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As the elections grow nearer, so does the fiscal cliff – the point early next year where tax hikes, debt limits and spending cuts will presumably converge.

• The debt ceiling. There appears to be an agreement, at least among key senators and congressmen, that the issue will be addressed after the election. The Federal Reserve and the Treasury also agree that we won’t have to deal with this problem prior to the first quarter of 2013. With this provision, the matter will be debated by the newly elected congressmen and senators in place, while outgoing congressmen will not have to deal with it and take extreme positions if they want to get a new term.
• Sequestration (expected cuts in programs), for which there has never been an agreement. This would cut rather indiscriminately across different segments of the budget, and amounts to about a trillion dollars over ten years, which is a fairly small number on an annual basis. The major source of cuts is going to be defense; the rest should be on discretionary spending. Both parties are eager to address this because neither is happy with how the cuts affect their particular interests. Sequestration would be a drag on GDP but might not be, in our mind, the largest source of concern for the market.
• Bush-era tax cuts expiration.  We believe the expiration of Bush’s tax cuts would have the most potentially negative impact. This would lead to higher tax rates on all constituents, most notably on dividends and capital gains. We think it could have a profound effect on financial markets   equity markets in particular   as investors have been reallocating large portions of their equity holdings toward income-generating large cap equities. We think the increase in capital-gain taxes would hurt all those interested in buying risky assets. (more…)

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