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The much dreaded fiscal cliff is on the verge of being set off by specific tax increases and spending cuts that will be implemented in the beginning of 2013. The programmed cuts and hikes are estimated to reduce the federal budget deficit by about 4% of GDP in fiscal year 2013. Because the fiscal year ends in October, and since most of the provisions of the fiscal cliff will kick in by January, the full calendar year impact will be greater; it is calculated to be 5% of GDP, according to estimates provided by the Congressional Budget Office (CBO).

It should be noted that a number of provisions have bi-partisan support for extensions and revisions, which makes it unlikely that the economy will bear the entire brunt of the fiscal cliff. If, however, the government fails to reach any compromise on the provisions, the fiscal cliff could well be recession inducing. The latest estimates provided by the CBO state that if the $560 billion mix of spending cuts and tax hikes are fully implemented, the economy could shrink by 0.5% in 2013.

One of the tools used to increase federal revenue is the expiration of the Bush-Tax cuts in 2013, which amount to $294 million or, roughly, 2% of GDP. Credit Suisse (NYSE:CS) estimates that hikes in federal income taxes for middle income earners are unlikely, which in turn takes out nearly 30% of the cliff. Tax increases are likely for the upper income bracket, which accounts for $75 billion or 0.5% of GDP.

Although the American economy is expanding, the recovery is only tepid, which makes the patent cliff particularly dangerous. Tax increases and reduced government spending will dampen aggregate demand in the economy which only put a drag on the existing state of affairs. Consumers will cut back on spending and businesses will be forced to take measures to reduce costs. A logical impact of this is a further pressure on the economy, as it struggles to find momentum.

Impact

Bloomberg estimates show a growth rate of 2% for the economy in 2013. If the government fails to reach a decision by early 2013, growth could fall to 1% for the first half of the year. Bloomberg also notes that the impending cliff is already drubbing the economy, with consumers starting to save to smooth out their future consumption, and businesses halting their planned investments and hiring processes. The Fed, on the other hand, will not have the strength to counter the full impact of the cliff. The uncertainty around the political process is making businesses nervous, and they are postponing many of their plans.

In a worst-case scenario, Citi estimates that the market could fall by 20%. However, as highlighted above, a situation where the government fails to reach a compromise on the provisions is highly unlikely. However, a contracting economy in the U.S. would depreciate the dollar in the international market, and the Fed would look to keep interest rates at their lows.

Healthcare spending on Medicare is scheduled to reduce by $11 billion. This is only part of the total spending cuts expected. For example, expiration of emergency unemployment benefits amount to $26 billion and items classified as other revenue increases/spending reductions amount to $105 billion. The Healthcare sector will be impacted from the reduced spending if Congress fails to moderate the impact of the cliff. The healthcare ETF (NYSEARCA:XLV) could be negatively impacted. The ETF has a YTD return of 17.44%. Also, if the economy does go off the cliff, investing in the PowerShares DB US Dollar Index Bearish Fund (NYSEARCA:UDN) could prove to be a prudent strategy. The ETF is designed to replicate being short the U.S. dollar against a basket of currencies. UDN has yielded a return of 1.19%.

To conclude, we believe that although the failure of Congress to address the pressing issue of the fiscal cliff could be very damaging to the economy, the worst-case scenario is unlikely, and the government will reach a consensus that will mitigate the impact of the programmed set of rules by smoothing them out over the years. Still, the uncertainty surrounding the situation has created some drag in the economy, which could continue into 2013, and investors need to be on the look-out for the sectors that will benefit and lose from the proposed changes.

Source: Fiscal Cliff Solution Will Be Reached