Fear of the Fiscal Cliff

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As I’ve said before, this letter is not intended to be a political soapbox and I will rarely comment on political ‘stuff’ unless there is an immediate and direct impact on the financial markets.  That is the case from time to time, but not as regularly as most people might think.

Business has a tremendous and long-standing track record of trumping politics.  Under the majority of circumstances, government’s role is not significant in the equation of the mutual benefit of a business delivering on the needs of a willing consumer.  Government’s role is potentially dangerous when its policies weigh far too heavily on either the business’s ability to produce their product or the consumer’s net after-tax ability to pay for it.

We all tend to complain about government’s approach to many important issues, but when the truth is told, for generations – centuries really – business has found a way to operate within the clutter of government and grow the world’s economy, create jobs, and provide citizens with the products and services they want and ultimately demand.  When government is too big, however, its weight slows down this system; but it doesn’t stop it altogether.

This might be the story of the current political hotbed – the “Fiscal Cliff”.  This is the generic phrase for the government spending cuts and various tax increases that will automatically take effect January 1st unless Congress somehow acts to stop or amend it.

With the re-election of President Obama, this debate is front and center.  Given our divided government, it will be a lively debate to say the least.  The fiscal cliff is essentially the result of the last time our government needed to avoid a financial mess – the debt ceiling dilemma last August.  Not enough political will was mustered up to actually solve a problem, so they kicked the can down the road a bit with a Band-Aid plan that did nothing other than buy some time.

Funny thing about kicking the can down the road – the road never seems to be as long as you’d like, and eventually you come up to that same darn can.  What then?  When it comes to this fiscal cliff topic, my hunch is there will be another swift kick.

The cynic in me thinks that our political leaders from both sides of the aisle will yet again put their jobs ahead of the jobs and well-being of those they are elected to dutifully represent.  I am afraid they will do just enough to show they’ve taken action, thereby not harming their chances of re-election; but they won’t do anything large enough to actually change the course of our growing debt problem in our nation.  Steps of that size take political will and that isn’t always good for re-election – but it is often the better thing to do.

The idealist in me wants to believe our elected officials truly can “rise above” (the current buzz-term in the press) partisan politics and self-serving stances and actually work on a balanced approach to reforming our tax code and our debt dilemma for the good of our country’s longer range future.

But in the end, I am a realist, and as a realist I have to believe we’ll avoid the fiscal cliff with some sort of weak trade-off that doesn’t do all too much to address the underlying issue.  It’ll likely be politics as usual.  The end result for the financial markets will be a near and intermediate term positive, but will leave the longer range picture still blurry.

There is no way to know exactly how the fiscal cliff is solved, or when.  So get ready for the doom saying commentary to ramp up in the coming weeks.  My belief is that this will be pushed as far as it can be by Washington before any sort of agreement is announced.  This means there isn’t likely to be an answer to this issue until well into December, and possibly the 11th hour near the New Year, much like the way the debt ceiling deal was announced at the last possible opportunity.

Let’s assume some sort of ‘deal’ is forged and the worst of the fiscal cliff is avoided.  This is, after all, the much likelier scenario since the majority of research indicates that an uninterrupted dive off the fiscal cliff would substantially raise the probability of a recession.  Politicians know this, and they also know that such a turn of events would create political turnover in 2014.  So in the end the agreement will likely contain some higher tax rates for investors and the majority of working Americans.  There would most likely be some modest cuts to Federal spending in the area of entitlements.

If that is the case, from an investment perspective solid fundaments in our economy can matter again.  Those fundamentals include widely reported higher home prices over the past year, modestly higher real wages, noticeably higher consumer and business confidence readings, and lower unemployment to name a few.  Incidentally, each of these bullets might point to why early reports show that Holiday shopping is off to a much stronger start than last year.  In short, while the financial media – most of them being pessimists – are carrying on about the fiscal cliff, US consumers seem to be ignoring them.  Let’s be sure to remember that consumers have whittled down their debts to the point where their monthly financial obligations – mortgages, rent, car loans/leases, and other debt service – are now the lowest share of after-tax income since 1984 according to First Trust economists.  Their bottom line is that for the fourth year in a row, consumer spending is on an upward path.

We’ve also seen respectable earnings growth from corporate America.  And it is on corporate America’s collective balance sheet that an estimated 2.6 trillion dollars’ worth of silver bullets resides in the form of idle cash.  This is an unprecedented sum of money sitting around earning essentially zero.  In real terms, this means there is a negative return – corporations are losing money to inflation on their cash balances.  This is something their boards of directors and shareholders won’t tolerate forever.  Rest assured that the CEOs don’t like idle cash either.  They’d much rather be growing their businesses than sitting on too much capital.

Once the smoke clears from the debates in DC, this cash could be in motion in a big way in coming quarters.  It could do a lot to reduce unemployment and get factories up and running to full speed.  This type of capital being put to work is a potentially overwhelming positive for financial markets.

As I’ve said previously, uncertainty is perhaps the greatest risk to corporate earnings and financial markets.  If we didn’t have this current haze in the air, the markets would likely better recognize some of the positive trends that are now firmly entrenched within the economy.  Likewise, investor sentiment wouldn’t be at such low levels.  Whenever sentiment is so low, opportunity exists.   Risk still exists as well, which is why I still believe the market’s pause that I’ve anticipated will continue.  And if the fiscal cliff talks fall apart and no deal is reached, there will likely be a dip in the markets that we wouldn’t want to be fully exposed to.

But don’t panic even if no deal is reached.  While there’s no denying this would put a strain on economic growth, there is no assurance that our plow horse economy wouldn’t continue to slowly meander forward.

Consider this, also from First Trust data – from the end of 1986 through the end of 1996 the S&P 500 produced total returns of 15% per year.  Yes, that includes a huge rally in 1995-96, but it also included the crash in 1987.  And during that entire period, the capital gains tax rate was 20% and the top tax rate on dividends (treated as regular income) went from 28% to 31% to 39.6%.  In other words, higher tax rates on investment than we are likely to get next year didn’t prevent a bull market.

We all know that no two periods in time are the same, but certain facts are well worth noting.  In this case, the benefit of the decade of ’86 through ‘96 was a drop in the size of government.  During that period, federal spending fell from 22.5% of GDP to 20.2%.  At the time, it was the largest drop in any ten-year period since the wind-down after WWII.  Ultimately it is the government’s spending that matters most because spending redirects resources from the more productive private sector to the less productive government sector.

We certainly don’t have this same advantage at the current moment.  Given the election and the inevitable implementation of the health care law, I wouldn’t expect a significant reduction in government spending.  Nevertheless, government spending is likely to be at least trimmed one way or another soon – either through the force of the fiscal cliff, or through cooperative and hopefully constructive negotiations.

Neither scenario will shrink government nearly enough.  Instead, the current benefit to the markets will be the old adage of “don’t fight the Fed”.  It is likely that the current easy money policies will create an asset bubble in this country.  This is dangerous looking farther out on the horizon, but for a period of years it is simply a powerful positive force for financial markets.

I can’t tell you I prefer this method for engineering a genuine recovery.  But my job is not to run Washington DC; it is to care for financial assets throughout whatever period comes to pass.  We need to recognize the most likely outcomes of fiscal and monetary policy and allocate assets accordingly.  And today’s combination of federal policy, prevailing economic conditions, corporate valuations and balance sheets leads to the conclusion that the path of least resistance for the markets in the coming years is upward.

The Takeaways –

  • Worth Considering is not a political letter, and I’m not in a political profession.  While I don’t downplay the important role of our government in our daily lives and in our society, my job is to responsibly steward my client’s financial assets and not waste valuable time opining on political rhetoric or dealings beyond the impact on their portfolios.  Who would want to read these comments if they were just more of the same one-sided diatribes on TV every night?
  • Depending on your political persuasion, you might either be devastated or elated by the outcome of the election.  But as an investor, you need to take a fresh look at what is now the reality of our nation.  In my estimation, nobody should be jumping for joy or trembling in fear.  A balanced approach is still in order.
  • Prepare yourself for an onslaught of negativity in the press on the topic of the Fiscal Cliff.  It is, indeed, a big deal; but it doesn’t have Armageddon potential.  Washington is most likely going to strike a late deal that will kick the can far enough down the road to support the financial markets as we look at the New Year.  I doubt, however, that meaningful reform is on the way.

Commentary by Jeff Winn, Financial Advisor – Orlando FL

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