A Special Update From Jurika, Mills & Keifer, December 3, 2012

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Cliff Notes: Fathoming the Fiscal Cliff

The “Fiscal Cliff” is a made-for-television drama worthy of the Super Bowl or a category 5 Superstorm wrapped into one: high stakes; powerful opposing forces; and a clock counting down to midnight on December 31st when, as we have been led to believe, life as we know it will come to an end. It even has a name that inspires shock and awe: Fiscal Cliff! Most people don’t know what it really means, but it certainly sounds dangerous.

With the election over, the major networks have all glommed on to this drama, creating their own theme music and graphics. CNN has yet to lower Wolf Blitzer or Anderson Cooper over the Fiscal Cliff in a HAZMAT suit to report, but it’s just a matter of time.

We have in the past referenced a contradictory phenomenon that we refer to as “The Paradox of Crisis” which simply states that in an apparent crisis, things are both better and worse than they seem at the same time. The reason for this is that in the short-term, through the thick lens of the media, events tend to get blown out of proportion, while the longer-term implications tend to get understated or overlooked completely. Drama sells. Nuance doesn’t.

The Fiscal Cliff is a perfect example of this paradox in play. The issues are serious and enduring but there is also a large amount of hyperbole and misunderstanding blustering about.

We therefore thought it would be helpful to reach out to our clients and friends to offer our own perspective on The Cliff, as well as the implications for managing portfolios.

What is the Fiscal Cliff?

The Fiscal Cliff is not from the Mayan calendar, ancient scrolls from the Temple of Doom, or a large rock formation somewhere in Arizona. Instead, the term describes a combination of four separate components of tax law and fiscal policy that either expire or go into effect at midnight on New Year’s Eve. These include:

  1. The expiration of temporary tax cuts that were adopted during the Bush era to stimulate the economy in the wake of the dot-com bust and September 11th, terrorist attack;
  2. $1.2 trillion in automatic spending cuts over the next ten years that kick in as a result Congress’ failure last year to come up with a “grand bargain” deficit reduction deal;
  3. The expiration of payroll tax cuts that temporarily reduced employee payroll taxes;
  4. The expiration of temporary unemployment benefits;

The sum total of these tax increases and cuts are estimated to range between $500 to $600 billion per year, starting next year, or between 3% and 4% of our annual Gross Domestic Product.

The largest component of the Cliff, and point of greatest political debate, is the expiration of Bush Era tax cuts, which, according to the Congressional Budget Office, represent about $280 billion in potential incremental tax revenue. If allowed to expire, marginal Federal Income tax rates would increase across the board by about 3%, except on incomes above $388,350, where they would increase by 4.6%. In addition, the tax on long-term capital gains would increase from 15% to 20% and the tax on dividend income would increase from 15% to the current income tax rate. Also, that mutant stepchild of the tax code, aka the Alternative Minimum Tax, would fail to index to inflation causing a large number of new victims to fall under its clutches. Finally, the minimum exemption for the Estate Tax would fall from $5.12 million, to $1 million.

The automatic spending cuts were designed around the cold-war era principle of mutually assured destruction – involving spending cuts to sacred programs that would be so devastating to both Democrats and Republicans that they would have no choice but to work together to avoid them.

In short, the whole thing is a big confusing mess.

But it is important to keep things in proper perspective. The problem with the Fiscal Cliff is not a matter of direction or degree, but rather timing, execution, leadership and confidence.

The larger problem remains that our economy is operating on borrowed money, spending about $1 trillion a year more than it earns in tax revenue. The solution to this larger problem is to spend less, earn more or achieve some combination of both. It is not to maintain the status quo.

At some point, the economy needs to be able to run under its own power, and return towards fiscal balance. The only way to accomplish this will be through significant spending cuts and higher tax revenues. There is no painless solution or miracle cure. The longer we go on putting off this inevitable fate, the more painful the ultimate solution will be.

But it is important how we get there. There is a big difference between falling off a cliff and walking down a gradual slope on a well-marked trail.

The Congressional Budget Office estimates that if we do go over the Cliff and stay there, it will result in a $500 to $600 billion decrease in our annual deficit along with a 3.5% reduction in our GDP next year, potentially pushing us back into a recession. They also estimate that unemployment will rise back above 9%. This would be a significant and unnecessary blow to the economy, likely offsetting all of the savings and benefits of the cliff.

Rather than fall off a cliff, it would be far better to adopt a gradual but significant set of tax increases and spending cuts, spanning several years, so that people know what to expect and can plan accordingly. A “grand bargain” of meaningful reforms of mandatory spending programs, an overhaul and simplification of the tax code, and a credible path towards fiscal balance, would do wonders to inspire confidence and stimulate renewed economic growth. The Simpson-Bowles Commission report of December 2010 outlined exactly such a plan. It contained something for everyone to hate, which meant that it was probably a very good start. It was promptly filed high up on a bookshelf somewhere in the Library of Congress to gather dust.

While the scheduled tax increases and spending cuts are painful, they are not in and of themselves, economy-killers. In fact, tax rates would revert to the same tax rates we had during the 1990s, one of the most prosperous periods for our economy, where we achieved significant economic growth and shrinking deficits.

The spending cuts are more draconian and indiscriminate, like trying to lose weight through amputation rather than diet and exercise. We can do better.

Which brings us back to leadership and confidence. Both are in short supply, and become a self-perpetuating force, holding back the economy from operating at its full potential. Expectations for Congress to achieve any kind of agreement prior to year-end are guarded and so individuals and corporations are sitting on capital rather than investing it.

We remain hopeful that away from the lens of the media, Congress and the President know what is at stake and will reach some sort of agreement to avert the Cliff either shortly before or after the year-end.

Our greatest concern is not that they will come up with an agreement, but that it will be half-baked, lacking in ambition and specifics. This may provide a short-term boost to markets, but it will do little to solve the underlying problem, restore confidence and create a solid foundation for robust new economic growth.

Portfolio Strategy:

And so we expect a fair amount of confusion and consternation in financial markets between now and year-end. There will be a daily does of sensational headlines and conflicting information.

We made a few changes in client portfolios in September to reduce overall risk exposure slightly given the strong performance in the markets in the first three quarters, and the looming uncertainty surrounding the election and fiscal cliff.

Having said that, we do not think it makes sense to make large portfolio moves around a projected outcome for the Fiscal Cliff, especially relative to our current positioning. In our experience, trying to second-guess short-term events tends to backfire. Things tend to play out differently than the majority of people expect, and the greatest risks are usually not the ones that everyone is focused on, but the ones they are ignoring. If anything, we think investors may be over-worrying about the Fiscal Cliff and underestimating the long-term strength and resilience of the economy. The unexpected risk may be that the economy bounces back faster than is currently expected.

This is why we think it is important to take a balanced approach in managing client portfolios, balancing risks against opportunities, and near-term events against long-term trends and objectives. We design and manage client portfolios to weather volatile markets, with a forward-looking and longer-term viewpoint, and with a focus on achieving long-term real capital appreciation.

However the Fiscal Cliff saga plays out, we think it makes sense to own high quality productive and real assets like stocks, commodities and real-estate, balanced with defensive and alternative investments to mitigate risk and volatility.

We will continue, of course, to monitor the situation and economic and other data, and will use major market moves to rebalance portfolios where appropriate, and to upgrade holdings if better opportunities present themselves.

Unless an investment has become fully valued, we do not think that the planned increase in the long-term capital gains rate from 15% to 20% is sufficient to warrant selling a perfectly good position and realizing a gain.

The proposed increase in tax rates on dividends is more significant. In some cases, the effective tax rate on dividend income will almost triple. This, in and of it self is not a reason to own or not own dividend paying stocks. Even at a higher tax rate, the dividend income from stocks is likely better than the fixed income from most bonds. What really matters is valuation and total return potential relative to risk, objectives and alternative opportunities.

The change does mean that dividends would be taxed at a significantly higher rate than long-term capital gains and that realized long-term gains would be a more advantageous source income than dividends. We therefore think it makes sense to tilt portfolios in favor of growth-oriented companies that are more likely to appreciate in value over companies that have high dividends but low growth prospects.

This is especially true now, after so much money has flowed into big dividend-paying companies that are perceived as safe, and out of growth-oriented and cyclical companies that are perceived as risky.

Like the election, Y2K, and a number of other sensational events, the Fiscal Cliff will come and go, and life will go on. The underlying U.S. economy is resilient and dynamic and will continue to grow, although likely at a sub-optimal pace.

Congress and the President have a unique opportunity to do something that could inspire confidence and make a real difference. We hope they capitalize on it.

In the mean time, if you have any questions about your own portfolio that you would like to discuss, please do not hesitate to call us.

On behalf of our entire team at Jurika, Mills & Keifer, we want to also take this opportunity to wish you a peaceful and Cliff-Free holiday season.

Karl O. Mills, CFA
President