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We are currently in one of the trickier investment environments of the past half-century. It's one thing to try to predict the fundamentals of companies or an industry moving forward. It's quite another to predict the arbitrary actions and compromises of a large government.

There are two major events coming up within the next 14 months that will make investment more difficult: the Fiscal Cliff and Affordable Care Act (aka "Obamacare"). These two events, coupled with a recent propensity towards large fiscal deficits, provide such a bizarre mix of economic distortions, that it's difficult to predict what precisely will happen.

As a value-based investment manager, I hate it. As a person who loves buying companies based on the fundamentals, it drives me mad. This is not a stock picker's market - at least not for the next couple of months. This is not the environment where one can simply look at good companies and say, "this looks underpriced", buy in, and then wait for it to rebound. No, we're now in a macro environment and we all just have to deal with political uncertainty for at least a few months.

This macro environment could be particularly confusing, due to a few countervailing headwinds. The problem is that two policies have the potential to be deflationary, while a third policy has the potential to be inflationary.

  1. The Fiscal Cliff. At its core, the fiscal cliff is a deflationary event. The "fiscal cliff" includes about $532 billion worth of tax increases and $136 billion in spending cuts. Since the tax increases will likely hamper investment, it will result in a destruction of jobs, and a weakening of loan demand.
  2. Obamacare. The Affordable Care Act will be largely implemented in 2014. Its affects will be difficult to anticipate. Health insurance premiums are likely to rise significantly, which is an inflationary impact. However, the bill's highly negative impact on certain industries (particularly restaurants and retail) will likely result in job destruction and create more "underemployed" individuals. Since more underemployed individuals will weaken overall loan demand, this will be deflationary. Overall, since most of the "inflation" is coming at the expense of other areas of the economy, my prediction is that Obamacare will be deflationary on the whole, but the law is complex enough to leave significant doubt in my mind on that issue.
  3. Budget Deficits. Here's where things get really tricky. If the fiscal cliff and ACA are deflationary, the Administration's propensity to run large budget deficits is very inflationary. It's true that the fiscal cliff would cancel some of the budget deficit out, but with a $1.1 trillion deficit in 2012, that would still leave a deficit of around $430 billion, or about 3% of GDP. But there's a huge caveat there, because that's assuming that the economy does not contract as a result of the above measures. In reality the budget hole is probably likely to still be over $600 billion - meaning that there will be significant money creation to offset the deflationary impact of the fiscal cliff and the ACA.

The debate in my mind is whether the combined impacts of these three economic currents will be deflationary or stagflationary. And yes, maybe I am being a bit pessimistic, but I've virtually ruled out other alternatives, such as a return to a "viable, healthy economy" - at least for the next couple of years.

Even if we end up with stagflation (as I am expecting), it's not necessarily clear-cut. For instance, we could see 1970's like stagflation, with 10% inflation being matched by high unemployment, and not particularly impressive nominal GDP growth. Then again, we could see a more subdued form of stagflation - one where we end up with 2% -3% inflation, but equally low nominal GDP growth and high unemployment. Remember, 2% inflation with 2% nominal GDP growth, and 9%+ unemployment is still stagflation. But the types of investments that will benefit in these differing stagflationary environments could differ significantly.

This is why I find the current investment environment very tricky to navigate, but I think resolution of the "fiscal cliff" (whether for good or bad) will help clear up the cloud of uncertainty, and at least tell us what sort of environment is most likely.

What is the Fiscal Cliff?

First off, let's define the fiscal cliff. The fiscal cliff is a series of tax increases and spending cuts set to take effect in 2013. Many of these measures have different sources. Some of the tax increases are coming from the expiration of the Jobs and Growth Tax Reconciliation Act of 2003, otherwise known as "the Bush tax cuts." Other tax cuts were included in the 2009 stimulus act. And then, there are some tax increases are coming from Patient Protection and Affordable Care Act, otherwise known as Obamacare.

The chart below summarizes the tax increases, as taken from the New York Times.

click to enlarge images

If you'd prefer this in pie chart form, here you go.

If you take a close glance at these threatened tax hikes, you'll notice something interesting. While the Administration's rhetoric has largely emphasized how the "wealthy should pay more", the vast majority of these tax increases fall on lower and middle income wage earners.

The chart below shows how the burden is distributed.

Notice that about 66.4% of the tax increases directly hit lower and middle income earners. This comes mostly from income tax increases, the payroll tax, as well as the elimination of the Alternative Minimum Tax "patch".

Only 9.8% of these taxes would seem to directly hit high income individuals. This would mostly come from the hikes in the capital gains and dividend taxes (a paltry 2% of the overall "cliff"), and income tax increases on higher wage earners.

The other 24.4% is more difficult to make any grand generalizations about, without digging deeper. This would include the "short-term breaks", the estate tax (6% of the cliff), and the Obamacare taxes (about 4%). At least with the estate taxes, we know that this will probably hit mostly higher earners. The New York Times believes the Obamacare taxes also hit high earners, but I'm not sure if I'd totally agree on that. The short-term breaks are likely a mix.

An educated guess then might suggest that about $400 billion of the fiscal cliff taxes will be absorbed by lower and middle income earners, constituting about 75% of the total new taxes. While the other 25%, or $132 billion might be upper income tax increases. In other words, by going "off the fiscal cliff", it would appear that the middle class would be the income group that would suffer the most.

Why is the Cliff So Important?

While many commentators have suggested that investors are making too big of a deal about the fiscal cliff, I'd argue that Investors are dramatically underestimating the potential impact of this. A recent article on the Fiscal Cliff … of 1937 highlights the similarities between our modern fiscal cliff and the tax increases instituted in 1937.

If you look at Federal fiscal data, in 1937, US Federal expenditures were 9.6% of GDP, while US Federal receipts were 6.8% of GDP. In 1938, spending increased slightly to 9.8% of GDP, while receipts increased to 8.4% of GDP. From this, we can see that spending stayed about the same, but the tax burden increased significantly - nearly 25% in one year!

The other takeaway from this data: that new money created by deficit spending equaled 2.8% of GDP in 1937, but it fell to 1.4% of GDP the next year. So while there was still a "fiscal stimulus" that was pumping more money into the economy, it was halved in one year.

The important difference to note between 2012 and 1937 is that numbers are much larger in 2012. The Federal budget deficit is around 7.5% of GDP right now. With the fiscal cliff, it would theoretically half, to around 3% - 4% of GDP. So this is similar to the "Fiscal Cliff of 1937", but we're dealing with larger numbers.

As for the results of the "1937 Fiscal Cliff": the US economy contracted 6.3% in 1938. While it would once again rebound in 1939 (with a likely boost from exports at the dawn of World War II), it's clear that the massive tax increases did have a major short-term impact on the economy.

If you're wondering how that impacted the markets, the answer is "it was pretty brutal!" In early 1937, the Dow Jones Industrial Average peaked at 194.40. By mid-1938, it had bottomed at 98.95. In other words, in about fifteen months' time, the Dow Jones lost nearly half of its value!

This is not exactly something I'd label as "not a big deal." The market did quickly rebound in late '38 and early '39, but it's difficult to figure out how much of that bounce was a reversal from market over-reaction and how much was the result of Adolf Hitler's militarism in Europe increasing demand for US exports.

The Potential for Monetary Contraction

As I've explicated in my article on How the Monetary System and Government Spending Impact Investment, since the US is a sovereign issuer of its own currency, its budget deficits are immediately monetized. This is to say, every dollar of deficit spending, results in a new dollar created.

For the past few years, the US has been running budget deficits in the range of 8% - 10% of GDP. The fiscal cliff would lower that number closer to 3% - 5% of GDP, depending on how it negatively impacts revenues and growth. Long-term, it's absolutely vital for the US government to weaken this "fiscal stimulus". Short-term, that's a very dramatic overnight drop in the rate of money growth.

My personal view is that if this drop were achieved through spending cuts, it would be more beneficial. Since government spending comes at the expense of the private sector, that means that cuts in government spending result in a re-allocation of resources back to the private sector. This shift of resources to the private sector can have a stimulative impact on the economy that could help offset that dramatic decline in the fiscal stimulus.

However, when a budget gap is closed merely through tax increases, very little is changed. While the "inflation tax" (i.e. a stealth tax imposed via the creation of new money) is weakened, it is merely offset by the increase in direct taxes. All that happens is that new money creation is substituted for direct private sector contraction.

Budget Deficits

In a recent article, I argue that signs of inflation are starting to take shape. In particular, M2 money supply figures have spiked over the past year, while there has been a rather short-term, but also very dramatic uptick in housing prices over the past six months.

It seems like nearly every single article on inflation I encounter mostly deals with the actions of the Federal Reserve, but I think the budget deficits are vastly more important when it comes to future inflation. Remember, that the actions of the Fed are still dependent upon bank lending to create new money. Conversely, Federal government deficits are immediately monetized. This is why John Maynard Keynes preferred fiscal stimulus to monetary stimulus in a balance sheet recession, but it's also why the concept of "stagflation" exists.

My view is that large budget deficits are rapidly creating new money, which is causing prices to rise faster than they would otherwise. That this would create inflation, I believe, is undeniable. That this inflation would offset weak demand from a poor economic environment, on the other hand, is far from automatic. Japan provides a stark reminder of this.

All the same, there are some major differences between the US and Japan, the most notable of which is that Japanese population growth has been near-zero for about a decade now, and the overbuilding in the Japanese Asset Bubble was much more dramatic than the overbuilding in the US Housing Bubble. In reality, we seem to be seeing housing shortages right now in the US, rather than a continuation of large excess supplies.

The budget deficits are certainly inflationary, though. Whether they offset everything else I don't know, but if we continue running budget deficits at 6%+ of GDP, I imagine that it's inevitable at some point.

The Likely Outcome

Two months ago, I would've argued that a deal was likely because the fiscal cliff was in neither major political party's best interests. Indeed, my recent articles on the possibility of stagflation have mostly been predicated upon this assumption. Today, I'm not so certain.

President Obama's recent proposal for $1.6 trillion in tax increases, with virtually no spending cuts, seems to suggest that he's not very serious about the fiscal problems. Virtually all the spending cuts proposed by the President consist of spending that was never going to happen anyway. For instance, the President insists on counting the "war savings" from not fighting a war in Afghanistan beyond 2014 as part of the spending cuts for an entire decade. Since the President's tax increases come with virtually no notable spending cuts, I'd argue that the fiscal cliff is a more desirable outcome.

In spite of the optimism publicly expressed by lawmakers recently in regards to a deal, I am extremely skeptical. The President's budget proposal suggests that he is OK with the fiscal cliff, because he'd get most of the tax increases he wanted, and most of the cuts would be in the military. Since the Democrats have been more willing to cut military spending (and less willing to deal with the entitlement programs), "the fiscal cliff" would seem to be more in line with what the Democrats want. This means that a deal is only likely if the Republicans agree to major tax increases, with few spending cuts in the entitlement programs.

For this reason, I view the odds of the fiscal cliff happening as being much higher than I did a few months ago. Whereas before I viewed it as maybe a 20% possibility, today I view it more as a 50% possibility. If there is a deal, it's likely to have a significant amount of punitive tax increases.

The Most Likely Alternative?

If we don't jump off the "fiscal cliff", I'd view the most likely deal being one that includes about $100 billion in annual tax increases, mostly coming from income tax increases on higher income individuals, with maybe $50 - $100 billion in spending cuts. This would actually not put much of a dent in the deficit, but might cut it from around 8% - 10% of GDP range down to the 6% - 8% of GDP range.

My view is that with this type of deal, we might see a small decline in GDP growth, but it would be less significant than the actual fiscal cliff. Yet, this deal would also result in more inflation.

Conclusions

Given all of the above, it's going to be difficult to predict what will happen to the markets and the economy in the next year. So much rests on the resolution of the fiscal cliff. If the US government continues to create a massive fiscal stimulus, we will likely see stagflation. If we go in the other direction with significantly higher taxes, that will weaken the fiscal stimulus, and lead to lower inflation (but also lower growth).

The fiscal cliff could result in a short-term deflationary scenario, or at least some scenario that benefits bond prices more than stock prices. But even with the fiscal cliff, there will still be a significant fiscal stimulus that could lead to higher inflation down the road. For this reason, I'd really hedge my bets in the near-term if this is the course we take.

On the other hand, if the Democrats and Republicans can agree on a compromise, I view it as likely to be rather feeble, and we will likely head more towards a full-fledged stagflation situation. This will make bonds (TLT) a poor investment, and make banks (KBE), insurers (KIE), and real estate (RWR) the most ideal investments.

For now, my strategy is merely to wait and see. I've increased my cash position significantly and have become more aggressive in hedging against market risks. It's safer to "wait and see" and miss out on a one- or two- day rally somewhere, rather than get slammed for major losses as a result of the fiscal cliff, or a tax deal that significantly changes the dynamics of the market.

I don't like it, but I don't see much of a better option in the face of such massive political uncertainty.

Source: The Fiscal Cliff: Stagflation Vs. Deflation