In just a few weeks we will have a very important and profound election. At the top of the docket is the Presidential election, but lest we forget, we will be voting on the Senate and House also. The outcome of all of the elections will provide answers to how we as a Nation want to deal with our debt and deficit. One of the issues we face in regards to our nation’s finances is termed the “Fiscal Cliff.” The current economic environment and the investor behavior it is influencing is in great part due to the threat of our country falling off the fiscal cliff. Therefore I wanted to take time to explain what it is and the impact it may have on you as an investor.
Current Economic Environment
The last recession technically ended in June 2009. That means the economy has been growing over the last 3 years. However, it is growing at a very tepid pace. I have heard the current U.S. economy described as a plane stuck on the tarmac. It is moving forward, very slowly. However, it isn’t in danger of falling because it hasn’t really taken off.
For many, the feeling isn’t that the current economic environment is dangerous…it’s just…well, disappointing.
Much of the disappointment comes from uncertainty. Uncertainty in the U.S. certainly, but also in Europe and Asia. U.S. uncertainty is created to a large extent now by fear of the ‘fiscal cliff.’ The fiscal cliff describes an abrupt slowdown in economic growth that could result from a worrisome combination of substantial tax increases and federally mandated spending reductions.
Whoever wins is going to have to deal with this quickly. The Super Committee creation of the expiring tax cuts and spending cuts was a “kick the can down the road” choice. Our elected leaders will probably try the same approach, as it is what they do. Where did the January 2013 cliff come from? In a nutshell, ‘debt ceiling,’ ‘super committee,’ ‘Washington intransigence.’ I’ll spare you a full rehash of last August, but it was born of the failed debt ceiling negotiations in summer 2011.
So, under current law, as of December 31, 2012:
- All Bush tax cuts are set to expire. The top tax rate would go from 35% to 39.6%; tax on dividends would increase from 15% to 39.6%; long term capital gains would go from 15% to 20%; and estate tax rates would boost from 35% to 55% while the estate tax exemption would go from $5m to $1m.
- The current 2% payroll tax cut would expire.
- Upper income earners (single earning $200,000 and couple earning $250,000) would have an extra .9% Medicare tax. The same households will have their Medicare tax base broadened to include an additional 3.8% capital gain tax on investment income.
- Extended unemployment benefits would expire.
- The two rounds of discretionary spending cuts agreed to in August 2011 would take effect. The goal of these is to cut $1.2b from the federal deficit.
If all of this was implemented, the deficit could reduce substantially. That’s good right? Yes, however, in such a quick stroke, there would be a great chance that our economy would fall into a recession as spending (consumer, business, and government) retracts.
It is estimated that if nothing is done, 83% of U.S. households would pay higher taxes, with the average tax increase totaling $3,701. Also, the Congressional Budget Office projects the U.S. economy would shrink by an annualized 1.3% rate in the first half of 2013. For an economy growing at only 2 – 2.5% or so, this is severe.
Most politicians of both parties know the nature of the problem, but nothing is going to occur before the election in November. Many people conclude there is one obvious outcome, abrupt and immediate. I would suggest there is not.
Plausible election result scenarios are; a Democratic sweep, a Republican sweep, or a divided government with Obama in for another term and Republicans running the House and Senate, or Romney in the White House with Democrats running the Senate and maybe the House. Each of these political outcomes would likely lead to separate fiscal outcomes.
If all of the listed tax increases occur, this will be bad for consumer, investors, companies, and the economy overall. If all of the $1.2b in discretionary spending cuts are implemented as scheduled, this will be bad as well.
I think each of the election outcomes noted above will lead to a mix of some tax changes and some spending cuts, but not all of the above. Therefore, the drag on the economy less severe; hopefully enough to avoid a recession, though no one knows whether this will be the case.
What This Means to You as an Investor
Politics can affect markets in the short term, no doubt. But in the long term, fundamentals of the economy and corporate profits, determine investment returns. No one can predict what degree the ultimate outcome does to our economy and investment markets. This is not a linear problem with a single, predictable outcome.
What we would look for is policy that would take resources away from the economy to the degree that GDP goes negative. Letting the economy run over the cliff would do it. But some middling choice that is likely to occur hopefully will not.
Therefore, I do not think this is an impetus for a significant portfolio change. As I’ve stated before, ‘all in’ and ‘all out’ investing is rarely successful as no one can time the market and there is not an email announcement for when particular sectors or industries will move to the head of the pack or fall to the back.
You should structure your portfolio, NOT to politics or the 24 hour news cycle, BUT according to your timeframe, your risk tolerance, and your financial needs.
The Federal Budget is in serious need of reform. We have a chronic problem. Fiscal cliff avoidance is only a start. The amount of debt we are in is troubling. If a business or house ran this way we would all be ashamed. In order for America to gain a competitive advantage again, we need serious long term tax reform and entitlement reform. This will unleash resources that please us as both citizens and investors.