Our thesis heading into 2013 was that greater transparency on the fiscal front would help unleash underlying cyclical momentum and spark a long-awaited reallocation of capital for both businesses and investors. The "baby grand" fiscal cliff deal passed by Congress on New Year's day was a step in that direction, in our view. The next phase, which will be centered around the debt ceiling negotiations, should include spending cuts that are needed to help solve the long-term fiscal problem and create a more "balanced" grand bargain. Bouts of market volatility are likely to come and go as the debates continue. We would view downside volatility as an opportunity to increase exposure to our top investment themes throughout equities and real assets.
FISCAL CLIFF Q&A
What does the agreement to avert the fiscal cliff look like? What are some of the highlights?
The core of the 2012 Tax Act once again extends "most" of the so-called Bush tax cuts, but not all. The 2012 Tax Act will permanently extend existing taxable income tax rates for all single taxpayers with taxable incomes below $400,000 and married couples with incomes below $450,000. The top marginal income tax rate increases to 39.6% from 35% and the top marginal dividend and capital gain tax rates rise to 20% from 15% on investments held for more than one year. Adding in the 3.8% health care tax results in an even higher effective rate. Additionally, various tax deductions and credits phase out for individuals earning more than $250,000 and couples making more than $300,000. The agreement also extends unemployment benefits for one year, delays automatic spending cuts for two months, raises the estate tax rate to 40% from 35% with a $5 million exemption, indexes the Alternative Minimum Tax (AMT), extends accelerated depreciation allowances for businesses for another year, renews the research and development (R&D) tax credit and extends the "Doc Fix" (cuts in Medicare payments to doctors).
What does all of this mean for the "fiscal drag" in 2013?
As it stands now, the fiscal drag should be about what we had expected, around 1.0% - 1.5%, with the most significant drag stemming from the expiration of the payroll tax holiday. Importantly, this federal fiscal drag should be offset by improvements in state and local government finances and accommodative monetary policy.
The automatic spending cuts were only delayed for two months. What's next in the "cliff debates"?
The election result sealed the deal on tax increases, but only spending reduction can solve the long-term problem. Studies of countries that have successfully reined in long-term deficit problems show that about $3 of spending reduction is generally required for every $1 of revenue raised. The catalyst for meaningful spending cuts (and potentially tax reform) should come from debt ceiling negotiations.
Thus, we expect the next phase in "cliff debates" to be centered around the debt ceiling in late February or March (and any concerns coming from the ratings agencies), the two-month delay in the sequestration which expires in March and heated discussions around spending cuts that are needed to create a more "balanced" grand bargain eventually. All of this needs to be resolved by March 27 when the current continuing resolution that authorizes all government spending expires.