2013: US fiscal cliff looms into the New Year, says Templeton

The US “fiscal cliff” clock is ticking loudly, and so far US politicians haven’t been able to cooperatively silence it, according to an outlook from the Templeton Global Equity group.

A sweeping roster of automatic spending cuts and tax hikes remain set to go into effect at year-end with what could be detrimental economic consequences.
In its entirety, the fiscal cliff is estimated to reduce the US Federal budget deficit by 4%-5% of gross domestic product (GDP) in FY 2013 ($670 billion), a severe tightening of fiscal policy which, if no deal is struck, would involve sweeping tax increases and mandated spending cuts across all budget items.

But Templeton said it is doubtful that the fiscal cliff will fully come to pass, as a number of the provisions within the cliff enjoy bipartisan support for extension or renewal.

The larger the fiscal drag, the worse for equities in the near term., it says. The more cyclically leveraged regions and sectors would be most impacted. Risk assets do not like uncertainty, creating selective investment opportunities for disciplined bargain hunters. And longer term, the US government must proactively address its fiscal position or rising interest rates will become a secular headwind for equity markets.

“With the Washington status quo intact after the November US elections, we doubt there have been any major, ground-breaking shifts to the key positions of the various negotiating parties.”

While Templeton remains highly skeptical of any process whose successful outcome hinges on genuine bipartisan cooperation, it says recent experiences appear to have softened political rhetoric and encouraged at least a degree of pragmatism as all sides position themselves for the negotiations.

Investors have experienced the fallout from partisan gridlock all too often in recent years. When political dysfunction derailed the debt ceiling negotiations in the summer of the 2011, the US lost its coveted AAA credit rating from Standard & Poor’s and more than $12 trillion of global equity market wealth disappeared.

The group’s report said the American public has just lived through one of the most negative election cycles in recent memory, and patience with political grandstanding has worn thin. “While we view the conciliatory headlines emanating from Washington in recent weeks with cautious optimism, we also realize that a return to business as usual would not mark the first time that policymakers have engaged in a bit of opportunism at the cue of public opinion.”

To prevent a potentially recession-inducing fiscal contraction, some compromise on revenue, spending and entitlement reforms must occur. Congress’s current “lame duck” session won’t make this process any easier; however, a grand bargain need not necessarily be struck in the waning weeks of the year.

It remains to be seen how deferral of a comprehensive deal would be taken by ratings agencies and financial markets, but given the constraints on the legislature in this transitional period, any deal that immediately reduces the impact of the fiscal cliff in 2013 may be deemed sufficient in the short term, particularly if it lays the groundwork for comprehensive reform once Congress reconvenes in 2013.

Templeton notes that on the revenue side, this means that Democrats, who would prefer to see statutory tax rates for the Wealthiest Americans revert to levels predating the prior (Bush) administration, may for the time being have to settle for raising effective rates through the closure of tax loopholes and capping or limiting of deductions.

On the entitlement side, it means that Republicans, who were pushing for $1.5 trillion of entitlement savings, may have to settle for roughly half of that, or a level of savings below the level of tax revenue raised.

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