Despite the recent media frenzy over whether or not Congress and the President will avert the “fiscal cliff,” we have until now resisted commenting for three reasons. First, this is not some new sudden crisis that could not have been anticipated – we have been discussing the looming fiscal challenges the US economy faces and positioning portfolios to mitigate risk against unpleasant outcomes for the better part of three years now. Second, since the election concluded, the political debate has not yet come close to addressing the real issues that are at stake for a decisive resolution. Instead, it has been a flurry of posturing on both sides. Finally, the “fiscal cliff” is really more of a “fiscal slope” and is only one piece of the puzzle in terms of how the US might fare in 2013 and beyond.
It is no secret that we face some unpleasant fiscal arithmetic and to restore the path of future deficits to sustainable levels, austerity is not a choice; it is an inevitability. However, the nature and size of the spending cuts and revenue increases over which opposing political parties are bargaining do not directly address the elephant in the room: the long term reforms that are required to sustain entitlement programs like Social Security, Medicare and Medicaid. For the last 30 years, we have enjoyed productive baby boomers; however, their coming retirement will place greater strain on these entitlement programs. Navigating this transition will require leadership and political resolve on both sides that we have not yet seen.
Instead of proactive, bipartisan leadership, in recent times it has only been when financial markets really balked that a feint hint of compromise managed to move the ball forward and appease markets. Two of the most recent examples are 2008 when Congress quickly passed TARP (Troubled Asset Relief Program) to avoid liquidity drying up amidst a bank panic and again in Summer 2011 when Standard & Poors downgraded the US credit rating after the debt ceiling crisis. Aside from a few debt financed “special dividends” declared by certain companies to change their capital structure, markets today are quite calm, suggesting they believe Washington will once again do just enough at the last hour to avoid sequestered spending cuts and automatic tax increases from taking effect. This time, we believe that the temporary patch will be some combination of Republicans agreeing to extend tax cuts for those earning less than $250,000 in exchange for Democrats agreeing to a base line in discretionary spending cuts and a credible promise to address entitlement reform in the near future. There are several reasons to suggest this:
- After the election, the President appears to have a majority of public support for raising revenue based on “fairness;”
- Business leaders are putting pressure on both sides to become less dogmatic and more practical;
- A growing awareness within Congress that the electorate has become increasingly impatient and frustrated with their performance in recent years.
This last minute deal will most likely occur before the new year and should buy Congress time to legislate around several important dates during the first half of the year and determine the size and balance of fiscal austerity required. The long-term goal of these actions will be to decisively deal with long-term structural issues, such as the entitlement programs mentioned above. Therefore, contrary to most descriptions, the fiscal “cliff” is actually more like a fiscal “slope” of several important dates around spending and revenue decisions, including authorization to increase the debt ceiling again instead of one, steep drop off come January 1, 2013.
Even if these issues are successfully addressed by next summer and the pain is spread over several years, by some estimates, the effect of less government spending and greater revenue collection may create a drag on GDP growth by as much as 1.5% in 2013. The greatest risk is not that GDP growth may contract and result in a recession, although that could occur during a protracted stalemate. Instead, it is more that anemic nominal GDP growth rates may fall below long-term interest rates for a sustained period. This could cause markets to question whether the US economy can continue deleveraging in an orderly fashion with economic growth and contained inflation helping to ease debt burdens in real terms slowly over time. The Federal Reserve has already resorted to substantial and unconventional monetary accommodation techniques to orchestrate that.
With all these other factors to consider, averting the fiscal cliff early next year is not the real issue, despite the rhetoric and media frenzy today. Despite these headwinds, there is still a real possibility that the economy could do well in 2013. In particular, there are three areas we are watching that may provide a boost to the economy: a rise in consumer and business confidence spurred by a deal; the nascent and spreading housing market recovery; and the burgeoning boom in oil and natural gas exploration. Additionally, our 2013 Capital Markets Forecast describes in detail the measures we have taken to position strategies for a wide variety of outcomes as we approach 2013.