After the Election: Pondering the Fiscal Cliff and Its Investment ImplicationsNovember 9th, 2012
by Don Gould
The campaigns are finally over and the results are in. In the game of political gridlock (or compromise), Washington will field the same players for another two years at least.
Fiscal Cliff in Focus
Investors woke up Wednesday morning, November 7, and with the election behind them, lined up their sights on the impending fiscal cliff. They didn’t like what they saw. Stocks fell by over 2%, while US government bond yields plunged more than 10 basis points (0.10%), both indicating fear of economic problems ahead.
To review, the fiscal cliff is the outgrowth of a deal negotiated in mid-2011 as a condition for increasing the US national debt ceiling at the time. The cliff entails substantial automatic cuts in government spending starting in 2013. Coupled with the scheduled year-end expiration of both the Bush tax cuts and the more recent 2% payroll tax reduction, it’s a fiscal double-whammy – spending cuts and higher taxes, both imposed on a weak and possibly fragile economic recovery. Absent action by Congress and the President, the fiscal cliff occurs by default.
Prognosticating what’s next is difficult. The easiest prediction: the fiscal cliff in its present form is not likely to happen in January 2013. At a minimum, Congress can postpone its implementation – say, six months, while the parties seek to craft the so-called “grand bargain.” It’s also possible that a compromise can be reached in the lame-duck session that follows the election, but we view a kick-the-can action as more probable. A somewhat less certain prediction, but still more likely than not in our view, is that a bargain will be struck in 2013. The most difficult prediction of all – what shape the compromise takes – we’ll address below.
Call me a cockeyed optimist, but despite the rhetoric and campaign-related antagonism, I believe the parties well remember their disastrous performance in the debt ceiling crisis of 2011 and will do everything possible to avoid a repeat. They understand that a failure to achieve something substantive in 2013 could easily result in a market and economic debacle.
The Grand Bargain
What might a grand bargain look like? First, it will have to contain elements that allow each faction to claim a victory of sorts. President Obama will need to show that the top 1% is paying more. The Republicans, in turn, will need to cite their own tax victory. One idea, floated during the debates, would be to cap tax deductions well below the level that top earners have been accustomed to. (Note that this has the political appeal of not repealing any specific deduction, while drastically curbing deductions in aggregate.) In exchange, the Bush tax rates might be held steady. Democrats can claim they’ve closed tax loopholes for the rich, while Republicans will argue they’ve beaten back growth-retarding higher marginal tax rates. Probably the payroll tax reduction is allowed to expire on the argument that it really was intended as a temporary measure.
A bolder compromise would also change the way investment income is (or is not) taxed. Examples include limiting the tax exemption of municipal bonds and the tax deferral benefits of whole life insurance. Even the tax-deferred nature of qualified retirement plans (e.g., IRA, 401k) could be on the table. The opposition by affected interests would be fierce, but such changes can’t be ruled out, especially if some meaningful concessions are gained in return. Much as we’d mourn the passing of these hallowed tax benefits, we would also be very impressed by a Washington that could enact such changes.
The next component would be to put Social Security on a sounder actuarial footing. A fix here is relatively straightforward and politically manageable – some combination of extending the eligible retirement age (reflecting today’s longer life expectancies) and broadening the wage base to which the Social Security payroll tax applies.
That still leaves the really big one, the really important one, the really hard one – tackling Medicare. Left unchecked, Medicare will swallow the federal budget whole in relatively short order. Unfortunately, we doubt that meaningful Medicare reform will occur in 2013. However, if a grand bargain is struck that markets view as, (1) a serious first step towards fiscal sanity, and, (2) balanced with respect to its impact on economic growth, we believe that markets could react positively and grant Washington more time to get its arms around Medicare.
The path to compromise will be filled with sharp twists and turns, so expect market volatility in response to alternating bouts of optimism and pessimism. In our experience, pessimism is the more natural emotion, but optimism is better rewarded over time. Investment plans, soundly crafted in less turbulent times, should prevail, much as we may be tempted to run for cover.
Higher taxes on investment earnings arguably could depress equity prices, but consider the paucity of alternatives. Bond yields are at historic lows, cash pays about zero, and even the government admits to inflation of 2%-3% annually. Retail investors have been net sellers of equity mutual funds for the past three years, often a contrary (in this case, bullish) indicator for stocks. On the other hand, we’ve had a massive rally from the March 2009 lows, so there is plenty of room for profit taking, perhaps already previewed in Apple’s 21% decline from its peak six weeks ago.
The best advice we have is this: remember your time horizon and don’t overreact to headlines.
With President Obama’s reelection, it seems likely that Fed Chair Bernanke (or his ideological equivalent) will be appointed to a new term in 2014. Hence, short-term interest rates will likely stay near rock bottom for the foreseeable future. Still, the upside for bonds is very limited at this point, even if major downside is not yet on the horizon. At this point, high quality bonds serve largely to dampen portfolio volatility (a critical function, to be sure), but do little else given their paltry yields. Consequently, investors should not expect rising bond prices to substantially cushion the next major stock market decline. (See my earlier blog post: Why the Next Bear Market May Be Even Less Pleasant than the Last). Now if we (or anyone else) knew just when that was going to occur, we wouldn’t have to work for a living.
Rather than reaching too far out on the risk spectrum for yield or return, it’s far wiser for investors to reduce their return expectations, at least temporarily, and adjust accordingly. (For more, see: On Financial Repression and Rate of Return Expectations.) Effective portfolio diversification today should also consider asset classes and investment strategies that go beyond the conventional stock/bond balanced mix. We’re continually working on this.
Year-End Tax Planning
Finally, get used to the reality that almost every worker will be paying higher taxes, and those with high earnings and/or substantial assets will probably pay a lot more. (With the passage of Proposition 30, top earners in California are already looking at a 3% rise in marginal tax rates, to 12.3%, retroactive to 1/1/2012.) High earners also need to consider the real possibility that the bulk of their mortgage interest, state income tax, and charitable gift deductions will be disallowed under a deductions cap. Tack on the 3.8% Obamacare tax on investment income for higher earners, throw in up to a 2.9% hike in the payroll tax, and, well, you get the picture.
In the short run, higher taxes will almost certainly reduce after-tax incomes. In the longer run, the hope is that well designed tax and budget reform will put the economy on a higher growth trajectory, such that pre-tax and after-tax incomes both rise. By far the most plausible path out of our budget morass is improved rates of economic growth. It’s just possible.
If (a very big if) a compromise takes the form presented above, affected taxpayers should accelerate income into 2012 where possible. The prospect of higher capital gains tax rates means net capital gains harvesting in 2012 will make sense for some, but we don’t advise upending long-term holdings for this purpose. If deductions are capped in 2013, it could also make sense to accelerate deductions such as planned charitable gifts and state income taxes into 2012. This is one of those curious situations where it could make sense to accelerate both income and deductions into the current year, though it’s a much tougher call on the deductions side.
 We note that this reaction is not unlike what occurred after Labor Day 2008. Recall that Fannie Mae and Freddie Mac were widely regarded as being on the ropes through the summer, but it wasn’t until Wall Street got back to work in early September that the wheels came off the bus. In less than a week, Fannie and Freddie were wards of the state. Nothing really changed on Labor Day, other than investors’ capacity for focusing on the problem. Likewise, nothing really changed on Election Day 2012. Of course, we hope (and expect) that the next several months will not largely resemble the horrific six months that followed Labor Day 2008.