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Market Commentary

Re-elected President Obama and Fiscal Cliff
November 07, 2012  David R. Kotok, Chairman and Chief Investment Officer

The almost interminable season of acrimony is over.  We have the results.  The Obama-led wing of the Democratic party will continue leading the nation in finance, economic matters, and social direction.

One hopes the nation will set aside the meanness that we have witnessed and become serious about compromise.  Issues need to be addressed, and this process starts in the lame duck session of Congress. 

The spending side debate has been beaten to death in the press and during the campaign.  Any more discussion of the Ryan plan or the Simpson-Bowles plan or other plans is likely to induce nausea. The time has arrived for action.

The catch phrase is “fiscal cliff.”  Both candidates allowed voters to draw inferences without specifics from their political vagueness and attacks on each other.  Neither was direct and honest with the voters.  Their advisers kept them from being specific, since specificity opens either candidate to distorting attacks by the other side.  Now the re-elected president must act immediately to avoid the cliff.

The cliff is summarized well on John Mauldin’s website, http://www.mauldineconomics.com.  Find the piece entitled “The Perils of the Fiscal Cliff,”  which is excerpted below.  Many thanks to John and to Jim Bianco (hat tip for reinforcing our reference to Mauldin).  Here is a link: http://www.mauldineconomics.com/frontlinethoughts/fiscal-cliff

John Mauldin wrote:

“Let me break down the major components of the Fiscal Cliff:

“1. Abolition of the Bush tax cuts, which amount to $265 billion, of which $55 billion is for the ‘wealthy’ and $210 billion for the ‘middle class’ (everyone else). Almost no one on either side of the aisle wants to actually go forward with axing the tax cuts for the middle class. Republicans want to hold on to the top-level tax cuts, and to my mind that’s a bargaining chip (see below).

2. The Budget Control Act, or the debt-ceiling deal, comes in at roughly $160 billion, with $110 billion of that in sequestration, mostly for defense; and there seems to be a growing consensus that not all of these cuts should be made.

3. The 2009 stimulus will also roll off (this is the 2% Social Security break and extended unemployment benefits). This amounts to $140 billion or almost 1% of GDP. Almost everyone agrees that these tax cuts were supposed to be temporary.

4. The ‘ObamaCare’ $24-billion tax increase on high-income households is almost sure to be allowed to go through.

5. Technically, there is $105 billion in the temporary ‘doc fix’ and Alternative Minimum Tax, which every year are supposed to expire and every year are postponed, which of course allows Congress and the president (whoever is in control) to project lower deficits in the future, even though those cuts never happen.

“If you add the $105 billion of fixes in #5 and the middle class tax cuts, you get $315 billion, or almost half of the Fiscal Cliff, which reduces the impact to 2% of GDP. Take some of the sting out of defense and you get to less than 0.5%.  But this creates a big but… What is your fiscal multiplier? It is not so simple as looking at what the IMF manufactures as a number and then extrapolating. Without trying to be cute, the US is not Greece or Spain or Germany; we are perfectly capable of creating our own unique brand of chaos. It is all debt-related to be sure, but the similarities begin to break down when you look at the gory details.

“Not all tax increases or tax cuts have the same multiplier, just as not all spending increases or spending cuts do. There is a big difference, as Gavyn Davies pointed out, between a fiscal multiplier of 0.5 and one of 1.7.”

Thank you, John, for an excellent summary.  We will soon know what the Obama multiplier actually turns out to be, as opposed to what what the campaigns say it is.  We expect that the multiplier is a lower number, so Obama’s projections and Krugman’s certainties are about to become frustrated.

Readers may note that item number 5 in John’s list is an example of why we found – and still find – both political sides disingenuous during the campaign and, regrettably, after it.  The government’s projections are now rigged by Congressionally-made rules which compromise their credibility.  We expect no change in this predilection for Congressional deception in 2013.

As for the fiscal multiplier, this is what all these projections are about.  And it, too, is an assumption, just as tax rates are an assumption when you try to project what the outcome of a tax-rate change will be.

Election night celebrations aside, the lame-duck session negotiation has already commenced.  It is influenced by the election outcome as each side tries to determine whether a deal now is better than a deal next year.  Remember, to get to next year, we need to go over the fiscal cliff or pass a temporary extension of the present system.

The Democrats maintain the majority, but neither side has locked the Senate.  Thus, the only way to avoid the 60-vote filibuster rule is to have a global agreement in the budget reconciliation bill.  This unique structure requires only a simple majority in each chamber and a president willing to sign it.  Such a deal is possible in the lame duck session if enough Republican members of Congress can be bought off with their favorite Christmas tree decorations.  But it may be easier to go over the cliff and then buy off fewer Republicans in the House in the new term.

Massive negotiations lie ahead.  The nickname for this process, attributed to Norm Ornstein, American Enterprise Institute, is “the mother of all reconciliation bills” (MARB).  Ornstein thinks it might happen after the New Year, when the US actually falls off the fiscal cliff for a temporary period.  Either way, before or after year’s end, MARB is the tool that can lead to a deal.

We believe hope of real reform is wishful thinking.  Flat taxes or simplification are not likely when the government remains divided.  So a real grand bargain is possible but likely to remain elusive.

Now let’s get to the markets.  We have maintained that markets fear uncertainty more than anything else.  Give market agents good news or bad news, and the market’s agents can figure out what to do.  Give them no news and uncertain outcomes, and they wait for more direction.  That is why the economy has struggled, and that is why the markets have experienced a sense of malaise.

All this now changes.  We know the winners and losers.  We will know who will lead each chamber and what the chambers will look like.  And we will quickly have a better guess at taxes (higher?), spending (staying high?), fiscal cliff (the threat will be worse than the actual pain?), and other outcomes (rogue nations will test Obama’s resolve in the second term?).

The greatness of America is that we tolerate this bizarre system and then move right on.  Our institutions are strong and survive changes in our government, without recourse to guns, tanks, and civil disorder.  Of the nearly 200 national jurisdictions in the world, only a few can match that tradition.  The US is a leader among those who do.

We congratulate President Obama and the new national legislature.  Now let’s move on.  There is serious work to do.

Markets will close higher at the end of 2012.  The fog is lifting.  We hope.

David R. Kotok, Chairman and Chief Investment Officer

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