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Just a Spoonful of Sugar

Eric Freedman
CAPTRUST Chief Investment Officer

It is always dangerous to write about a topic that could go in a different direction before your content reaches readers. While we endeavor to get this publication out to readers as soon as possible, paper-and-ink publishing necessarily drives a “time wedge” between when we write and when your eyes hit this page. I recall a period early in my CAPTRUST career when I dutifully penned a 1,500-word article a week before deadline, only to have the Federal Reserve announce an unexpected policy change that rendered my missive, as they say in the business, old hat. “Rookie move,” as the kids say. 

The topic of the fiscal cliff presents a similar authorship risk. As I write in early October to a readership that will see this article in late October at the earliest about an event that will occur on December 31, I risk that said “time wedge” may include critical developments that render this article old hat. However, my editorial staff and I agreed that the probability of this event being resolved before publication was extremely limited, and since resolution would likely be a positive development, we rolled the dice. 
Before we delve into specifics, let’s start with what the fiscal cliff actually is. While the mainstream media has affixed this catchphrase onto potential year-end events, we do not want to presuppose that what the phrase embodies has been well-explained. The fiscal cliff represents tax cut expirations, Medicare tax increases, unemployment benefit program extension terminations, and two rounds of discretionary spending cuts resulting from the 2011 Budget Control Act that are all slated to become effective on December 31, 2012. These various programs clearly represent some political sensitivities, with parties deeply entrenched as we approach year-end. 
The fiscal cliff has clear economic implications from a directional standpoint. Economic textbooks suggest that U.S. government spending as a percentage of Gross Domestic Product (GDP) is normalized in the 15-20% range (while more skeptical sources say the range is highly volatile, more like 10% to 40% over time), so any government spending decreases would impact growth in the very near term. Effective tax increases also impact growth, as less discretionary spending means less available consumption dollars. This year, National Bureau of Economic Research economist Valerie Ramey concluded that — even if higher taxes translate into more government spending — the government spending GDP “multiplier effect” (how a dollar of increased spending reverberates in the economy) has a very wide range of potential outcomes and most likely decreases private (non-governmental) spending.1 In aggregate, the fiscal cliff ’s directional economic impact is clearly negative. The order of negative magnitude, however, is unclear and a major point of debate among economists. 
So why do we need to go through this? The answer rests on America’s increased reliance on debt fi nancing, within both the public and the private sectors. In prior Strategic Research Reports, we have analyzed consumer debt growth and how that has correlated with economic output. Government debt, however, has become a more topical discussion, particularly given the political climate. 
Cumulative deficits (when government expenditures exceed revenues) have brought our debt picture to untenable long-term levels, and both political parties agree that high debt levels are not conducive to economic growth. In a comprehensive analysis that included both developed and developing countries, economists Carmen Reinhart and Kenneth Rogoff noted that median growth rates fall by 1% and average growth rates fall more than that for countries saddled with debt-to-GDP ratios above 90%.2 We have to go through it because, just as Mary Poppins prescribed to Jane and Michael Banks, we need to take our collective medicine, and investors are trying to see how much “sugar” will be included, as the list of policy changes could come all at once (representing sugarless castor oil in the form of a potential downward GDP shock) or in a more piecemeal fashion (attenuated castor oil that the economy could more easily stomach) should Washington decide to compromise. 
Figure 1 shows the non-partisan Congressional Budget Office’s (CBO’s) late August estimates of federal debt held by the public over time (a slightly different debt measure than that cited by Reinhart and Rogoff, but instructive nonetheless) as well as forecasts from fi scal year 2013 (which started on October 1) through 2020.3 As Figure 1 displays, the dotted line represents a figurative fork in the road for the U.S. debt-to- GDP ratio. If the full fi scal cliff occurs in early 2013, the CBO projects a drop in debt to GDP to more favorable long-term levels under its baseline scenario. However, should a spoonful of sugar dilute this tough medicine, the “alternative” fiscal scenario shows debt to GDP drift higher and into the 90% of GDP red zone. So the tradeoff is clear when assessing the CBO’s projections: Should the economy endure the “full” fiscal cliff, our debt-to-GDP ratio improves, but the economy likely suffers. If instead Washington compromises and we delay parts of the tax increases or sequestration (a term that encompasses the budget cuts), the economy may experience some short term relief at the expense of longer-term debt considerations.
Given a wide range of potential outcomes and pending the political horse trading in coming weeks, we caught up with Dr. David Kelly, JP Morgan Asset Management’s chief global strategist and head of the Global Market Insights Strategy Team. David and his colleagues penned a lucid piece, describing several scenarios that may play out, and we wanted to share a few takeaways from our conversation with Dr. Kelly. 
Dr. Kelly and team do not anticipate any legislation prior to the election, but instead anticipate the balance of power after presidential and congressional elections to drive further action.4 Based on election outcomes, Kelly sees one of four scenarios playing out: a Democratic sweep of Congress where the Bush-era tax cuts end for wealthy households, a Republican sweep with a focus on spending cuts, a divided government that induces the fiscal “ledge,” or a divided government that results in a fiscal “ladder.” Let’s look at each scenario and JP Morgan Asset Management’s investment conclusions for each scenario.
If this scenario occurs, Kelly assumes that:
• the Bush-era tax cuts would be extended only for those households earning less than $250,000/year,
• top dividend and capital gains tax rates rise from 15% to 20%,
• the payroll tax cut is phased down and eventually eliminated,
• extended unemployment benefits expire on schedule, and
• higher Medicare taxes ensue.
In terms of sequestration, he assumes that only the first round of spending cuts takes eff ect.5 Kelly sees this scenario as a negative for equities given their diminished after-tax cash flows but potentially positive for municipal bonds. The overall GDP impact would be a one percentage point drop in GDP from current levels if no tax increases or sequestration events happened.6
Assumptions for this scenario include:
• extension of all Bush-era tax cuts, along with a fix for the Alternative Minimum Tax,
• expiration of the payroll tax cut and extended unemployment benefits on schedule, and
• no increase in Medicare taxes.
Similar to the Democratic sweep scenario, only the first round of spending cuts takes place and the second does not take effect.7 Investment implications include a positive impact on equities but the opposite for municipal bonds. Kelly and team note further that, in this scenario, a Romney administration may seek additional tax and entitlement reform.8
If we see some split at the executive and legislative branches of government, JP Morgan anticipates a combination of spending cut compromises and some higher tax rates that could include the following:
• extension of the Bush-era tax cuts only for households earning less than $250,000/year,
• top dividend and capital gains tax rates rise from 15% to 20%,
• expiration of the payroll tax cut on schedule,
• higher Medicare taxes to pay for President Obama’s healthcare plan, and
• both sets of spending cuts are implemented.9
Kelly and team expect that outside of a full fiscal cliff realization, this scenario would have the worst impact on the economy and stocks and would have an uncertain impact on Treasury bonds.10
This would be a better economic scenario with a more gradual deficit reduction, with:
• full extension of the Bush-era tax cuts in 2013 and for households earning less than $250,000 from 2014 onwards,
• top dividend and capital gains tax rates rise from 15% to 20%,
• the payroll tax cut is maintained in 2012, phased down in 2013, and eliminated in 2014,
• unemployment benefits expire on schedule,
• higher Medicare taxes to pay for President Obama’s healthcare plan, and
• only the first set of spending cuts is implemented.11
Kelly and team see this as a potential positive for equities. Even though tax rates would move higher, GDP would expand and the fiscal defi cit would simultaneously decline, potentially boosting investor confi dence.12
In our follow-up conversation with Dr. Kelly, we asked him what he was seeing investors do to prepare for this range of outcomes, and David responded that retail investors appear to be voting with their feet, as mutual fund flows out of stocks and into bonds have occurred at the fastest rate in the last five years, a curious development in light of recent equity market performance. He was also seeing some taxable investors take steps to realize some gains this year across asset classes in light of higher anticipated taxes. In summary, though, Dr. Kelly argued that investors who are properly diversified do not need to take action ahead of the uncertain outcomes that await us this year-end. Our view — a solid asset allocation, and a spoonful of sugar, may be the best combination for investors heading into 2013. 
1 Ramey, Valerie A., and NBER (2012). “Government Spending and Private Activity.”
2 Reinhart, Carmen M. and Kenneth S. Rogoff (2010). “Growth in a Time of
Debt,” American Economic Review, May. (Revised from NBER working paper
15639, January 2010.)
4 Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset
Management Market Insights, 2012, page 5.
5 Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset
Management Market Insights, 2012, page 6
6 Ibid
7 Ibid, page 8
8 Ibid
9 Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset
Management Market Insights, 2012, page 10
10 Ibid
11 Ibid, page 12
12 Ibid