November 19, 2012
On October 18 I published our last newsletter discussing why the risk of a significant equity correction is unlikely and why the US economy is in much better shape than the general media portrays. See out Blog posted on October 19 at http://SchwabenCapital.wordpress.com. Now a month later I feel that I have to re-defend this position. The US election has caused a re-emerged reason for concern in equity markets because Obama has taken the presidency again for another 4 years however the Republicans still control the house and everyone panics fearing a standoff just before the “Fiscal Cliff”.
What is at stake ? To bring the $1.1 trillion US deficit and the $16.3 trillion US public debt under control. Please see the US public debt clock for more detail: http://www.usdebtclock.org/
What does it mean?
1.) A consensual budget agreement between the Democrats and the Republicans by December 31, 2012 through the CBO (Congressional Budget Office) or,
2.) Face the “Fiscal Cliff”, a bundle of momentous U.S. federal tax increases and spending cuts that are due to take effect at the end of 2012 and early 2013. In total, the measures are set to automatically slash the federal budget deficit by $503 billion between FY 2012 and FY 2013.
Some of these taxes are automatic tax increases due to the expiration of the Bush Tax cut extension that were initially scheduled to expire in 2010. The impact of the Fiscal Cliff would be a reduction of Real GDP by 0.5% and rise of the unemployment rate to over 9%. In 2013 numbers this would mean an economic contraction of 4% for 2013. This would with all certainty throw the US into a recession. The fear of a potential recession has spooked equity markets since the election due to the fear of a recession. A full blown recession would from this level likely cause equity markets to decline by at least 15% to 20%.
Fig.1 from “Renewing America – What is the Fiscal Cliff”
What are the components of the fiscal cliff?
The following set of revenue and spending measures are set to expire or take effect at year’s end, representing an acute fiscal consolidation that could be further intensified by a potential showdown over the debt ceiling.
• 2001/2003/2010 Tax Cuts & AMT Patch. This series of legislation, often referred to collectively as the “Bush tax cuts,” will expire on December 31, 2012, raising all income tax rates (top will go from 35 to 39.6 percent), as well as rates on estate and capital gains taxes. The alternative minimum tax (AMT) will also automatically apply to millions more citizens.
• Payroll Tax Cut. The Social Security payroll tax holiday will expire December 31, raising the rate from 4.2 to 6.2 percent.
• Other Provisions. Several other policies such as the Research and Experimentation tax credit, many of which are typically enacted retroactively, are due to sunset at years’ end.
• Affordable Care Act Taxes. Some provisions in the Obama health-care legislation, including increased tax rates on high-income earners, are set to take effect in January 2013.
• Budget Control Act. The automatic spending cuts or sequester legislated by the Budget Control Act of 2011 will hit January 2. Half of the scheduled annual cuts ($109 billion/year from 2013-2021) will come directly from the national defense budget, half from non-defense. However, some 70 percent of mandatory spending will be exempt.
• Extended Unemployment Benefits. The eligibility to begin receiving federal unemployment benefits, last extended in February, will expire at year’s end.
• Medicare “Doc Fix.” The rates at which Medicare pays physicians will decrease nearly 30 percent on December 31.
The debt limit, which sets the maximum amount of outstanding federal debt the U.S. government can incur by law, is currently capped at $16.39 trillion. Treasury is expected to hit this borrowing capacity again sometime in early 2013. Analysts fear another protracted debate over the debt ceiling could bring repercussions similar to those that followed the debt battle in summer of 2011, which rattled financial markets and, according to a study from the Government Accountability Office, raised the cost of Treasury’s borrowing by $1.3 billion for FY2011.
The effects of the policies differ both because they vary in their budgetary cost and because they spur output and employment by different amounts per dollar of budgetary cost.
Very heated debates during the last few election weeks have caused many investors to fear a dead lock in budgetary talks, the same as in 2010, which would result in the mandatory fiscal tightening as was agreed at the 11th hour and 59th minute before a default would have occurred by the US. The poor negotiations by Congress caused credit rating agencies to downgrade the US credit rating from the highest credit rating “AAA” to a double “AA” status lower than some high quality US and international corporations.
This time, Obama is fighting for a higher tax rate for the country’s richest or in Obama’s terminology that “everyone pay their fair share” and Boehner, the speaker for the house, vigorously defending a “no tax increases for the rich” policy and to more drastically reduce entitlement programs. The irony is that several of the ultra wealthy and influential business supporters such as Warren Buffet, Chairman of Berkshire Hathaway and Alan Greenspan, the former Chairman of the Federal Reserve support Obama’s positions however one or two levels below in the “very rich” category that include investment bankers and many high end executives support Boehner. The other side of deficit reduction, of course, is reduction of spending. The largest portion of the entitlement programs are Medicare and its sister plan for the poor, Medicaid. In 2011 this represented with $768 billion 21% of the federal budget. Even Obama recognizes that the larger portion of the deficit reduction plan must come from reduction of spending rather than additional taxes. Obama has already talked about a $2.50 spending reduction for every $1.00 in additional tax revenue. Obama has also agreed to not cut defense spending however to slow the rate of increase of the defense budget. These are significant strides by the President to attempt to reach a deal.
The Republicans however have reduced their negotiation leverage over the past two years by taking on a “complete refusal and denial” policy of any proposals that the Democrats have tabled in order to starve government and unseat the Democrats from taking a second term. This has had numerous adverse affect for the Republican, both in voter support and negotiation options in avoiding the “Fiscal Cliff”. The Tea Party, that several years ago, energized some Republicans, has now become a millstone to the GOP due to their radical positions towards immigration and non-white US citizens. In 2012 89% of Mitt Romney’s voters were whites versus 56% for Obama. The Latino’s support for the Republicans has drastically declined over the past 4 years from 44% in 2008 to 29% in 2012 and as the Latino population will continue to increase, Latinos will make up an ever increasing population of supporters for the Democrats.
Boehner’s negotiation position has been compromised in 2010. During the last debt crisis John Boehner initially agreed to a secret deal with the Obama administration to cut spending and raise taxes. However a leak of the proposed deal forced Boehner to abandon the deal after an insurrection from conservatives. Since then the relationship between the White House and Boehner has been practically non-existent.
What does this all mean to equity markets until the end of the year?
During the last 2 years there was significant motivation by the Republicans to have a “Refusal Policy” in order to unseat the Democrats during this presidential election and argue that the President was unsuccessful in accomplishing what he had set out to do. This policy has become known and frowned upon both by democrats and some republicans. Should the House attempt this policy in “Fiscal Cliff” negotiations the resulting failure to come to an agreement in Congress and failure in budgetary talks would primarily be blamed on the Republicans, which would cause further alienation by the American public and voters in the next election even though it is 4 years away. Obama has also made additional concessions to the Democrat’s position in 2012. While I expect that a deal will be consummated before the end of the year, further rhetoric from both parties in the coming weeks will likely cause additional volatility and eliminate the chance of a significant equity rally before the end of the year. I expect that equities will perform well again in the new year and continued economic activity will drive equities higher at that time. For additional insight into my comments on US economic activity please refer to my previous newsletter on our Blog at:
Should you have any comments or questions please contact me at:
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Albrecht Weller, CFA
Schwaben Capital Group Limited
161 Bay Street, 27th Floor
Toronto ON M5J 2S1