On December 31st, 2012, a significant amount of the federal income tax code is scheduled to expire, an event that has come to be known as the fiscal cliff. The 2001 and 2003 tax cuts enacted under President George Bush, a compromise on the estate tax, a patch in the Alternative Minimum Tax, the temporary 2 percent payroll tax, and the “extenders” package of miscellaneous tax deductions are all scheduled to expire.
On January 1st, 2013, five taxes enacted as part of the Patient Protection and Affordable Care Act (Obamacare) also go into effect as well as $109 billion in spending reductions. The size and speed of these tax increases and spending decreases has many concerned that this could push our economy into a recession.
The fiscal cliff is the culmination of a decade of temporary tax and budget bills that have allowed our politicians to avoid solving key policy differences. The good news is our politicians can no longer afford to avoid good governance. Unfortunately, we believe that there are enough politicians on each side of the aisle who prefer going over the cliff (allowing these tax codes to expire) to strengthen their respective bargaining leverage next year. With only a few days remaining in session this year, there is an increasing chance that this sparring will continue into January, which could increase volatility in the financial markets as we move through the holidays. We believe this volatility will be short-lived because both sides of Congress cannot afford to let these budget talks extend for very long. It is not a matter of if there will be a compromise, but when this compromise will take place.
In 2010, President Obama created the bipartisan National Commission on Fiscal Responsibility and Reform. The committee, called “Simpson Bowles” after co-chairs Alan Simpson (Republican) and Erskine Bowles (Democrat), created a template for fixing our country’s fiscal problem. Unfortunately, neither the President, who created the committee, nor Congress has provided broad-based support for their recommendations. The reason is simple: every organized constituency from AARP to the National Association of Realtors will find something wrong with a balanced solution because a balanced approach affects everyone. Although the Simpson-Bowles proposals were not adopted, they have recently resurfaced as a template for pushing toward a bipartisan solution. We had the opportunity to meet and listen to Simpson Bowles at a recent conference in Chicago and walked away encouraged with their basic message, but felt a modified version would serve as a better long-term solution. Although we favor cutting expenses, through streamlining inefficiencies within government, over raising taxes, we do not believe there is a way forward without a compromise.
Their basic proposal serves as a good foundation for a compromise. Specifically, their plan incorporates simplifying the tax code, lowering marginal tax rates, widening the tax base, and increasing effective tax rates on upper-income individuals through the elimination of deductions. Their plan also addresses entitlement reform, which, they correctly pointed out, is unsustainable in its current form. Their proposal was to eliminate tax deductions and use the revenue to both reduce tax brackets and the ongoing deficit. Notably, as part of their proposal, preferential tax treatment for long-term capital gains, qualified dividends, and the Alternative Minimum Tax would be eliminated. As the Simpson Bowles proposal has gained momentum in the media, this has had an impact on the equity markets as investors rush to realize gains and question their preference for dividends. We feel both of these trends will correct as a long-term solution is negotiated.
The good news is the word is out. You cannot avoid hearing the constant barrage of doom and gloom coming from all sides of the financial sector. In our experience, investors are paid to take a contrarian view to that of the investing public, and it is difficult to find anyone optimistic on the financial markets, despite relatively positive news recently reported on the economy. Black Friday weekend spending was up 13 percent from a year ago. In September, the housing market posted the sixth straight monthly increase, and we are in a seasonably weak period. GDP was revised up to a 2.7 percent annualized rate in Q3, more than double Q2’s 1.3 percent.
Although our long-term views have not changed, we expect some volatility over the next several weeks as the negotiations play out. In October, we took steps to modestly lower the volatility in our portfolios in anticipation of these negotiations. Specifically, we decided to take defensive positions within our bond portfolios by reducing our exposure to high-yield, convertible bonds and preferred stock, which typically move in line with equities and added exposure to emerging market bonds and residential mortgage backed securities (RMBS). We believe our portfolio of high-quality equities, with a bias toward dividends and an emphasis on diversification, will continue to provide our clients with the right balance between reducing volatility and providing attractive returns when Congress finally compromises and finds a long-term solution to our budget woes.
What are your throughts on the fiscal cliff?