LPL’s Jeffrey Kleintop wrote the following letter on our next few weeks and the approaching fiscal cliff. It’s longer than our normal weekly updates but worth the read.
Please take the time to review it.
The Next Few Weeks
Fiscal Cliff Approaches
Dear Valued Investor:
In the past, the month of October has given investors a scare. This year, it is the election that comes right after Halloween that could turn into a trick or a treat for investors as Washington policymakers debate the fiscal cliff.
The 2013 headwinds, often referred to as the “fiscal cliff,” comprised of both tax increases and spending cuts are due to go into effect on January 1, 2013 and total over $500 billion, or 3 – 4%, of the U.S.’s economy. While that may not sound like much, the United States has never experienced a drag of more than 2% of the economy that did not result in a sharp decline in the economy and the stock market. These tax increases and spending cuts for 2013 are already in the law and would need to be changed to be less of an economic drag. If not, a return to recession may be looming in 2013.
There is only a ghost of a chance that the fiscal cliff gets resolved before the elections. However, the so-called “lame duck” session that takes place between the November 6 elections and the end of the year holds some promise for getting a deal done.
Most polls, including the LPL Financial Research “Wall Street” Election Poll*, point to the status quo in the White House and the Senate as a high probability outcome for these elections. Although there would be no change in control, holding the White House and the Senate given the sluggish, zombie-like economy could be considered a victory for the Democrats, and to top it off, the Republican’s majority in the House may shrink. If this happens, a deal in the lame duck session to mitigate the fiscal cliff would probably be reached, but it would likely be closer to the victorious Democrat’s terms which primarily consist of higher tax rates.
Alternatively, the election is bound to be close and if the shift in momentum that began with Romney’s debate performance continues, there is the potential for a Republican sweep of the White House and Congress. If so, Washington goes from being gridlocked to unlocked and a deal in the lame duck session, or early next year, that extends the Bush tax cuts would be likely.
There is always the haunting possibility that Congress fails to craft a deal in the lame duck session and the United States goes over the fiscal cliff into the darkness of a recession. However, we find this outcome relatively unlikely as Washington has a lot of experience in kicking the can down the road to avoid short-term pain and will likely find an eventual compromise.
The more likely risk to the markets is what Congress may do in the lame duck session on the way to this eventual compromise. We only have to look at the negotiations around the debt ceiling increase in August 2011 to see how bad the process of negotiations can be for the markets. Back then, we ultimately got the eventual compromise of an increase in the debt ceiling, but not without a 13% stock market decline in a week and Standard & Poor’s lowering the U.S.’s triple-AAA credit rating.
The elections will influence the direction of the negotiations, but it may be the journey – not the destination – on the way to the deal to mitigate the fiscal cliff that has the most potential to spook the markets and contribute to volatility in the coming months. We believe a deal will be forthcoming, but only after the elections can we expect Washington to begin to attack this monster. As always, if you have questions, I encourage you to contact your advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
* To track what the market has priced in for the Democrats’ odds of retaining the White House and Senate, we have taken the Democrats index and divided it by the Republicans index. An upward sloping line suggests the market may be pricing in a rising likelihood of the Democrats retaining the White House and their majority in the Senate, while a downward sloping line suggests improving prospects for the Republicans.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.