The Looming Fiscal Cliff

Okay... so here we are, back again with the election behind us. And, as some of you might recall, about a month back my commentary had a piece about how the elections would impact you with Obama vs. Romney.

So now that Obama has won, let me just summarize what I had mentioned a month ago on Obama's likely impact on some key economic issues.

The first thing I spoke about was that Obama will let tax cuts expire - those so called Bush Tax Cuts which expire on December 31, 2012, unless Congress does something to keep them in place. I'd mentioned that Obama wants to raise taxes on those earning over $250,000 and use this additional tax money to reduce the budget deficit. These tax cuts represent roughly $400 billion that could potentially flow to the government along with payroll taxes and higher taxes on investments: dividends, long-term capital gains.

Part of the package with the "sunsetting" of Bush era tax cuts were across the board spending cuts that also go into effect on January 1, 2013 - something called sequestration - that would impact discretionary spending on items like defense spending, and total about $200 billion in reduced government spending - with higher taxes and spending cuts jointly aimed at reducing the budget deficit, balancing the budget and reining in our national debt. These measures are expected to reduce the budget deficit by roughly 50% in 2015 and budget and debt by $7.1 trillion over the next 10 years.

It's this combination of tax increases and spending cuts that everyone's calling the fiscal cliff that goes into effect on January 1, 2013. It's this uncertainty over the fiscal cliff that was one of the causes of the markets' swing sharply lower on November 7, the day after the election.

And the reason everyone's talking about this fiscal cliff is that it's likely to increase the risk of a recession in 2013 if we just let it happen as is. Under a baseline scenario, the Congressional Budget Office (CBO) expects GDP growth to go down to 0.5% in 2013 from its current run rate of 1.1% and this contraction in GDP could significantly increase the probability of a recession in the first half of the year. So this "do nothing" scenario is a fearful one for both Main Street and Wall Street because it portends a recession that could hit us while we are only in the early stages of an economic recovery after the mortgage banking crisis of 2008. And economists fear that this could be hard to get out of especially since the world around us is in pretty bad shape too.

Now, none of this is going to be easy. For one, after this election, the Democrats have a firmer grip on the Senate and the Republicans are stronger in the House of Representatives, and neither party appears very willing to strike a compromise. Additionally, our debt ceiling will soon be reached and our lawmakers will have to soon reach some agreement on raising the debt ceiling so we can at least continue to pay our bills as a nation.

And to make matters worse, the European Union recently downgraded its economic forecast for 2013 - it now expects GDP to contract by 0.3% rather than stay flat as was earlier projected. Even strong nations like Germany are now feeling the pain with growth forecasts revised down to 0.8%, less than half of what they were just a few months ago.

The bang opposite scenario is one where the deadline is simply extended - tax cuts are left in place, at least for now, and spending cuts too are deferred - the kick the can down the road scenario. Under this scenario, the CBO expects deficits to remain high and for public debt to increase, indeed shoot up, from 69% of GDP in 2011 to 100% by 2021 and to 190 percent by 2035 - not a pleasant thought. This scenario would give the new government some more time to strike a compromise but would cause significant uncertainty until some decision is reached... and likely increase market volatility with daily swings tied to pieces of good news and bad news, much like what we've been seeing with the European crisis.

Another scenario is one where Republicans and Democrats reach a modest compromise and let some tax cuts expire while retaining others and enforce some spending cuts while ignoring a few others - sort of a give-and-take approach to avoid political confrontation and economic paralysis. Perhaps this is most likely because the electorate - we, the people too, want both parties to collaborate on this one because a slip-back to recession is bad for employees, businesses and governments that get less tax revenues.

And one final scenario is a grand bargain where both parties work in a bipartisan manner to come up with a solid plan that addresses comprehensive fiscal issues including tax cuts and spending cuts, and put us firmly on a path to balancing our budget and reducing our national debt. Gosh that sounds too good to be true, and unfortunately, it's less likely because neither party will substantially agree to give up too much.

This grand compromise is also something that the CEOs of over 80 major U.S. corporations urged lawmakers in Washington to reach to address our nation's fiscal woes.

So as we go into this lame duck session before the new government is inaugurated, my advice to my listeners is that you continue to stay invested through this uncertainty, even Buffett says "hold" right now and seize significant market declines as buying opportunities of companies that will survive all of this over the long run, and not let any volatility over the coming weeks and months shake you off your investment goals.

The Looming Fiscal Cliff