Diving Into The Fiscal Cliff

Well, the election is over and I know what you’re thinking:

“Calhoun is an idiot. He said last week that elections don’t matter but just look at what the market did last week. Obama gets re-elected and the market immediately takes a dive. See, elections do matter.”

Given the 400 point plus spanking the market took in the three days following the election, it is tempting to blame the market action on the re-election of President Obama but I think that would be a mistake. I have been saying privately (hey, there are benefits to being a client) for months that if Obama won, the market would sell off immediately and if Romney won there would be a rally and then a sell off. My reasoning was quite simple. Once the election was over all eyes would turn to the fiscal cliff and what that might mean for the economy and markets. And if Romney won there would have been additional uncertainty regarding monetary policy. That’s one of several reasons we’ve been raising cash for the last few months. So, the market action immediately after the election was not a surprise to us here at Alhambra.

The point I was trying to make last week is that what matters is not the party affiliation of the President or the Congressional majority but rather the policies that get enacted. The movement of the stock market in such a short period of time means absolutely nothing. There is an old Wall Street saying that the market has predicted 9 of the last 5 recessions and this may turn out to be a blip that no one remembers a few months from now. We didn’t know last Tuesday if the economy was headed into recession and we don’t know now. What we do know is that, for now, the economy is still growing – slowly – and that fiscal policy is about to change because of the fiscal cliff. That is exactly the situation we would have faced if Romney had been elected. And because there was essentially no change in the make up of Congress, a President Romney would have faced the exact same negotiating position as President Obama, a divided Congress. And I suspect we would have seen a similar market reaction.

We’ve all heard a lot recently about the Fiscal Cliff (rendered so important in news articles that I am forced to capitalize it) and what it means for the economy. Economists of all political hues have said that if the Fiscal Cliff is not addressed, it will push the US economy into recession. Of course, those are the same economists who have been wrong about just about everything over the last few years so I wouldn’t give those forecasts a lot of weight when considering changes to your portfolio. There are a lot of moving parts in our economy and predicting future economic growth is quite simply impossible. At best we can predict the obvious primary effect of a new policy, but the magnitude and secondary effects are just not within the grasp of economics. If they were, central planning would be all the rage and the Soviet Union would still be around.

I would also point out that what most seem to believe about the fiscal cliff – that it is a combination of spending cuts and tax increases – isn’t even true. The tax increases are real enough but the spending cuts are not really spending cuts at all. Analyses by the CBO and OMB both show that total 2013 spending will exceed 2012. So there are no spending cuts involved and anyone talking about the negative impact on the economy from those phantom cuts is practicing politics not economic analysis. Furthermore, we don’t know how these tax increases would affect the economy except in very broad strokes. Economic research done by Christina Romer shows that tax changes enacted to reduce a budget deficit have a large negative impact (a 1% tax increase reduces GDP by 2 to 3%) but the Fiscal Cliff is not exactly new information. The tax increases embedded in the budget deal that produced the Cliff have been known for over a year. We don’t know the degree to which the changes have already been anticipated so we don’t know what the effect will be if they are allowed to take effect. I think it is safe to say a tax increase would be negative for growth but to what degree I cannot say.

Having said that, I am struck by the incantation of the President’s party that the budget problems cannot be solved without both spending cuts and tax increases. That quite simply is not true and we have real world evidence of that fact as well as evidence that trying to close the deficit through tax hikes is a fool’s errand. Canada faced severe budget difficulties in the 1990s and resolved them through real spending cuts (10% in total non-interest spending) and tax cuts (particularly on the corporate side). The result was better economic growth and a balanced budget every year from 1998 to 2008. What doesn’t work? The most obvious example is today’s situation in Europe where despite howls about “vicious spending cuts”, the fact is that European “austerity” has primarily taken the path of tax hikes. The spending cuts, depending on the country, have either been miniscule or non-existent. It might be too early to pass judgment on the fiscal cliff negotiations but if the outcome is higher taxes and no spending cuts, I feel safe in saying the outcome will not be optimal.

What should happen in a perfect world is that our politicians would look at the actual evidence of what is going with economic growth, tax revenue and government spending and then make rational, logical decisions about what to change. The argument for raising tax rates rests on the simple fact that tax revenue as a percentage of GDP is low relative to the historical norm but that isn’t sufficient evidence that tax rates need to be raised. The fact is that GDP is now larger than it was prior to the recession and yet tax revenue has not recovered apace. If tax rates haven’t changed – and they haven’t – then maybe raising tax rates isn’t the answer. The problem would appear to be that the increase in GDP hasn’t translated into taxable income. Indeed we can see this in the economic data where personal income has increased by 6.7% from the previous peak in 2008 while GDP has increased by 9.4%. Furthermore, wages and salaries are only up 4.9% during that time. There is obviously a problem here but it isn’t due to tax rates and raising them will not solve it.

So, what should investors do? I think it makes sense to see how the economy performs in coming months and see what comes out of the budget negotiations. It is possible that the politicians finally act like adults and get a deal done that doesn’t damage the economy. I’m not willing to bet on it though so for now we’ll keep hanging onto our big cash reserve, see how the debate develops and let incoming data dictate how we proceed. It is entirely possible that the economy surprises on the upside due to several factors unrelated to the fiscal cliff. China’s economy has shown some recent signs of life and Europe may also be hitting its nadir. Add in a continued recovery in housing and what the politicians do about the fiscal cliff may not matter.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773.

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