A “fiscal cliff” lies just ahead but heads-up investors can turn that danger into opportunity.
In recent days, Federal Reserve President Ben Bernanke and others have sounded the alarm about the looming “fiscal cliff” they see coming in late 2012 that could have enormous economic impact for 2013 and beyond. While Dr. Bernanke has said that the Fed would be unable to offset the negative effects of this drop off, everyone seems to agree that Congress and the White House need to act to prevent a significant hit to the U.S. economy and avert a double-dip recession.
The “fiscal cliff” revolves around $500 billion worth of tax cuts and spending boosts that will expire at the end of 2012. If Congress fails to act, all bets are off. Most politicians and analysts don’t believe Congress will let it get to that point, and many hope they're right. Between now and then, we have the Congressional summer recess and a Presidential Election, which means that Congress will have to act after the Election, which will coincide with a lame-duck session of Congress.
If Congress fails to act, the absence of tax cuts plus new tax hikes could drain nearly $7 trillion from the American economy, thrusting the U.S. back into recession almost instantly, according to Maya MacGuineas, president of the Committee for a Responsible Federal Budget. Additionally, economist Mark Zandi estimates that Congress’ failure to act to resolve the fiscal cliff by the end of 2012 could lead to a GDP drop of 3% for 2013, while other estimates range as high as 4-5%. Since the economy is currently growing at less than 2%, the fiscal cliff represents the potential for significant contraction in U.S. GDP coupled with another recession.
Conversely, if the tax cuts are extended and spending cuts canceled or delayed, the $7 trillion that is added to the economy would likely lead to continued growth through 2013. But that would raise the national debt by $7 trillion, potentially hurting the U.S. economy by the end of the decade. Hence, the dilemma known as the “fiscal cliff.”
The four main issues behind the fiscal cliff are:
- Expiring Bush-era tax cuts
- An end to the 2% payroll tax holiday
- An end of the extended unemployment compensation
- Automatic spending and budget cuts enacted by the Budget Control Act if Congress does not meet the Supercommittee’s deficit reduction goals
How did the economic landscape come to this looming financial cliff?
The groundwork was first laid with the Bush tax cuts that were a series of measures enacted by Congress in 2001, 2003 and 2006. These tax cuts lowered income and investment tax rates, reduced estate taxes while increasing a number of tax breaks for low- and middle-income families. In addition, Congress also extended the temporary “patch” to the Alternative Minimum Tax (AMT) so that more than 20 million families were not hit with the AMT.
If these policies are not extended, the average tax increase for households would be $3,000, according to the Tax Policy Center. The lowest 20% of households would pay $512 more on average, while the highest-earning households would pay $12,819 more on average. Of course, if these policies are extended, the federal budget will incur more debt and, without the corresponding policies to pay for them, the extensions would cost $5.35 trillion over 10 years, according to the Congressional Budget Office.
Another factor contributing to the current economic landscape is the round of big spending cuts that will go into effect in 2013. This was part of the debt-ceiling deal that Congress struck last summer. These cuts would amount to $1 trillion over the next nine years, and would see defense spending dip by 10% and non-defense, discretionary programs by 8%.
A third factor is known as the “doc fix”, which involves reimbursements to Medicare physicians. Without an agreement, reimbursements will be cut by 30%. Due to the fact that the doc fix has been in place for years, its likely to remain in place, adding another $30 billion to the 2013 budget.
A fourth factor is the tax extenders. These temporary tax breaks for individuals and businesses enables them to deduct state sales taxes from their federal taxable income, while also allowing businesses to accelerate depreciation on equipment purchases. It's debatable whether these will be retained in 2013. Some say many of the breaks should be eliminated, while the breaks that remain should be made permanent. Extending these tax breaks will cost another $25-$35 billion.
A fifth factor is the payroll tax cut (also known as the “payroll tax holiday”). This involves the social security tax rate, which has been at 4.2% for the last two years (it used to be 6.2%). Extending the payroll tax holiday to keep rates lower will cost about $115 billion in 2013.
The sixth and final factor to the “fiscal cliff” calculations revolves around extended unemployment benefits set to expire at the end of 2012. While eliminating these benefits for the unemployed could be devastating, their extension will cost around $44 billion in 2013.
If Congress does not navigate around the fiscal cliff or takes too long to settle this dilemma, we can expect a significantly negative reaction from the U.S. stock market as another recession becomes the more likely scenario.
Strategies To Dodge The Fiscal Cliff
Should Congress fail to avert this disaster and we take a dive, savvy investors with a well thought out plan will have plenty of ways to protect their assets -- even grow them -- through any downtrend that might occur.
Options To Consider:
1. Move to the safety of cash, which is the ultimate hedge. Cash is king during times of severe market turmoil.
2. Buy put options as “portfolio insurance” on long equity positions you don’t want to sell.
3. Increased allocation in U.S. Treasury Bonds. While bonds carry their own set of risks, prices tend to rise as stocks fall during periods of economic stress.
4. One could seek profits in any stock market decline through the use of inverse exchange traded funds. Referring to the above major indexes, we find inverse ETFs that track opposite to the Dow Jones Industrial Average, Nasdaq 100 and Russell 2000. These are ProShares Short Dow 30 (NYSEARCA: DOG), ProShares Short QQQ (NYSEARCA: PSQ) and ProShares Short Russell 2000 (NYSEARCA: RWM)
5. One could short the major indexes themselves by shorting ETFs that track the major indexes. They include SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA), iShares Russell 2000 Index ETF (NYSEARCA: IWM) and PowerShares QQQ Trust (NYSEARCA: QQQ).
Bottom Line: The U.S. economy is coming to a crossroads at the end of 2012, the “fiscal cliff” created by the confluence of expiring tax cuts, spending cuts and tax increases all set to occur at approximately the same time.
While most analysts expect a political resolution to come in the nick of time, it's a high-risk game that's set to play itself out in the months to come.
Disclosure: Wall Street Sector Selector has positions in DOG, RWM, HDGE, TLT and positions can change at any time.