This Fiscal Cliff Might Be Steeper Than You Think

by: John P. Cogswell

What is the fiscal cliff?

Unless the government acts quickly, it is probable that the term "fiscal cliff" will become a household phrase over the next few months. Unfortunately, this is reminiscent of the budget ceiling crisis about a year ago. In this report we will explain what the cliff is, discuss the worst case scenario, and determine what, if anything, you should do about it.

Fiscal cliff is a term that describes the combination of tax increases and spending cuts that are automatically set to take effect at the end of this year. The likely impact of this combination of actions will be to reduce the budget deficit by $604 billion over the next year. Although reducing a budget deficit might intuitively sound like a positive event, there is a good argument that if the measures are too extreme, it could hurt our already lackluster economy.

As a preface, let's take a step back and dissect the size of our economy relative to total debt and spending deficit. The purpose of this exercise is to bring some clarity to the mind-bogglingly large numbers often cited by the financial media when discussing economics. Thinking in terms of billions and trillions is not something most do on a daily basis. For simplicity, we will use percentages where we can and do a little bit of rounding with the large numbers. This should make the details easier to grasp and remember.

The generally accepted method of valuing an economy is GDP (Gross Domestic Product). GDP is the value of all final goods and services produced in a country. Some think of it as the income of a country.

US GDP is about $16 trillion a year. The components of GDP are consumption (71.2%), government spending (19.5%), investment ex-housing (10.9%), housing (2.3%), and exports which reduce GDP by about 4%. The 20 year average growth rate of GDP, after inflation, is 2.6%.

Regarding the budget for 2012, the Congressional Budget Office (CBO) assumes total spending will be about $3.6 trillion dollars. However, revenues (taxes) will only be about $2.5 trillion. This $1.1 trillion is a shortfall of about 32% of total spending.

Our total debt, which is a culmination of past budget deficits, is about $15.5 trillion and is very close to 100% of the size of our economy as measured by GDP. Below is a chart (Chart 1) from the Federal Reserve showing how much our public debt has grown over time. Please note the obvious increase in steepness since the early 2000s.

Source: Federal Reserve Bank of St. Louis

It is true that, as our debt has grown, so has the economy (GDP). Unfortunately, the rate of growth has not been the same. As evidence, please see Chart 2 below from the Fed, which depicts debt as a percentage of GDP. The debt has clearly grown at a higher rate than GDP.

Source: Federal Reserve Bank of St. Louis

The details of the estimated $607 billion deficit reduction (fiscal cliff) are:

  • 36% ($218 billion) - Tax cuts and AMT "patch" (Bush tax cuts). See chart below.
  • 28% ($170 billion) - Other changes and expiring provisions.
  • 16% ($97 billion) - Payroll tax cuts.
  • 11% ($67 billion) - Budget Control Act (automatic "supercommitte"cuts).
  • 0.4% ($24 billion) - Unemployment benefits expiration.
  • 0.3% ($18 billion) - Affordable Care Act (aka Obamacare).
  • 0.2% ($12 billion) - Medicare "Doc Fix". The rates Medicare pay doctors will decrease by as much as 30%.

Source: JP Morgan Guide to Markets 2012 Q2

The other less discussed component of the fiscal cliff is the debt ceiling. Technically, the debt ceiling is not a direct part of the fiscal cliff. However, combine this potential issue with the possible tax/spending changes and it's the perfect storm for markets across the globe.

Currently the debt ceiling is set at $16.394 trillion. The CBO projects this level could be reached by early 2013. If the Government is unable to reach a compromise, this will most likely have the same type of negative impact on the market as it did in August 2011. For those of you who do not remember, this was not a pleasant environment for many investors. For more details on the 2011 budget ceiling crisis, visit our website under the Resource tab to view our reports and interviews from July and August of last year.

The Impact

Now that we have explained what the fiscal cliff is, let's evaluate what kind of impact it could have on economies and markets throughout the world. To be very clear, we are concerned that many people do not understand exactly how steep the fiscal cliff could be under a worst case scenario.

Simply reducing GDP ($16 trillion) by the combination of estimated tax increases and spending cuts ($607 billion) is not the optimal way to do this scenario analysis. However, it is a pretty good start. The reason a simple approach is not perfect is because of the interconnection between the different variables involved. For example, if higher tax rates lead to higher unemployment it is likely GDP will be lower than it would have been otherwise. Therefore, GDP could be reduced by more than 3.8% (607/1600). In any case, if the average GDP growth rate is around 2.5% a year, it is easy to see how this fast approaching cliff can lead to recession.

We are not alone in our concern of a recession. The CBO, a bi-partisan group, has estimated negative GDP growth should our Government drive us right off the cliff. In fact, from our vantage point, both Republicans and Democrats have roughly the same opinion on the negative impact this could have on our economy. The difference is in the fix. As always, the Right seems more focused on cutting spending while the Left is primarily concerned with raising taxes. Assuming these deep routed philosophical differences are unlikely to change any time soon, we will have to keep our fingers crossed for some sort of compromise. Ideally, the compromise will not come at the last minute.

So What?

This "So What?" section of our monthly reports is probably the most important to our readers. In the past we have overloaded readers with economic data, valuation metrics and scenario analysis without really explaining what it means to them. So let's discuss what we think will happen and what investors should do about it.

We are never so arrogant or foolish enough to believe that we, or anyone else, can predict the future. However, at its core, portfolio management is about assigning probabilities to future events and allocating assets accordingly.

Our base case scenario is that a compromise will be reached sometime between September and early 2013. Obviously, the sooner the better but the most likely scenario will be at the tail end of the year. Specifically, we think:

  • The tax cuts will be extended but may not apply to families with higher income levels.
  • Spending cuts will probably be a mixed bag and will add to the upcoming presidential debates; particularly regarding defense spending because about 50% of the scheduled cuts are supposed to come from the defense budget.
  • The payroll tax cut will probably expire as both sides of the aisle seem to agree it is not necessary.
  • The tax embedded within The Affordable Care Act (Obamacare) is likely to stay unless there is a major turnover in both the White House and the Senate. Aside from the immediate cliff, we do fear this overhaul of the health care system could have more of a negative impact on unemployment and the economy than many people realize.

We believe that as we approach November, the frequency with which the press discusses the fiscal cliff will increase. This will no doubt lead to higher stress and volatility levels. As usual, most of this potential volatility will be unwarranted and emotional. On the other hand, some volatility will be justified. For example, given the elevated probability of a higher capital gains tax rate next year, it would be irresponsible not to consider realizing some gains sooner rather than later. If enough investors act in a similar manner, it could have substantial short term negative implications for certain assets. In other words, risk assets like stocks could go down quite a bit. This is why we hope for a solution sooner rather than later.

Our general advice, which is always the case, is to make sure you are truly diversified (not just stocks and bonds), make sure you are invested according to your current risk tolerance (ability and willingness), and do not hold back information from your advisor about relevant changes in your life. Over the years we have had the opportunity to work with many clients. One of the lessons we have learned along the way is that just as it is obviously not a good idea to withhold information from your doctor, it is not a good strategy to withhold information from your financial advisor.

Our specific advice given the short term uncertainty is to not wait until the end of the year to take relatively large distributions from investment accounts. In general, markets are up for the year so if you need money we advise getting it out of riskier assets before the last minute. In other words, do not behave like the Government with your own personal finances.

What do we mean by "riskier assets"? Our view of what is a risky asset in the context of a portfolio can be explained by the RAD Ratio™, our proprietary risk metric. The objective of the RAD Ratio™ is to eliminate the traditional method of classifying or analyzing a portfolio based on a percentage of stocks to bonds. In our view, this classification method is outdated and no longer applicable in current markets. To a large extent we are agnostic as to whether a particular security is a stock, bond or an alternative. To us, the important starting point for analysis and portfolio construction is not what a security is named, but rather whether that security adds risk, decreases risk, adds diversification, decreases diversification, or protects the portfolio in times of volatility.

The RAD Ratio™ labels each asset as a "Risk Asset," "Diversification Asset" or a "Protection Asset." We view Risk Assets as investments with volatility characteristics similar to equities. For example, we classify equities, commodities, REITs, and high yield bonds as Risk Assets, because they each have similar historical volatility levels and/or have behaved similarly in markets with high volatility. Diversification Assets within the RAD Ratio™ are investments that reduce the risk of the overall portfolio because of correlations and volatility levels. Examples of Diversification Assets are high grade fixed income, broad currency exposure, hedge fund beta replication strategies and government securities, to name a few. Finally, Protection Assets are investment strategies that aim to preserve capital and in most portfolios these assets are displayed through cash and put options. These are low to zero volatility or low to zero correlation investments with a primary goal of preserving capital.

Please understand that this is not a recommendation for long term investors to "time the market" and move into money markets, etc. We are simply suggesting that it would be prudent to take advantage of the profits we have experienced so far this year, and take some money off the table if you know you are going to need it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This report contains the opinions and views of John Cogswell and Josh Pierce. While John Cogswell and Josh Pierce are employees of Baystate Wealth Management, the views and opinions expressed herein are their own, and do not necessarily represent the views and opinions of any other employee or representative of Baystate Wealth Management. This report is not intended to provide investment advice and no one should rely on the views and opinions expressed herein in making investment decisions. All recipients and readers of this Report must consult with and rely on their own investment professionals in making investment decisions or when buying or selling securities of any type. Standard & Poor’s 500® consists of 500 US stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value. The MSCI EAFE Index® is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indices, representing the developed markets outside of North America: Europe, Australasia and the Far East. The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 90% of the U.S. market. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 8% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Index represents approximately 27% of the total market capitalization of the Russell 1000 companies. The STOXX Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom. You cannot invest directly in an index.All performance figures per Morningstar Direct™Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Baystate Wealth Management), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the contBaystate Wealth Management is a Registered Investment Advisor located at 200 Clarendon St, 19th Floor, BOSTON, MA-02116. Submission Number: 688145