I’ve been saying that December 31 was a media deadline, not a real deadline for a fiscal cliff resolution, since Congress could act retroactively. However, I guess I underestimated the extent to which politicians dance to the media’s tune, instead of Wall Street’s or Main Street’s. Given how little turnover there was in Congress, it seemed there was little real pressure to get a deal done in the lame duck session (which ended last night) rather than in the new Congress. But, again, a deal was done – and, like most such negotiations, was done only at what the negotiators perceived to be the very last instant.
The outlines of the deal are being widely reported, so I won’t rehash them, but I will make a few observations:
- The tax increases are smaller than they would have been if we went over the cliff, but it’s still a big tax increase by historical standards…especially when the Affordable Care Act taxes are layered on.
- The spending cuts are negligible…something like $1 in spending cuts for every $40 of tax increases.
- The “fiscal drag” (reduction in the budget deficit) will be in the range of 1.25-1.5% of GDP. In an economy growing at 2% and with good momentum, it won’t cause a recession. Since the AMT (a potential big hit to consumer pocketbooks in Q2) was eliminated and the “sequester” spending cuts have been pushed out two months, the immediate impact on GDP will be very small.
- Markets are obviously happy….it’s a big “risk-on” rally globally (stocks are up, U.S. Treasuries are down today)…but the more important point is that the deal is only additive to the positive (risk-on) trend we’ve been seeing for a while…a trend based on improving economic conditions and fundamentals. While everyone was focusing on the cliff, the improving economy was the real story.
- The debt ceiling and deficit are still out there…we’re not out of the woods. The fiscal cliff was (and remains) less of a concern to me than those issues.
On to the debt ceiling…
- As you know, the U.S. has effectively hit the debt ceiling and is expected to run out of spare cash sometime around the end of February.
- Kicking the “sequesters” can down the road for 2 months plays into the debt ceiling debate…remember: the sequesters were the “punishment” Congress laid out for failure to come up with spending cuts in the last debt ceiling deal.
- Yesterday, President Obama repeated that he will not negotiate with Republicans on raising the debt ceiling. Leaving aside the obvious observations about ‘autocratic tendencies’, I don’t see how he can avoid such negotiations.
- Republicans didn’t have the high ground on the fiscal cliff…most voters want lower taxes…but they may control the ‘commanding heights’ on the debt ceiling: failure to raise it will force the federal government to cut spending.
- I wouldn’t be surprised to see President Obama remain in “campaign” mode, rather than “bipartisan” mode and immediately begin a “Harry and Louise” style pre-emptive attack on any thoughts of reforming Medicare and Social Security spending.
And the rating agencies…
- There’s a perception that the rating agencies were poised to downgrade the U.S. if it went over the fiscal cliff. It’s not that simple. Continuing to run trillion-dollar deficits is not the path to retaining the AAA rating. It’s the dysfunction in DC (of which the cliff was a symptom) and politicians’ unwillingness/inability to address the deficit that the rating agencies are (or should be) keying on. Last night’s deal should, from an analytical point of view, make a downgrade more likely/imminent, not less.
And your retirement…
- When the baby boomers retire, Social Security and Medicare could collapse (or strangle the economy).
- Unfunded public employee pension and post-retirement health care benefits are also massive (albeit smaller) time bombs.
- The longer it takes to force politicians to deal with this issue, the more severe the crisis will be. Greece remains the Ghost of Christmas Future.
My Own Thoughts on Investment Implications:
- U.S. Treasury yields are unattractive…but it’s important to remember two things:
- Don’t fight the Fed. QE 3&4 are $85 billion/month of buying power…enough to monetize roughly 100% of the 2013 deficit.
- Deficit monetization usually results in a really bad outcome…eventually…but the market can remain irrational longer than you can remain solvent (Keynes).
- Credit spreads remain wide relative to near-term default risk and equity valuations are very attractive relative to bond valuations. The economy is growing and corporate profits are holding well. The stock market will probably continue to climb the “wall of worry”…but not without volatility.
- Volatility is, by definition, ephemeral. In the short run, markets are a voting machine. In the long run, they’re a weighing machine (Buffet).
- The market is more myopic (near-sighted) than Mr. Magoo. Keep your focus on the long term.