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Market Commentary

Fiscal Cliff or Slippery Slope?
November 19, 2012  David R. Kotok, Chairman and Chief Investment Officer

When it comes to US fiscal policy, are we faced with a cliff, or a slippery slope?  There is a difference between off-the-cliff Greece, the slippery-sloped European periphery, and the not-there-yet US.

We shall see if Alexis de Tocqueville may be right in his quote, "A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury."

George Santayana was certainly right in his quote, “Those who cannot remember their past are condemned to repeat it."

Fiscal cliffs are not unique to the US. However, there is a big difference between the European confrontation and the US confrontation. In Europe, the political forces have to deal with the results of failing to address budget gaps. They now confront debt in excess.  In many of those countries the debt-to-GDP ratio exceeds 100%.  Italy is the worst case among large economies; it is the third largest debtor in the world.

In Europe government budgets continue to swell. In France, the Economist reports, government has swelled to 57% of GDP.  This kills investment.  The CAC Index hasn’t had a new addition in a very long time.  The top income tax rate of 75% is driving wealth out of the country.

I will stop about Europe, since their rolling disaster is so well-known.

In the US, the Congress and the President are trying to negotiate a deal to avoid a European-style outcome. Our debt-to-GDP ratio is low enough (about 70% in publicly held debt) and our economy is strong enough (slow growth is not the same as shrinking) to permit that from happening. But to avoid disaster will require prompt, no-nonsense action.

In the US, it is possible to deal with our deficit problem prospectively. We have already done that once with the entitlement system, by recalculating Social Security payments over a longer time span and extending the retirement age.  We have the capacity to do it again with regard to post-retirement benefits and with additional changes in long-term entitlements. We also have demographics that have not deteriorated to the extent of Europe’s or Japan’s. If we wait long enough, however, we will descend to the same state of no return.

If we are smart enough to change our immigration laws and permit younger, entrepreneurial, enthusiastic people to enter our country legally, we will change our demographics for the better. The demographics would then favor robust growth for an extended period and provide adequate funding for our future entitlements and post-retirement benefits.  Is the US Congress smart enough to make that change?  I wonder – the indications are uncertain at best. We still elect too many idiots to the national legislative body.

By the way, those who accuse me of being either a Democrat or a Republican, depending on what I write, are quite wrong. I am neither. I believe both our political parties remain corrupted by money and ambitious politicians who are driven by short-term, election-driven agendas. Until our country is so disgusted with both of these parties that it is ready to demand material change, we will continue to get the shoddy government we asked for.

Let us get back to the difference between the US and Europe. European peripheral countries waited too long.  Now they cannot fund the promises that they made for retirement and post-retirement benefits, and so they have to impose austerity budgets. Those budgets strip away promises that were made. That is what drives people into the streets and increasingly threatens the political regimes of Europe.

European political leaders realize they have run out of rope. Especially in Greece, where the turmoil has been greatest, governmental leaders realize they must either severely alter the form of their government through austerity measures or see their society collapse into anarchy and chaos.

When governments impose austerity, they need police power to maintain civil order. In some sections of European cities, the police presence has been withdrawn or reduced and there is turmoil and deterioration of safety for the citizens. Other European countries are experiencing a migration of wealth. Citizens are not dumb; they vote with their feet if they are able to do it.

In the US, we see increasing divisions among the states. States that impose increasing levels of taxation continue to lose wealth to states that invite wealth and entrepreneurial spirit.  A good case in point is California, which has now imposed a higher level of taxation in order to preserve the payment streams from its pension system.  That system is bankrupting California cities, due to the overly generous pension policies they have put in place.
Here’s an example reported by Reuters: 

“In bankrupt San Bernardino, a third of the city's 210,000 people live below the poverty line, making it the poorest city of its size in California. But a police lieutenant can retire in his 50s and take home $230,000 in one-time payouts on his last day, before settling in with a guaranteed $128,000-a-year pension. Forty-six retired city employees receive over $100,000 a year in pensions.  Almost 75 percent of the city's general fund is now spent solely on the police and fire departments, according to Reuter’s analysis of city bankruptcy documents - most of that on wages and pension costs.”  Hat tip to my colleague, Michael Comes, for sending me the report.

Until California changes its behavior, it will lose wealth and income to other states.  We see this in comparisons among states around the country.

Now the US federal system is in the throes of a great debate as to whether it can remain a functional democracy and act prospectively.  Will it do so, rather than being forced to act retrospectively?  Consider this:  Barron’s reports that New Jersey’s median income for a household of four people (two kids) is $102,000.  That household will see a $6900 tax increase if we fall over the fiscal cliff and stay there.  Mississippi’s median income for the same-sized household is $58,000.  That household will get a $3100 tax hike.  I think you get my point about the cliff.

With regard to market impact of the fiscal cliff, one of the best summaries we’ve seen is from Strategas. We excerpt:

“Negative economic growth is typically associated with a drop in the S&P 500 of -30%.  Perhaps the Fed can help cushion this blow, and perhaps a “QE4” could boost the market +10% (QE1 saw the market rise +80%, QE2 was +33%, Operation Twist & LTRO were +29%, and QE3 was +15%, i.e., diminishing returns).  So, even if QE4 helps mitigate, say, +10% points of the -30% equity decline, that’s still a -20% decline, based on history.  It would be much better for fiscal policy makers to simply remove the cliff.”  Source: Strategas Weekly Economics Summary, November 18, 2012.

Let me repeat their final sentence for the congressional members who read this and for their staff. 

It would be much better for fiscal policy makers to simply remove the cliff.”

We think the Obama, Reid, McConnell, Boehner, and Pelosi nexus may have begun to understand this. The election is over. We shall soon see whether we have adults in Washington.  Both sides now lose if they do not reach an agreement.  My colleague Bob Eisenbeis and I discussed this on Bloomberg TV on Friday.  See www.Bloomberg.com for the clip or go to www.cumber.com .

We wish readers a Happy Thanksgiving. This is a uniquely American celebration. Perhaps its traditions can inspire our politicians to seek compromise for the good of the nation.

David R. Kotok, Chairman and Chief Investment Officer

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