Tuesday, 28 August 2012

Fiscal Cliff and Superman

The Cliff

What's all this Fiscal Cliff talk? The fiscal cliff is a mix of expiring tax cuts (Bush tax cuts, Alternative Minimum Tax inflation patch and the payroll tax cut) and spending cuts (the “sequestration.” which chops 10 percent from defense and 8 percent from all discretionary spending; Medicare doctor payments; and extended unemployment benefits).  All these cuts are set to expire by year end and are likely to pose a big threat if not resolved.  

Last week the Congressional Budget Office (CBO) stated that the American economy is headed for a full out recession if all tax increases and spending cuts occur.
"The deficit will shrink [by] almost $500 billion ... Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013"
Simply put, if Congress doesn't get their act together Americans should expect a loss of "2 million" jobs and a "recession".   That's right folks, a recession.  A loss of $500 billion is equivalent to 4% GDP.  Current GDP is 1.5%.  Therefore, in a 100% scenario (worst case)  we can expect GDP to be -2.5% (1.5%-4%).


I expect Congress to act similarly to last year debt ceiling crisis where republicans and democrats acted like children and after much political brinkmanship and a rating downgrade by Standards and Poor's, Congress finally came to their senses. 
Although a full blown scenario where all tax cuts and spending expire seems very unlikely.  Given Congress's track record it is also unlikely to assume they will extend all tax and spending cuts.  This leaves one to assume that half the cuts will be extended and the fiscal drag on GDP will be about 2%.

No Fiscal Cliff (not likely)
Full Fiscal Cliff (not likely)
50% of cliff (most likely)

It gets worse! ...... The clifflet

Here's the real threat. Even if the Bush tax cuts are extended and the sequester delayed, a huge amount of fiscal drag remains in place. They include the expiration of the payroll tax cut, the expiration of extended unemployment insurance benefits and an imposition of a new 3.8% Medicare investment tax on the wealthy.  The IMF reckons fiscal policy will tighten more in America next year than in Spain, Italy or Portugal. Though smaller than the full fiscal cliff, the fiscal clifflet still poses a significant headwind to the economy.

Bernanke to the Rescue!

Paying close attention to the minutes released by the Feds and reading between the lines, one can see  there's a very high probability that we see some sort of quantitative easing come Sept 12.   According to PIMCO's Bill Gross QE3 is 80% probable. 
Passages from the minutes: 

Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.
The data has been improving slightly, but nothing impressive and sustainable to withstand a large fiscal drag.  Expect the Feds to keep interest rate depressed throughout 2014 and inject liquidity through some sort of Treasury/MBS purchase program.

As a Canadian, why should you be concerned about Fiscal Cliff?
Contact us to learn how you can hedge your portfolio and profit for what's about to come.

      Herman Venegas


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