During the month of December 2012, the Fiscal Cliff was widely discussed in financial circles. The notion that the American economy could nose-dive if simultaneous tax increases and spending cuts kicked in at the end of the year was front page news. In a stunning show of brinkmanship, no deal was inked right up to the midnight deadline. In fact, we briefly went over that cliff for the first few hours of 2013. But a compromise (of sorts) was reached at 2 a.m. on January 1st, with the Senate passing the American Taxpayer Relief Act of 2012, and after some false starts, the House passed the Act at 11 p.m. that evening. This Act (bizarrely named -- we'll come to that in a moment) has two key elements: 1) taxes would rise for the wealthiest, those individuals earning over $400,000 and those families earning over $450,000; and 2) spending cuts would become the proverbial can and get kicked down the road until the end of February. The Act was 157 pages long. Those two elements were the ones having the greatest impact, but there were certainly many other aspects to it as well.
In this article, I will briefly discuss how the Sequester could impact the stock market, and equally importantly, how the politics surrounding the debate could further impact stock prices.
What Is The Sequester?
The Sequester is one of two main aspects of the Budget Control Act of 2011. This Act was passed into law by President Barrack Obama on August 2, 2011 to bring a conclusion to the 2011 debt ceiling crisis. The United States has legally imposed limits to the amount it can borrow. Those limits, if reached, could cause a default on U.S. debt obligations, having serious implications for credit ratings, costs of borrowing, federal spending and the nation's economy. The Budget Control Act of 2011 gave an immediate $400 million increase to the debt ceiling, and gave the President power to make certain additional increases beyond that number. To demonstrate sincerity in the will to keep borrowing under control, the Budget Control Act of 2011 also enacted certain other features that would force deficit reductions. Principal among these were increases to taxes and cuts in government spending that would automatically be enacted at midnight on December 31, 2012, unless otherwise amended by law. The spending cuts were called the Sequester. The intention was not to have them implement automatically, but to force both sides of the aisle to come together on a reasonable plan that could avert their implementation.
That Sequester calls for spending cuts totaling $110 billion per year, applied from 2013 to 2022, split equally ($55 billion each) between defense and non-defense discretionary spending. The implementation of such cuts represents extreme austerity, and comes at a time when the economic recovery is fragile and has been largely dependent upon government spending and stimulus measures such as quantitative easing.
Why Is The Sequester Such A Big Deal?
Full implementation of the Sequester could tip the economy back into recession, which would reduce the economic well-being of Americans. Failure to reduce spending will continue to increase deficits, weaken the value of the American currency, escalate inflation and reduce the economic well-being of Americans. Deficits need to be brought under control. But the economic recovery needs spending to continue. There is no easy solution.
How Have Politics Impacted This?
This has been and will continue to be major political football. Leading up to the Fiscal Cliff of December 31, 2012, we witnessed the most brazen and reckless game of political chicken that may have ever taken place. Neither side would budge, and each side blamed the other for any potential consequence. In the end, it was the Democrats who prevailed. They used political will to get the masses on board with the notion that the consequences of going over the Fiscal Cliff were avoidable if only the Republicans would compromise, that it would be blood on the Republicans' hands if they did not. At the last minute, actually several hours after that last minute, a settlement was reached. A settlement that called for an increased tax on the most wealthy; an increase that the Republicans said would never happen on their watch. In terms of the Sequester, the can was kicked two months down the road. A decision was deferred to give both sides of the House time to come up with an acceptable compromise.
Taking full political advantage of the situation, the Democrats named their Act "The American Tax Payers Relief Act of 2012." "American" (who else would it belong to?) to pull at the patriot heart-strings and "of 2012" so as to suggest they had actually enacted it in a timely fashion (they didn't; it was enacted in 2013).
The politics continue. The Democrats continue to play the blame game. The political tactic of saying implementation would leave blood on the hands of Republicans worked like a charm in December. Delay, and forcing a last-minute, emotionally based decision was a political coup. The Democrats got what they wanted and appeared to suffer no political loss.
The Republicans, regardless of how they may spin those events, lost the battle. Obama out-maneuvered them, plain and simple. And now, just two months later, the Democrats are employing the same tactics. Will the outcome be any different this time?
It Is Different This Time
I think this time, it is different. First, there has been a change to the debt ceiling dynamic. On January 23, 2013, the Republican-led House passed a bill suspending the debt ceiling until May 13, 2013. This is politically significant. By moving that feature out past the time of the Sequester debate, the Republicans have disarmed a significant weapon in the Democrats' emotional arsenal. The extreme and dire consequence of forcing a default on government debt and the full faith in the American currency is no longer at play at this point in time. Taking away the blame for a potentially enormous calamity is of great significance to the debate. The Democrats can still point the finger of blame if the Republicans allow the Sequester to take effect, but it puts much less blood on their hands than if the government were forced to default on their debt.
The Republicans are showing more political savvy than they did during the first Fiscal Cliff debate. Their quiet stance is allowing the Democrats to hang themselves. The Republicans have put themselves into the politically strong position to implement the tactic of "just say no." This is actually a very strong position, as it allows them to reverse the blame game and put it back on to the Democrats. The facts make it easy for the Republicans to spin that the current mess is, in fact, a Democratic Party-created mess. The Democrats enacted the Budget Control Act of 2011, which creates the cliff; it was their Act, and I expect to see the Republicans talk up that rhetoric over the next week. The onus is upon the Democrats to come up with the compromise solution, one that is tenable enough for the Republicans to pass. They were given 60 days to accomplish that task, and precious little has been done so far. They cannot take this to the brink and blame the Republicans. The ball is squarely in the Democratic court to create the solution. Brinkmanship, which worked so well for the Democrats in December, is likely to fail miserably at the end of February. So in the end, the Democrats will likely ask for more time, kicking the can down the road yet again.
How Will This Affect The Markets?
Unfortunately, I am unable to envision any outcome that is not negative for the stock market. If the Republicans do "just say no," as I think they will, the resulting spending cuts will jeopardize the recovery and weaken stock prices. If the Democrats come up with a plan that is ultimately approved, which waters down the Sequester significantly, implementing little or no cuts, it will only increase the reputation of a tax-and-spend government lacking in fiscal restraint, which will weaken stock prices. If the Democrats somehow succeed in kicking the can down the road again and get yet another deferral, this will create more uncertainty and increase the reputation of an indecisive government stuck in gridlock. And that too will weaken stock prices.
Politics are very much at issue here. The Republicans cannot be seen as weak again, nor be seen to be out-maneuvered a second time. To win back their own voters, they need to "just say no." The Democrats need to be able to point a finger of blame for having finally run out of options to defer the nation's spending problem. Rather than actually dealing with the problem over the last two years, they have played politics. The repercussions for this are likely to lower stock prices from here. Look for some significant changes resulting from next week: Democrats going from winners to losers, Republicans going from losers to winners, and stock market investors going from winners to losers.
Portfolio insurance makes sense to me here. Volatility is cheap, with the VIX having recently hit a six-month low. Insuring your portfolio against a politically-driven calamity that could occur at the end of the month makes sense here, and the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), which tracks the VIX, is a potentially effective way to acquire that insurance.
Disclosure: I am long VXX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.