Sizing Up the Fiscal Cliff
November 29, 2012
The fiscal cliff largely comprises expirations of Bush-era tax cuts, fiscal stimulus measures enacted during the crisis of 2009 and the introduction of spending cuts negotiated last year to raise the federal budget ceiling. Absent congressional intervention, all these measures are scheduled to take effect on Jan 2, 2013. The fiscal cliff is particularly worrisome given the strong likelihood of it leading to a recessionary scenario in the U.S.
By the Numbers: The Fiscal Cliff
The same political partisanship that drove the 2011 debt ceiling debacle also underlies our current fiscal cliffhanger. The lack of agreement on tax increases and spending reductions has been the primary reason for stalled negotiations. However, most observers anticipate a resolution—likely a temporary one that will essentially delay long-term decisions— coming after the November elections, when policy makers have had a chance to gauge the mood of the nation.
Scenario 1: 'Fall Off' the Cliff
Despite the uncertainties, we believe a number of scenarios are possible, with varying consequences for the U.S. economy. The worst of these would involve the U.S. “falling off” the fiscal cliff, even on a temporary basis. While we believe this scenario is unlikely, there are potential incentives for each party to hold out. An electoral sweep by either party could make outgoing members less interested in negotiating. Further, Democrats could let the Bush-era tax cuts expire should Republicans remain steadfastly opposed to any tax increases, in order to secure a better deal in the future.
We believe this worst-case scenario would pose a significant danger to the U.S. recovery. According to the Congressional Budget Office (CBO) estimate, the scenario would drive the U.S. back into recession, with the economy contracting by 0.5% in 2013. More painfully, progress made on the labor front would likely reverse course and unemployment could increase from already elevated levels of 7.9% to 9.1%. On the bright side, the federal budget deficit would theoretically decline from $1.13 trillion in 2012 to $642 billion in 2013, while the amount of government debt held by the public would fall to more sustainable levels over the longer term. As with all projections, there is uncertainty in the CBO’s estimates and some economists expect more downside risk in a fiscal cliff-related slowdown. In our view, there would likely be a selloff in the stock markets and movement toward the “safe haven” assets such as Treasuries amid declines in growth and inflation expectations.
Scenario 2: Temporary Extension
We believe a more likely scenario would involve Congress buying time with short-term extensions to current polices, enacted during the post-election lame-duck session later this year. This scenario is probably priced into the markets right now, as current economic projections of U.S. GDP remain at approximately 2% for the first half of 2013 when the effects of the spending cuts are expected to have the greatest impact on GDP.
Given this scenario, we would anticipate an extension of possibly three to six months on items such as the Bush tax cuts and spending reductions. However, this would merely push the uncertainty further into 2013 and policy makers would still need to find a solution to rein in the federal budget deficits. During these negotiations, we believe issues such as tax increases on upper income households and changes in the mix of the spending cuts would likely be in play. We anticipate the market would experience a temporary shortterm boost as the fiscal cliff is avoided, with uncertainty again weighing on sentiment as negotiations persist. An extension might also draw negative attention from rating agencies who have reiterated that more downgrades are likely if federal deficits are not expediently addressed.
Scenario 3: Speedy Full Solution
Aside from the two scenarios above, there remains a remote possibility that a full resolution can be achieved by year-end. For this to occur, lawmakers would likely need to have been working behind the scenes prior to Election Day in order to have a bill ready in time. Given the recent history of political polarization and, with only a few weeks to hammer out the details, we believe this scenario is unlikely.
Journey to Cliff’s Edge
Wanted: Meaningful Compromise
Beyond its recessionary impact, the “do nothing” fiscal cliff is problematic because of the crudely selected spending reductions it requires, amounting to $100 billion for 2013 alone. The cuts are the result of a hastily reached compromise between the White House and Congressional Republicans, and were supposed to be refined by a bipartisan Super Committee that ultimately failed to reach agreement. Areas such as defense and education will face draconian reductions in funding, which could have serious implications for short-term U.S. security and long-term labor productivity, respectively.
Many observers agree that the U.S. fiscal situation is unsustainable. Thus far, lawmakers have been unable to negotiate a thoughtful solution to the problem. However, we are optimistic that the government will eventually develop a credible long-term plan to address these problems—something that would support stronger economic growth. While sacrifices in the short and medium term would be necessary, clarity on regulations and taxes would allow businesses to gradually increase hiring and spending. Importantly, investors could also benefit from rising multiples as renewed confidence helps equity valuations move closer to historical norms.
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This material is provided for informational purposes only. Nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Berman’s Investment Strategy Group (ISG), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of investment professionals who consult regularly with portfolio managers and investment officers across the firm. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events may differ significantly from those presented. Any views or opinions expressed may not reflect those of the firm as a whole. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
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