Fiscal cliff fears vs. probabilities Featured

4:30pm EDT August 28, 2012
Fiscal cliff fears vs. probabilities

Who's afraid of the fiscal cliff? Apparently just about everybody! In our opinion, this topic is nearly as overplayed as last year's debt ceiling fiasco. People feared the U.S. debt ceiling would not be raised and the government would have to shut down. We disagreed, partly because we are realists and partly because of the "Laws." First, economist Herbert Stein's Law states: "If something cannot go forever, it will stop." I have morphed that into Leggett’s Law: "If something is impossible, it will not occur."

Using our Laws, we determined the U.S. would not shut down its great fiscal machinery that extracts and/or borrows money from some people so it can be given to other people. An actual "debt default" was totally out of the question, but there was still a great fear that we were headed for one.

A similar situation is taking place now, only with a broader topic, the fiscal cliff. It is certainly not impossible for a few people (as in the movie, "Thelma & Louise") or even for a segment of the population (Arctic lemmings) to go over a cliff, but intentionally driving the U.S. economy off a cliff seems, well, impossible.

The fiscal cliff is a mix of expiring tax cuts (Bush tax cuts, Alternative Minimum Tax inflation patch and the payroll tax cut) and spending cuts (the "sequestration" which chops 10 percent from defense and 8 percent from all discretionary spending; Medicare doctor payments; and extended unemployment benefits).

The nonpartisan Congressional Budget Office added fuel to the fire recently with their projection that the fiscal cliff will amount to $487B in 2013, a 3.1 percent GDP reduction. With real GDP currently creeping higher at a 2 percent pace, that reduction would result in negative GDP (a recession). That's worth fearing! But what is the probability of such an outcome?

It is very close to impossible to imagine that none of the fiscal cliff issues will be addressed, either in a lame duck post-election session, or retrospectively by the President and Congress, whoever they may be. In fact, several of the fiscal cliff issues are perennials. AMT, Medicare payments and tax increases threaten the economy year after year — much like the dreaded debt ceiling. Somehow, the cliff dive is averted each time. To quote Sherlock Holmes, "When you have eliminated the impossible, whatever remains, however improbable, must be the truth." So, however improbable it may seem that our politicians will act like grownups who care about our country's future, in the end they will (as always) be forced to act.

Does that mean we are home free? Alas, no. We believe the unrelenting barrage of negative campaign ads and the real uncertainty as to exactly which fiscal cliff issues will be avoided (and when) are a major factor in the 2012 economic slowdown. Since businesses and consumers are uncertain, they are slowing their spending and investment, which has caused a minor negative feedback loop and dropped GDP into its current 2 percent stall speed growth rate.

Nonetheless, despite the distressingly slow pace, both business and consumer spending are growing at a rate that more than offsets government spending cuts. Some key sectors such as housing and energy production are improving, but that's not enough to reaccelerate the economy. What we need is a resolution to the fiscal cliff fears. Before the election is highly unlikely, but soon thereafter looks highly probable to us.

Our plan is to step away from the fears and concentrate on the impact of the probable fiscal cliff resolution. Coupling that with a very friendly Federal Reserve (QE3 anyone?) and a more-friendly European Central Bank, we expect economic expansion into 2013. With the Market Meter at +2, we remain fully invested in client equity accounts, but with a modestly defensive tilt to our tactical asset allocation recommendations.

The opinions and information contained in this message have been derived from sources believed to be accurate and reliable, but FirstMerit Bank, N.A. makes no representation as to their timeliness or completeness. This message does not constitute individual investment, legal or tax advice. All opinions are reflective of judgments made on the original date of publication and do not constitute a guarantee of present or future financial market conditions.

Bob Leggett, CFA, is the Senior Investment Strategist at FirstMerit Wealth Management Services. Reach him at robert.leggett@firstmerit.com.