Let’s talk about the “Fiscal Cliff” and its potential investment implications.
The election season is behind us. We’re ready for Starbucks holiday cups and Jimmy Stewart. But before we pour the eggnog, we have a bigger problem to deal with.
President Obama won another term as our 44th president. With a few new players, Republicans maintained control of the House of Representatives and Democrats kept control of the Senate, leaving the door open for political gridlock. Equity markets sold off Wednesday and Thursday – perhaps due to concerns about the looming “Fiscal Cliff”, or maybe for another reason. The true driver(s) of short-term market movements are impossible to corral.
Addressing the so called “Fiscal Cliff”, a term coined by Federal Reserve Chairman Ben Bernanke, is likely to be top of mind when lawmakers return to work next week. If they can’t find common ground before the year-end, the federal government will automatically cut spending and increase taxes. Ordinary income, capital gain, estate and payroll taxes would increase. Tax credits and itemized deductions would be reduced.
The Tax Policy Center estimates that households earning between $100,000 and $200,000 would pay, on average, an extra $6,400 in federal taxes. Those earning between $500,000 and $1,000,000 would pay on average an additional $34,600 per year.
There is no question that reducing consumer spending power and cutting defense contracts would be a set back to the economy. A weaker business climate would exacerbate the big problem facing the U.S. and other developed world economies: the increasing level of government debt.
But would it impact equity markets?
While everyone likes lower taxes, tax rates are not directly correlated with market returns. Let’s remember that the S&P 500 returned 18.2% compound annual return in the 1990s even though higher tax rates were in place. And the tax cuts that began in 2001 did not result in positive market returns; the S&P 500 is currently below where it was at the turn of the century. We see that financial markets rapidly disseminate information into prices. The possibility of higher taxes, reduced government spending and a 2013 recession have been widely discussed during 2012 – and yet equities have, so far, posted double digit gains in nearly every asset class this year.
We don’t know how this situation will play out. We hope that our politicians can work together and make compromises to tackle the big issues. There is no certainty. But either way, people around the world will need food, shelter and goods. They will want products and services. They will long for better lives ahead and demand innovations. Companies provide these things.
The investment thesis behind employing a diversified portfolio of stocks and bonds isn’t dependent on an undivided and harmonious Congress. You own stocks because the private sector has demonstrated an ability to earn positive return on capital, irrespective of the economic challenges du jour. Obstacles to economic progress come and go. This problem will be solved. Others will surface. The only certainty is always uncertainty.
We expect to see increased volatility in equity markets as lawmakers work toward a solution. But we don’t see it as motivation to alter your investment strategy – a strategy that is designed to provide a lifetime of financial wellbeing. Please don’t hesitate to call us if you have any questions.