Understanding the “Fiscal Cliff”
To the surprise of many investors, this year has been very rewarding, with the S&P 500 returning 13.5% (year-to-date as of August 31st). While the economy has been moving along at a sluggish pace, growing at an estimated rate of less than 2%, corporate profits, unemployment and even the housing sector have improved over levels from a year ago. Although the current economic picture isn’t great, it is certainly not pointing in the direction of doom and gloom. However, given current market conditions, investors remain pessimistic, with many citing a major roadblock ahead in what is being called the “fiscal cliff.” This Viewpoint will attempt to shed some light on the so-called fiscal cliff and offer some perspective on how one should manage investments in times of such uncertainty.
The fiscal cliff refers to a combination of federal spending cuts and increases in taxes, which are scheduled to begin in 2013 under current legislation. This includes the expiration of the Bush tax cuts, the temporary payroll tax cut and emergency unemployment benefits, as well as reduced Medicare payments to doctors and sequestered cuts to discretionary spending, which will kick in as a result of Congress not coming to an agreement last August. If Congress were to allow all of these measures to go into effect, it would result in an estimated deficit reduction of $641 billion in 2013. This would equate to taking roughly 4% of gross domestic product (GDP) out of the economy. Assuming the sluggish growth continues in 2013, these measures would likely send the U.S. economy into a recession.
With such immediate and severe consequences surrounding a single event, the fiscal cliff has become a popular topic with the financial media, who often feed on the fear and uncertainty of the markets. There is no doubt that in the months leading up to the end of the year, investment managers and market experts will claim that they have the best strategy to profit off of this significant event. When evaluating these “fool-proof” strategies, one has to wonder how these experts can know what is going to happen. Do they have inside information that gives them an edge or a crystal ball which lets them look into the future? The reality is that they are likely making an educated guess, as no one will know the outcome and its near-term impact on your investments until it actually happens.
A strategy concentrated around a single event is more akin to gambling than a sound long-term investment strategy. Instead of focusing on what is unknown, such as whether or not Congress will take action to lessen the impact of the fiscal cliff, investors will be better off focusing on what they do know, mainly that a portfolio highly diversified across asset classes will likely not experience the same level of declines as the broad market and that a disciplined rebalancing strategy will position one’s portfolio to maximize its potential once markets recover.
In the end, it is likely that Congress will address some of the issues and come to a modest agreement to reduce the burden of the fiscal cliff on the U.S. economy. The fiscal cliff would have too severe of an impact on the economy for Congress not to take action, but no one is certain which tax cuts and/or spending programs will be extended and what effect those measures will have on financial markets and the economy as a whole. The best advice one can give in times of such uncertainty is to tune out the short-term focus of the financial media and adhere to a disciplined, long-term investment strategy.