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The US Fiscal Cliff – Fact or Fantasy?

by Mark Causer

After a seemingly endless campaign and $6 billion worth of political spending, Americans voted to re-elect President Obama, keep Congress more or less the way it’s been and continue the divided government that’s been in place for the last two years.

With Obama re-elected, investors will now turn their focus to the US ‘fiscal cliff’; the substantial tax hikes and spending cuts set to come into effect on 1 January 2013 if Washington doesn’t come up with a better plan.

Given the fragility of the US consumer, should all or most of the fiscal drag (as a result of the tax increases and spending cuts) follow in Saint Nick’s slipstream, there will be an impact on US economic growth. Any outcome that limits this fiscal drag is likely to be viewed as a positive, particularly as it relates to tax rates.

History has shown that rising marginal tax rates have exerted a negative impact on equity markets; from an investing standpoint, investors should be more concerned over rising tax rates than lower government spending in 2013. The longer-term issue is broader tax reform, as the US tax system in its current form—is arguably acting as an impediment to sustainable US economic growth1.

Fiscal pressure in its current guise, will build later this decade as the demographic shifts begin to hit pension and healthcare obligations, even though Government and Budget deficits might fall in the coming years. The challenge for the renewed Obama administration is to adjust these programs before large deficits become structural.

Divided government is likely to continue to make things difficult. Averting the cliff will require compromise between the Democrats who control the White House and the Senate, and Republicans who control the House of Representatives. However, any outcome that allows for a quicker and more definitive solution should be market-friendly.

The US economy, although doing better than Europe, is hampered by the indecision of the government on this subject. For several years now, the US Government has been unable to provide any long-term solutions to issues as far ranging as entitlement spending to the nature of the US tax system1. This has hurt financial markets, but to the extent that other countries were in worse shape. To date, the United States has benefited in a very real way from Europe’s dislocations. As Europe has faced a significant crisis, the dollar has rallied and yields have plunged1. Rightly or wrongly, investors rushed to what has been perceived as a safe haven.

In the near term, the January deadline looms. Some tough decisions need to be made and it is expected that some sort of deal will be reached. The time that it takes to reach this deal will weigh on markets. A compromise will provide some buoyancy for the US economy as it looks to long term growth to help it regain its position on the world stage. Warren Buffett has revealed his views on the fiscal cliff, stating that he expects Washington to reach an agreement. Buffett said he is relaxed and that “the fiscal cliff is having no effect on his long-term investment decisions”.

1 iShares Market Perspectives August 2012

 

December 1, 2012
 
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