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.

Obama 2.0

With the inauguration of President Obama's second term upon us, we thought we'd take stock on the governance of his truly unorthodox administration.  First, let's define unorthodox.  Throughout the 20th Century US Presidents have been moderates, either moderately liberal in the character of Jimmy Carter and Bill Clinton or moderately conservative in the policies of George Bush senior and junior.

Barak Obama, however, most would agree breaks the mold and sets a new direction of extreme ideology for America.  Many of course support this vision, as evidenced by his solid victory last November over his moderate challenger, Mitt Romney.  Be that as it may, it would be hard to argue that Obama is a centrist or one who is seeking to lead by unifying America across political lines.  You may love him, you may hate him, but by now everyone understands him.

Obama speaks extensively about equally.  He speaks about the great and growing divide between the rich and the poor, income inequality, tax policy and his vision of fairness. Supported by uber-wealth and self-effacing Warren Buffet, he argues that America should put an end to tax breaks, low tax rates that enable Mr. Buffet to a pay lower tax rate than his secretary.  After all, let's be fair about this.

It's inarguably true that income disparity has grown in America, a subject which we've written about before.  It's also patently clear to everyone by now that President Obama is determined to rectify this problem.  The much herald fiscal cliff was resolved weeks ago with no expenditure increases and substantial tax increases - win/win you might say for the Democrats.

And so we ask, what is likely to come of all this new tax policy?  Well, as anyone who is paying attention learned quite readily from the tax returns of Mitt Romney and sifting through the rhetoric of Warren Buffet, the truly rich amass a very small fraction of their wealth through ordinary income.  Despite all the populist banner waving of Buffet, this is the reason why his effective tax rate is lower than his secretary.  It's not a mistake, it's not the unfairness of US tax policy and it's certainly not by accident.

Thus, the recent and seemingly relentless effort to raise taxes on the rich has two fundamental flaws.  First, the ultra rich grow their wealth only modestly by current income (and therefore higher tax rates have only minimal impact upon their wealth) and two, any greater tax revenue that the government derives from higher taxes does little to improve the lives of the middle class.  That is the subject perhaps of another blog, but there is zero evidence that government deploys greater tax revenue to reduce taxes on the middle class. Rather, greater tax revenue simply grows the size of government.  You see, there are actually three parties at the table, not two.  And the government has its own needs.

But if tax rates go up certainly someone must lose?  This is correct.  But it's not the ultra wealthy billionaires who have more than enough to go around.  These people by design have minimized their ordinary income (Warren Buffet, of course, included). The group who loses the most is the aspiring affluent class, the upper-middle class who has over achieved in their aspiration to become wealthy.

It is this group, more than any other who is at the greatest risk for adversity under the Obama administration. The problem with redistributing wealth through tax policy is despite all our political hand wringing and teeth mashing, America has never found a way to confiscate existing wealth.  This leaves the far left perplexed and frustrated and forced to settle for lowering the living standards (i.e. limiting inequality) not of the truly wealthy, but of those who aspire to be.