Market Overview

The Election, the Fiscal Cliff and the Economy

No doubt you've heard by now... there's an election coming up. Even more than usual, the stakes are high. Very high. Republicans and Democrats are vying for the top job in the land, along with control of both the House and the Senate in hopes of molding the economic future of the nation and its citizens in the manner they view as most appropriate given the various economic issues facing the country.

To borrow a phrase from President Bill Clinton's successful campaign 20 years ago; “It's the economy, stupid.” Unlike prior elections, though, the economic problems faced by the nation today are broader, more far-reaching and less easily understood or explained than ever before.

One topic that has been pushed to the forefront is the so-called fiscal cliff. An issue so ominous sounding that Americans now fear it more than even a weak economy (according to an article by Adam Shell in the USA Today, 9/19/2012) even though most don't understand the issue or implications since the fiscal cliff and a weak economy are related. Leading to more confusion is last week's positive stock market reaction to the official announcement of the third round of quantitative easing (QE3) by the Federal Reserve - itself a topic for another day that has served to only confuse voters more than they already are.

Turning back to the fiscal cliff, the term refers to the expected result at the end of 2012, where in the absence of new legislation, the Bush tax cuts expire along with extended unemployment benefits and the temporary payroll tax cut while Medicare taxes are increased and cuts to discretionary spending take effect. These actions would combine, according to the Congressional Budget Office (CBO), to reduce the budget deficit from 7.3% of GDP (fiscal 2012) to 4.0% (fiscal 2013). On a calendar year basis this is even higher as the fiscal year does not match up by three months.

If we can all agree that cutting the budget deficit is a good thing, why then should we fear the fiscal cliff? Most economists agree that the combination of decreased spending, along with higher taxes are likely to push the economy into another recession, including driving unemployment up. Taking into consideration that nothing will be done until after the election, the window for a satisfactory conclusion is seemingly narrower and narrower.

Outside pressures are mounting too as Moody's Investors Service on Tuesday, September 18th announced it would likely downgrade US government debt one notch from ‘Aaa' if budget talks fail to produce a satisfactory solution.

In lieu of panicking let's consider what a likely resolution may look like given the three possible election outcomes; 1) President Obama is voted in for his second term while Democrats simultaneously sweep the House and Senate, firmly giving their party the upper hand in setting the country on the path to economic prosperity in the manner they see fit, 2) President Obama is unseated by Mitt Romney with Republicans also retaining control of the House and gaining a majority in the Senate, giving them the strength to set fiscal policy according to Republican principles, or 3) the Legislative and Executive branches are divided with neither Republicans nor Democrats controlling both branches, forcing either gridlock or gritted compromise

Speculating on the likelihood of any of the three options is premature given the speed with which things can change, but considering the likely scenarios facing American investors under each of the three possible outcomes is much easier.

Let's consider the first scenario, a Democratic sweep of Congress with a second Obama term. Under this type of government we are likely to see:
- Extended unemployment benefits expire on schedule.
- Higher Medicare taxes to pay for President Obama's healthcare plan.
- Bush tax cuts extended only for some households (likely those earning less than $250,000/year).
- Top dividend and capital gains tax rates rise to 20% from 15%.
- The payroll tax cut is phased out over the next 3 years.

Under the second scenario, one in which Republicans control Congress and the White House we can expect:
- An extension of the Bush tax cuts for all Americans.
- Payroll tax cut expires on schedule.
- Extended unemployment benefits expire on schedule.

Under both scenarios the first round of spending cuts agreed to last year take effect, while the second round does not. In either scenario, the legislature will be cognizant of not cutting too much, too soon to avoid being the party that pushed the country back into recession. The true test, however, will be how the government works together in the event of scenario three, divided control, which is the most likely outcome.

Under this third scenario the risks are that to satisfy both sides (spending cuts for Republicans and increased taxes on higher income Americans for Democrats) the cliff, if not managed properly, becomes more of a reality than is likely under one party rule. Perhaps we shouldn't be so cynical. Perhaps we will be proven wrong and Republicans and Democrats will finally be able to work together to reduce the deficit at a pace that won't have a detrimental impact on the economy. Even if that is the case, further reform is still needed. Under any of these scenarios the debt-to-GDP ratio of the country would be expected to stabilize at about 80% of GDP, a level that is still far too high.

Not that we need it but let's keep this in mind as one more issue to consider before pulling the lever in November.

About the author: Michael Prus is the President and Founder of Scale Investment Group, LLC, a registered investment advisory firm based in White Lake, Michigan. Scale Investment Group is a leader in providing low-cost institutional investment services, like 401(k) and 403(b) plans, to small and mid-sized organizations and also manages money for private clients. The firm is a champion for small investors promoting low-costs and transparency of the investment advisory industry. For more information visit scaleinv.com or contact Michael directly at mprus@scaleinv.com.

 

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