reaches its top speed well before you think it should. You naturally assume you got the slow go-cart and go find another that you believe will go faster. What you don’t know is that all of the go-carts have governors attached to their engines to prevent them from going too fast. Why would anyone want to have a governor on a go-cart? The reason is twofold; it is there to protect you from getting hurt, but at the same time it’s there to protect the cart from getting destroyed. Gridlock serves the same purpose. It keeps things in check and slows things down so everyone can hear what others are saying.
For the quarter ending September 30, 2012, returns for the S&P 500, NASDAQ, Russell 2000, MCSI EAFE, MSCI ACWI, and Barclays U.S. Aggregate Bond indexes were 16.44%, 19.62%, 14.23%, 10.08%, 12.88%, and 3.99%, respectively.