If nothing else happens between now and January 1, 2013, the United States will by law jump over the so-called “fiscal cliff.” This has significance both as to taxation and as to spending. Spending for a variety of federal agencies and departments will be cut (“sequestered”) under the Budget Control Act of 2011, for a savings of $65 billion. Also, payments to doctors for services they perform under Medicare will be cut by $11 billion; emergency unemployment insurance benefits by $26 billion.
Changes on the revenue side set to come into effect as we wish each other a happy new year include: an end to the Bush-era tax cuts; the re-introduction of the alternative minimum tax; an end to the two percent cut in the payroll tax that has been in effect over the past two years; an end to the partial expensing of investment property, and so forth.
We spoke recently to Reto Gallati, formerly the chief risk officer of Nuveen Investments, now the chief investment officer of Raetia Investments LLC, an independent Chicago based investment manager, who outlined for us four distinct scenarios on what might happen with the fiscal cliff and what it might do to the economy and the investment climate.
Savings / Debt Data
Source: Reto Gallati, Raetia Investments
The first possibility is that both the lame duck Congress and the President (whether that is Obama or Romney) will “punt the issue into 2013 with a bill that simply delays [any of the above listed consequences and other cliff phenomena] for a matter of weeks, until after the inauguration and the seating of the new Congress.”
A slightly bolder lame-duck Congress might work out with the President at least a modest compromise (scenario two), which would combine sufficient revenue measures with spending cuts to give them all some cover for delaying the issues further out, perhaps another couple of years. In this case, though, the fiscal cliff will remain in place; it will continue to loom, as a way in which the office holders can hold the feet of their own future selves to the fire of fiscal responsibility.
Gallati regards this as the most likely outcome of the four, because “it allows both parties to claim victory with some moderate compromises … and walk away.”
The third possibility is what Gallati calls the lemming scenario. There might not be any agreement, and the nation might go off the cliff, with the above listed consequences and more. We mentioned to Gallati that there are some people who think this result is optimal. Perhaps the U.S. needs the shock therapy that such a development would bring.
He said, “We haven’t built enough of a reserve to make that possible,” and referred to the statistics graphed above.
The fourth possibility is the most optimistic, some might say wildly so. It is that the Congress and the White House, between Election Day and January 1, will agree on a package that takes in revenue and expenditure issues in a broad-based and in a serious way, a Grand Bargain. Gallati said this would require “a president who can lead, and bring all the factions together, not one who takes a my-way-or-the-highway approach into a situation that is already polarized. The question is … what kind of a president is the new president?”
Fascinating as all this is to U.S. citizens as such, what does it mean to portfolio managers, like Gallati himself?
He expects what he calls range-bound development within the U.S. because of the uncertainties created by the cliff. Ironically perhaps, much of the market will flee to the safety of … U.S. Treasuries. “Even as the U.S. government basically becomes bankrupt by general standards with all the accumulated debt, the market will continue to run for safety” precisely into that debt.
Upcoming weeks may provide a good opportunity, in this climate of uncertainty, for investors to build out their equity positions in the U.S., and to make some careful moves into emerging markets, but it is probably too early to venture into Europe. It will be too early until there are “some tangible results regarding Spain and Italy” that will establish the worst of the crisis has past.
Promising markets in developing nations include both Brazil and China. Gallati would invest only “in large cap positions, either through ADR or ETF/mutual funds regulated here in the U.S.” in order to get the upside exposure to such markets while mitigating the risks.