The US Fiscal Cliff four scenarios
Will the U.S. tilt the world towards global recession once again?
In 2008, the U.S. subprime mortgage and banking crisis touched off the Great Recession, the effects of which have lingered for four years. Washington then tottered perilously close to another economic crisis last summer (2011) as political gridlock led the U.S. to an impasse centred on the debt ceiling.
Now, those same forces of brinksmanship are hard at work in what’s being called the U.S. Fiscal Cliff. The ‘cliff’ is the series of sunset clauses that are set to kill $540 billion worth of simulative tax cuts and spending provisions in the weeks following the upcoming U.S. presidential election on November 6, 2012.
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Those whose summer reading included an in-depth study of the U.S. election and economy will already know that the so-called Fiscal Cliff consists of:
• An end to Bush-era tax cuts of $230 billion for lower-and middle-income Americans (worth $2,000 to $5,500 per household);
• Expiration of $50 billion in Bush-era tax cuts for upper-income earners;
• Termination of $40 billion in extensions to unemployment insurance eligibility;
• Expiration of $120 billion in payroll tax holidays;
• and $98 billion in federal spending cuts, enforced by the Budget Control Act of 2011.
The Budget Control Act itself is an artifact of the partisan politics gripping America. It was in the summer of 2011 that the Republicans and the Democrats could not agree on how to raise the debt ceiling, which was required to allow the U.S. Government to stay open for business.
The solution to that deadlock was the Budget Control Act, under which the Republicans would increase the debt ceiling while, in return, a Joint Committee of Congress would be formed to agree on $1.5 trillion in budget reductions over 10 years – OR, if the Committee failed to agree, the Budget Control Act would impose automated cuts to discretionary spending, defense, Medicare, farm subsidies and other entitlements.
Well, the Joint Committee has failed to agree so those cuts, along with others, are now looming. But the $540-billion wallop to the economy of all these impending, automated pull-backs doesn’t include the multiplier effect as the cuts ripple through the economy, or the resulting fear factor that could further constrict investment.
The deadline for the Fiscal Cliff comes at the same time as Europe and China are both struggling. Even a slight blow to the U.S. economic engine could be damaging to investor sentiment.
But while we can all expect economic volatility in the days and weeks ahead, it is not all gloom and doom.
One piece of good news is that, similar to the European debt crisis, the human instinct for economic self-preservation will encourage leaders of both parties to eventually temper their positions to overcome the political impasse. Despite the elections’ tendency to escalate division, calmer voices will soon be heard – either just before or just after November 6, 2012.
There are four potential scenarios that could play out after the U.S. elections with regards to the Fiscal Cliff.
Scenario #1 – President Barrack Obama wins the election and begins his second term with bargaining powers reduced. Democrats would most likely have retained control of the Senate and Republicans would hold the House, resulting in potential continuation of political gridlock. We suspect that the markets will begin to price in this gridlock and inaction will lead to volatility. As a result, the politicians will have to come to the bargaining table in Q1 2013 to avoid further downgrading of U.S. debt.
Scenario #2 - Republican presidential candidate Mitt Romney wins the election by taking swing states, heralding a shift of control in the Senate. Republicans control the House, Senate and Executive Branch, enabling Romney to take a pragmatic, centrist approach that would allow for quick compromise and clarity for the equity markets.
Scenario #3 - Romney wins but Democrats maintain control of the Senate. As a new president, Romney uses his “honeymoon period” to enact legislation that prevents the worst of the Fiscal Cliff impacts. The presumably weak Democratic majority in the Senate softens towards the new administration and the finer fiscal requirements of true long-term solutions can be debated.
Scenario #4 - Either party wins the presidency. Both sides recognize that the elections are too close to call and the ‘Cliff ’ starts to take hold of the markets. Parties pre-emptively moderate their tone on economic issues during the closing weeks of the election in order to pave the way for compromise that prevents most of the looming cuts.
In-house analysis at McLean and Partners puts the odds at 70-30 in favour of avoiding the Fiscal Cliff. That being said, we are concentrating our efforts on things we can control. That means hoping for the best and preparing for the worst.
No matter who wins the election, it will be several weeks after the vote before the bulk of the sunset clauses are triggered. This will give added time to gauge whether the results of the election will lead to continued widening of the political gorge or a move toward conciliation and compromise.
If entrenchment appears to be taking hold, several steps to protect investors will have to be taken: lengthen the maturity of bond holdings in anticipation that the U.S. Federal Reserve will move to drive down interest rates; as yields decline, longer-dated bonds will experience greater price appreciation; active hedge equity markets in order to create positions that are inversely related to anticipated downward moves in the markets; finally, eliminate equity risk and increase cash positions, retaining companies with strong balance sheets, large cash holdings, and the most attractive dividends.
A clear bipartisan solution to the current fiscal realities would be the best outcome of the coming election in the U.S, of course. Let us hope thatleaders will win control of the U.S. government and take the immediate, pragmatic approach needed, to credibly address the serious fiscal and monetary issues facing the U.S.
David Sherlock is Portfolio Manager with Calgary-based McLean and Partners.