By now, everyone has heard all about the dreaded “fiscal cliff.” So I decided to take one more leap into the unknown to see if I could sort out when and how we would experience this upcoming historic “splat.”
Before we get started, let's review what the term “fiscal cliff” actually means. Here’s the definition from Investopedia.com:
“Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.
Among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect. According to Barron's, over 1,000 government programs – including the defense budget and Medicare are in line for "deep, automatic cuts."
Now that we are facing this self-inflicted law that Congress has imposed on itself (Budget Control Act of 2011), the government has three basic options moving forward:
1) Congress could simply let the stated law go into effect on January 1. This harsh, albeit way overdue, fiscal budget policy measure features a plethora of tax increases and spending cuts that are expected to slow economic growth. This decision would most likely drive the economy back into a recession or possibly worse. The positive take-away? If they decide to take this bold step, the deficit, as a percentage of GDP, would be cut in half.
2) Congress could repeal some or all of the scheduled tax increases and spending cuts, and once again raise the debt ceiling. Of course, this decision would add to the current $16 trillion mega-debt deficit, thus demonstrating to the world that the United States is unwilling (or unable) to get its fiscal budget under control. Can you say European debt crisis?
3) Congress could draw up a compromise of sorts involving a potential combination of moderate tax increases and fewer spending cuts. A calculated attempt to address the alarmingly huge and constantly growing budget deficit over a longer period of time should have a more modest impact on current growth.
Here is my take on how all of the upcoming madness will play out. Obama wins a very close presidential election by just a few electoral votes. The Republicans maintain control of the House, 235 to 200. Surprisingly, the Senate ends up with a Democratic majority. So it’s essentially status quo as far as party control goes, except that the conservatives feel most energized about their unexpected national resurgence, perhaps even winning the popular vote outright. We have certainly seen stranger things occur.
After Obama's narrow victory, the market gives him a minor reward by pushing the S&P 500 toward the highs of the year. However, once the Democrats have finished their obligatory week-long celebratory partying and the Republicans are done crying, the realities of the “fiscal cliff” become apparently clear. Seemingly out of nowhere, equities will reverse course, as investors start to insist that politicians get their act together on the long term fiscal sustainability of the U.S.
The market insists on a verifiable budget deal and wants it fast. After all, we don’t want the same fate as the Greeks, right? The S&P will start to push below 1,400 in a hurry. (Remember last year’s 11% drop over the course of a few trading days. Get ready for much of the same this time around.) Momentum will gain before the December 31st deadline.
Feeling confident again after their failed presidential bid, Republicans will decide to use the market for revenge. They will most likely insist on fewer tax hikes and more spending halts. The conservatives will take the grand bargain vote down to the last hour.
The market will make multiple lower lows heading into Christmas at sub 1,350 … and approach the New Year with increased volatility as seen by the CBOE Volatility Index (V IX). Expect to see 30-point swings in the S&P 500.
Finally, just like last year, a marginally magnificent deal is magically struck as the clock strikes twelve, whereby the market maker mavens then push the intensely ignited indices right back over 1,400.
Basically all of this “fiscal cliff” nonsense is for naught.
The lesson here: stop panicking and stick with your original investment goals. Ignore the noise and stay proactive, not reactive.