The media is filled with stories quoting pundits about the perils of the so called 'fiscal cliff' on capital markets. The 'Fiscal Cliff' is part of the legislative agreement that Congress passed as the Budget Control Act of 2011 to aid in resolving the debt ceiling crisis. The legislation provided for a bi-partisan super committee to produce legislation by November 2011 that would reduce the deficit by $1.2 trillion over ten years; failure would automatically trigger across the board spending cuts on January 1, 2013. Under the so called 'fiscal cliff', spending cuts amount to $100 billion in 2013, while the higher taxes/revenues amount to another $500 billion as the so-called 'Bush-era tax cuts' expire along with the reversion of other taxes, such as AMT. The immediate net impact of both higher revenue and spending cuts is approximately $600 billion. Taking into account fiscal multipliers most analysis points to a decline in 2013 GDP of 0.5%. However, the cliff will reduce the fiscal deficit by almost 50% in 2013.
It is my belief that earnings multiples are a function of the long-term sustainability of economic output and the faith in capital markets, both of which hang in limbo today. In order to restore the long-term sustainability of U.S. credit markets, our country needs to correct the extreme current fiscal imbalance through a strong deficit reduction program. While I favor a strong bi-partisan deal to solve the fiscal imbalance, going over the cliff might be better for the economy over the long-run as opposed to postponing the inevitable through a watered-down agreement. I believe it is more important to protect our sovereign credit standing over the long-run rather than worry about earnings over the next year.
Consider this: Japanese equity markets have been trading at cheap valuations for the last ten years, but have found few investors willing to take on the exposure. This is because for those ten years most international investors have been betting that Japanese Government Bonds (JGBS) will decline in value given the high Debt/GDP ratio and the unsustainable budgetary and fiscal deficits. While shorting JGBs has been a losing trade, it also has discouraged investors from investing in Japanese equities. Investors have little faith in the sustainability of the Japanese credit markets given the country's extremely high debt and deficit levels. While the popular view is that Japanese corporate governance (or lack thereof) is responsible for the consistently low multiples, I believe that Japan's sovereign credibility and lack of faith in the debt market are the prime reason for the under-performance of its equity market.
Many experts also suggest that recovery in capital markets can be achieved by boosting aggregate demand through highly accommodative monetary policy. The idea here is that an accommodative monetary policy increases GDP by more than the fiscal deficit, subsequently reducing the Debt/GDP ratio. Many believe in the work by noted monetarist Irving Fischer which proved that one could increase the money supply to positively impact GDP growth. His theory postulates that the amount and speed of money spent equals the prices we pay for everything we purchase, in essence MV=GDP. Where M is Money Supply, generally considered M2, and V is Velocity of money, which is the rate at which money is spent or turned-over. The M2 measure of money supply represents money in circulation plus demand, other checkable, savings and time deposits. M2 is most commonly used to gauge economic activity and inflation. M2 is calculated as the monetary base, also called M0, multiplied by a multiplier m. While I agree that accommodative monetary policy can stabilize the system and can effectively eradicate the credit crunch, I also believe this approach has limited efficacy with regards to the improvement of GDP growth.
As you can see from Chart 1, the Federal Reserve has increased the monetary base, but since the multiplier m has fallen (Chart 2), there has not been a corresponding increase in the M2. Additionally, if the velocity of money is analyzed (Chart 3), it is observed that the velocity has so appreciably declined that the impact on economic output (GDP) has been negligible. Thus, I believe that a monetary response alone cannot significantly increase economic output and can only work in conjunction with a sound fiscal policy.
Chart 1 - Monetary Base
Chart 2 - M2 Multiplier
Chart 3 - M2 Velocity
In summary, I would prefer a strong bi-partisan deal that tackles the fiscal imbalances in a prudent way rather than going over the 'fiscal cliff'. However, in the absence of a strong, credible deal I would grudgingly favor the cliff and brace for a strong, albeit short, adverse reaction rather than muddle along for the foreseeable future.