Driving Over the Fiscal Cliff

With Friday's deadline for the sequester now past, it might be time to take stock of how this whole Fiscal Cliff matter was resolved.  You'll recall, Ben Bernanke first coined this term in respect to several contractionary forces that faced the US economy at the end of 2012.  These items included the sequester, the expiration of the Bush tax cuts (including dividend and capital gains), the expiration of the payroll tax cut and the imposition of the Obama health care tax.

The months leading up to December 31st were filled with great theater, fueled by the Obama administration's fear mongering and the gravitational pull toward sensationalism by the news media.  Reports were widely circulated that the Fiscal Cliff would result in some $600 billion of combined spending reductions and tax hikes, enough to snuff out a fragile economic recovery and send unemployment soaring. JP Morgan broke out the effects of the various tax and spending items on its forecast for 2013 GDP as follows:

At year end, America breathed a collective sigh of relief as politicians reached a stumbling, bumbling eleventh hour aversion to the crisis, as the always weepy Boehner knuckled under while the triumphant Obama prevailed on his new found goal of deficit reduction through tax hikes for the wealthy.  Nothing much else happened at year end, other than the tax hikes and of course, a swift punt of the remaining issues to a later date.

Surprisingly to us, economists, politicians and pundits alike now cheer the outcome as we tipped away from the precipice.  But now, less than 90 days later and taken in the context of Friday's relatively uneventful start to the sequester, it might make sense for us to re-examine what really happened up there on that cliff.

Of the four elements to the cliff (tax hikes on the middle class, tax hikes on the wealthy, expiration of the payroll tax cut, imposition of the ObamaCare tax and the sequestration) all, with the exception of the tax hike on the middle class have now taken place.  From a total of $600 billion in projected fiscal drag, perhaps as much as a total of $400 - $450 billion of these measures are now in effect.

So, by most measures, we went over the cliff.  Albeit, from lower elevation than we had been warned, but still likely high enough to hurt.  Add to the pain, the projected $150 billion in further drag from higher gasoline prices and it looks like we're going to get a good peak at just what was beyond that cliff after all.

Don't Fight the Fed

The Federal Reserve Bank recently issued its forecast for US economic activity for 2013.  The Fed continues to walk the delicate line of reporting soft growth and weak unemployment, thereby supporting their unbridled monetary zeal, while at the same time projecting sunny skies ahead.  In the din of Wall Street trading rooms, once enlivened by ringing telephones and shouting traders, all that can now be heard amidst the clicking of keypads is the occasional mantra uttered by a young trader under his breath, "don't fight the Fed", "don't fight the Fed".

That spark of trading ingenuity, coupled with the equally insightful advice "buy the dips" has worked superbly as a trading strategy for equities over the past four years.  Gone are the days of bottoms up analytical rigor and valuations analyses.  These sorts of 'old school' things are still done, quaint as they may be, but who has the time to pay attention?  If the Fed is still pumping, then you betta be a humpin.  BTFD.

This strategy will continue to work until one day it just doesn't.  No one will know why, but it just won't.  Then, as now, investors will continue to buy the dips in an attempt to average down the cost of positions, but this time it will be in vain.  Prices will continue to edge lower.  Undeterred, the buying will continue until investors are fully invested.  Then the selling will start to escalate and the buy the dip crowd will eventually capitulate, unable to bear the ever growing red numbers on their trading screens. Welcome to the new bear market.  In hindsight, everyone will be pointing to the bubble in equities, the bubble in Treasuries and the crazy scheme of the Fed to prop up prices with QE.

Investment banks have teams of Fed watchers to prevent just this sort of thing from happening.  News media interview guests who speculate on the actions, if not every word of Ben Bernanke, only to post-script and de-brief after every Fed meeting, interview and speech.  Aside from divining direction, though, we ask the question how much insight the Fed really has and much can this organization really tell us.

If we look back on the Fed's record of market forecasts, they're questionable at best.  In early 2009 the Fed predicted that GDP for the year would decline 0.9%.  It actually declined 2.60%.  That's a margin of error of 189%.  For 2012, they forecast 2.45% growth at the beginning of the year, only for the US economy to see something on the order of 1.85%.

Over two years, their forecasts are even worse.  In early 2011, the Fed forecast a one-year GDP number of 3.65% (actual of 1.70%) and a 2012 GDP number of 3.95% (versus 1.85% actual).  Note also, that each of these egregious errors of forecasting was uniformly to the upside.  No accident there.

Add to this the fact that five years of Fed engineered zero interest rates and three trillion dollars of QE have failed to restart the economy and it has us really scratching our heads.  With a record like that, we have to ask why anyone would place confidence in such an institution.  Maybe someday.  But for now, we'll just put our heads down and murmur the mantra like everyone else.