42 Days to the Fiscal Cliff!
On the morning of the election, U.S. stocks sported a year?to?date return of 15%. Seven trading days later that figure had shrunk to 9.7%. What’s going on?
Fiscal Cliff… what’s that?
Back in August of last year, a politically divided government which borrows more than $1 Trillion every year just to pay its bills was faced with a ceiling on its ability to borrow. The disputants side?stepped a default by passing a statute they labeled the Budget Control Act of 2011. It contains provisions to raise taxes on January 1, 2013 by an estimated 20% and to automatically cut spending on most government?sponsored activities at the same time, all in an effort to begin shrinking the annual deficit and at least move in the direction of fiscal health. The Budget Control Act adds a bit of drama to New Year’s Day 2013, and media are making the most of it! This sudden and rather radical set of changes, while perhaps a turn for the better in the nation’s long?term outlook, could plunge us “over the cliff” into another recession before we’ve recovered from the last one. Of course this has been known for over a year; did investors just start to worry about it when election results were in? Your guess is as good as anyone’s, but it may be that traders had bid up stocks, hoping for a shift in the political climate that might favor a more rational solution to the fiscal cliff. They may have been discouraged when the election results trumpeted “no change”. What now?
View from 30,000 ft.
The debt/deficit problem behind all the political theatrics is real and it is serious. But it’s been 40 years in the making; over two generations, we’ve enjoyed a culture of living beyond our means with government footing much of the bill. We won’t see that transformed in two months, or probably even in two years. There is no painless way out of the situation. It’s “Pay me now or pay me (more) later”. Creating the fiscal cliff was a desperate effort to buy time for a more reasoned solution… but nobody made good use of the time. So here we are again. If we do not begin soon to eliminate the deficits and reduce our national debt as a percentage of GDP, the problem will get worse until it ends either in a sovereign default and a high?unemployment depression, or in a chaotic era of hyperinflation. Neither end?game is bullish for business or for stocks! Can we solve the problem by “growing our way out of it”? Highly unlikely, for the simple reason that economic growth proceeds from savings and investment...not from government programs that divert money from the risk?taking, innovative, jobs?producing private sector. Not from government programs that punish saving and with 0% interest rates, currency abuse and rising taxes.
What Can “They” Do?
It’s conceivable, though barely, that the Executive and Legislative branches will agree on a plan to change the fiscal momentum without killing the golden goose. The trouble is we have elections every two years, and it’s hard to run for political office by saying to the electorate, “Please re?hire me because I want to increase the taxes you pay and reduce (fill in whatever benefit you like… green jobs, defense jobs, medical treatment, unemployment pay & retirement benefits).” Remember that old line about “a camel is a horse designed by a committee?” John Mauldin says he has a terrible feeling that we are all passengers on a ship-of?state run by not one but many committees who are all in over their heads. Perhaps the most powerful “committee” of all during this period of financial stress is the Federal Reserve. They are committed to the belief that consumption drives economic growth. To make the economy grow, they say, the government can just put money in the hands of people who will spend it and that will cause manufacturers to hire and then more people will have money, blah, blah, blah. It is the big Keynesian myth that money is money and it doesn’t matter if you earn it, borrow it or print it. Understandably, it is a very popular theory! It is a solution without cost; “a free lunch”. Right! Only problem is, it doesn’t work; and the last four years of experimenting prove that beyond doubt. We are millions of jobs shy of where we were six years ago (which includes administrations of both major parties) but we have an extra $7.5 Trillion dollars that we are obligated to service!!! Does that sound like something we can afford to keep doing? Does it sound like a good plan? We think this is what worries Mr. Market. That’s why be we believe we need a well?reasoned plan, not just to postpone the “cliff” but to move the discourse back in the direction of a free?market culture; now, that would be greeted enthusiastically in the capital markets. We are not, though, holding our breath.
What Can We Do?
The role of government and its size and cost are millennial issues of great import to all citizens, perhaps especially to savers and investors. Given the importance and the elevated uncertainty about future developments, investors and their financial advisors need to take matters into their own hands and create a realistically diversified portfolio capable of earning a return in the interim. We have already designed our client portfolios for the likelihood that global economic growth will be sub?standard for the foreseeable future, and with the expectation that the risk of serious financial disruptions will remain elevated until the debt/deficit conundrum is addressed realistically. We are confident that this will come to pass, and hopeful that the nation’s course will be changed by prudent policies rather than by crises. For some specifics on how we approach that responsibility at FAI Wealth Management, if you haven’t seen it yet, please read our September 2012 Blue Sheets on Managing Risk. We are convinced that the free?market enterprise model which has allowed American citizens to build the freest, most prosperous and harmonious society in all of history will survive the latest governmental experiments. Even now, we see opportunities to put savings to work in well?managed and innovative businesses, and we expect returns on investment to normalize when the debt / deficit difficulties have run their course, however that eventually plays out. Stay tuned! For the Investment Committee, J. Michael Martin, J.D., CFP®
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