Merrill Lynch conducted a survey in mid-October of 253 fund managers who invest some $681 million for clients, and 42% listed the upcoming fiscal cliff as the biggest risk to their investments (up from 35% in September and 26% in August). Nevertheless, a quarter of the respondents noted that they were overweight equities, which was nine percentage points higher than the previous month. Are those two facts contradictory?
Just hours after the re-election of most incumbents, the U.S. Stock Market dropped almost 2.2% reportedly on fears that the fiscal cliff is imminent. The sell-off continued another 1.22% today. Clearly there will be some economic impact if a solution is not reached before year end. It would only be logical that significant spending cuts and effective tax hikes will have a drag effect on the U.S. economy. The full impact of the Fiscal Cliff could amount to 4 ¼% of GDP, and in that case, according to the CBO, would lead the country into recession. Anecdotal evidence is beginning to suggest the same. Boeing and Rockwell Collins are among the first to announce massive cuts in response to the upcoming sequestration.
The fiscal cliff and sequestration was originally designed to be a big game of chicken for a divided and deadlocked legislature. The plan called for a mixture of automatic spending cuts, tax increases, elimination of certain business credits and expiration of emergency unemployment benefits with a arbitrary deadline so painful to both sides of the aisle that it would force a larger more “rational” budget compromise. Yet, they may have underestimated their own stubbornness.
So, what could happen? Our friends at Deutche Bank wrote a nice primer on the Fiscal Cliff last week.
As stated above, the cliff is intended to impose draconian measures upon no other resolution. The table below the difference between current policy versus the cliff if imposed as written.
What is sequestration? Thanks to the Glossary of Political Terms we know,
Originally a legal term referring generally to the act of valuable property being taken into custody by an agent of the court and locked away for safekeeping, usually to prevent the property from being disposed of or abused before a dispute over its ownership can be resolved. But the term has been adapted by Congress in more recent years to describe a new fiscal policy procedure originally provided for in the Gramm-Rudman-Hollings Deficit Reduction Act of 1985 — an effort to reform Congressional voting procedures so as to make the size of the Federal government’s budget deficit a matter of conscious choice rather than simply the arithmetical outcome of a decentralized appropriations process in which no one ever looked at the cumulative results until it was too late to change them. If the dozen or so appropriation bills passed separately by Congress provide for total government spending in excess of the limits Congress earlier laid down for itself in the annual Budget Resolution, and if Congress cannot agree on ways to cut back the total (or does not pass a new, higher Budget Resolution), then an “automatic” form of spending cutback takes place. This automatic spending cut is what is called “sequestration.”
The Fiscal Cliff, as it is know, is combination of revenue increases ($520 billion) and sequestration of funds ($130 billion):
1. Expiration of all the various tax cuts passed under the Bush Administration (including a change in the level of taxation on dividends and capital gains);
2. Expiration of the “fix” for the Alternative Minimum Tax;
3. Expiration of the payroll tax cuts;
4. Expiration of various tax “Extenders” such as incentives for biodiesel and renewable fuel, credits for energy efficient appliances, deductions for individual and business tax payers, and temporary disaster relief; and
5. Automatic, across-the-board spending cuts of defense and non-defense by 10%.
The path that we are on puts revenues and expenditures on an unsustainably divergent course. The Cliff’s rules target a much narrower gap that with a growing GDP will place the country on a path of debt-reduction.
Lawmakers have one of three options available to them. They can kick the can down the road and extend the deadline. They can throw us all off the fiscal cliff by letting the existing rules be implemented. Finally, they could reach a grand compromise. Many believe the divisiveness among issues make this last option practically impossible. The Republicans have voiced opposition to tax increases, but look to significantly reduce government as outlined by the House Budget Committee proposal 2013 proposed by Paul Ryan. The Administration has proposed substantially less cuts with an increasing revenue percent from tax premiums on the highest incomes. Both plans narrow the deficit, albeit to different degrees as seen below in Chart 6, and consequently debt as a % of GDP in Chart 8. Not surprisingly, the bi-partisan commission of Bowles-Simpson lies in the middle.
I find it hard to believe that such austerity will not hurt the performance of equities, but the fund managers overweight nature discussed above would seem to contradict that opinion.
In later September, Fidelity Investments printed comments from the portfolio manager of the Equity Income Fund in their monthly Fidelity Viewpoints that changes in tax policy are not relevant even if that change is to how the dividends themselves are taxed. Although they never actually make this statement in the article, a number of blogs summarize Fidelity’s opinion that the fiscal cliff is a non-event particularly for dividend-paying stocks. Portfolio Manager, James Morrow, notes that demand from risk-adverse and yield-hungry investors will create a much smaller impact than one might expect. Their study noted the following:
“We examined the historical record to see how previous changes in dividend tax rates affected the performance of dividend-paying stocks. We found only one time when the rate on dividends changed to a degree comparable to the potential 2013 hike: when the Bush cuts were enacted and the rate fell from a high of 38.6% to 15%.
The research team divided the market into five groups based on the size of the stocks’ dividend yield. If dividend tax rates meaningfully affected dividend stocks’ performance, the expectation would be that the highest-yielding stocks led the market around the time of the 2003 tax cut. The researchers found no such evidence.”
The investing blog Minyanville makes a similar argument that tax rates and spending cuts are uncorrelated in their article today, Debunking The ‘Fiscal Cliff’ Myth.
and…
The markets of the last two days show an equity market that, at least for the moment, shows fear about the upcoming cliff. However, a number of professionals argue that it is an overreaction. Which is it? You decide.