“Americans can be counted on to do the right thing – after they have exhausted all other possibilities.” -Winston Churchill
Here we go again. A lot of drama is playing out in the press this holiday season. Just a month or two ago, everyone was concerned about what would happen to the stock market if a non-business-friendly president was elected. Well, the U.S. stock market did drop about six percent right after the election; however, it immediately recovered and, actually, we ended November up a half percent.
Now it’s a Rockyesque fight being called Obama vs. Boehner II (the Sequel) with a Bondesque name: The Fiscal Cliff. Sounds scary, huh? I think everyone, except James Bond maybe, has a fear of falling from a high place. But a cliff is much worse.
Regardless, it’s a complex issue for anyone and, with terms like “sequestration” being bantered around, I suspect some Americans don’t understand the argument. (By the way, sequestration relates to the automatic government spending cuts set to be implemented Jan. 1, 2013. More on these cuts in the next section below.)
One thing I do know is that the press is doing a darn good job of scaring everyone into to stuffing money back in their mattresses despite the great year we’ve had in the stock market.
Don’t get me wrong. I think there will be considerable volatility in the market over the next couple of months and that political decisions made during this debate will have an impact on the economy. However, I think this is the flavor-of-the-month issue and a distraction Americans should ignore when implementing a 5-10 year investment plan.
What is it?
Fiscal cliff is a term used to describe the parameters of the Budget Control Act of 2011 that’s set to begin Jan. 1, 2013. Essentially, in the absence of congressional action, your personal income and payroll taxes will increase sharply at the same time government spending cuts agreed upon as part of the 2011 debt-ceiling deal are going into effect.
You’re probably saying to yourself, “If taxes go up, the government will have more money yet they’ll be limited in what they can spend it on. That means a more balanced budget, which is good, right?”
Not exactly. Yes, the U.S. government spending deficit would drop by an estimated $560 billion. However, the Congressional Budget Office, which is responsible for economic forecasting, estimates that these policies would cut GDP (the amount of total goods and services in the U.S.) by more than four percent while unemployment would rise by one percent. Why? Higher taxes mean less disposable income for individuals and corporations, causing people to spend less and companies to cease hiring. Less government spending also means less stimulus in the economy.
What do we expect to happen?
The worst-case scenario is that nothing happens, causing us to go into a recession and stock market volatility to increase.
Best-case scenario is that a “grand bargain” occurs as PIMCO calls it. In this situation, the stock market and GDP are both positive in 2013.
Most likely, some sort of small deal will occur that doesn’t necessarily help or hurt GDP; markets and GDP continue on as normal.
I find it hard to believe that a deal would not happen. The president has a natural desire to strike a deal because most of the people hurt by a no-deal scenario are the non-rich (i.e., people making less than $250,000 per year). In addition, like all second-term presidents, he is concerned with his legacy.
Republicans are concerned with the next elections in two years, the frustration of their constituents with losing the election and hearing the same old story of nothing getting done in Washington.
Having said this, keep in mind that while “cliff” indicates an immediate disaster, the impact of the changes – although destructive over a full year – will be gradual at first.
How does this affect our investment strategy?
Just like the election, debt downgrade and European woes, this is a blip on the radar screen. I like to remind clients that we invest in companies, not governments, and there is no correlation between stock-market returns and government structure, tax policy or country GDP growth.
As always, we are focused on the 5-10 year strategy, not the next 1-3 years. Thus, anything could happen in the meantime. One week, it’s the election; the next week, it’s the fiscal cliff. And coming up this same quarter will be the debt-ceiling debate. It doesn’t change the fact that we invest in companies; not governments that are cheaper than their peers (“value stocks”) via mutual funds. In fact, it may raise some opportunities to add more of these value funds to our portfolio. If you have a long time horizon, this is great. If you have a shorter time horizon, you’ll have more bonds in your portfolio to cushion you from any significant drop in the stock market.
Remember also that your stock investments are scattered across 40 other countries, which means 40-50 percent of your investments are in companies outside the U.S.
How does it affect an individual tax strategy?
We don’t know exactly, but most likely, taxes will increase if you make over $250,000 per year. It may be via a change in tax brackets or limitations on deductions. The capital gains rate will probably increase to 20 percent. Dividends will go from 15 percent to ordinary income. In addition, don’t forget, if you make over $250,000 per year, you’ll pay an additional 3.8 percent on these taxes due to the Medicare surcharge on unearned income, so your net capital gains rate will be 23.8 percent, not 20 percent.
It may be advantageous to take some gains this year and perhaps even consider a Roth conversion, so speak with your advisor.
As a side note, the estate-tax exemption is scheduled to drop to $1M today (from $5M) and the top estate-tax rate will increase to 55 percent (from 35 percent). Be sure to talk to your advisor and your estate attorney about this as well.
Lane Steinberger MBA, CFA, CFP®
Partner, Chief Investment Officer