Ian Nar­ine

Thurs­day, Jan­u­ary 3, in the year 2013. Are you alive? Check again to make sure. Seems the world got past De­cem­ber 21, 2012, in­tact, but what about De­cem­ber 31?

If you are a mul­ti-mil­lion­aire liv­ing in the Unit­ed States and you man­aged to live past De­cem­ber 31, then that act of in­dis­cre­tion could cost your heirs a tidy sum. En­ter the US fis­cal cliff, as it is com­mon­ly called, and all the per­mu­ta­tions and com­bi­na­tions as­so­ci­at­ed with the event.

As we en­ter 2013, tax cuts in the US en­act­ed in ear­li­er years ex­pire and with­out any ad­just­ments, tax­es will rise. In ad­di­tion, a num­ber of spend­ing cuts pro­posed in 2011 will now come in­to ef­fect. The com­bined ef­fect of high­er tax­es and re­duced spend­ing seems, on the face of it, a good thing as it can, in the­o­ry, re­duce the US bud­get deficit, which has been run­ning at more than US$1 tril­lion per year for the past four years.

The is­sue is the ef­fect on the econ­o­my as high­er tax­es means less dis­pos­able in­come for con­sumers, and spend­ing cuts on the part of gov­ern­ment re­duces a sig­nif­i­cant eco­nom­ic buffer that has be­come more im­por­tant fol­low­ing the fi­nan­cial cri­sis in the US.

To il­lus­trate the point, if the changes are al­lowed to come in­to ef­fect un­al­tered, es­tate tax­es, which are paid when the wealth of a de­ceased per­son is dis­trib­uted, will rise sig­nif­i­cant­ly. The fi­nan­cial news ser­vice CN­BC re­port­ed that if a per­son died on De­cem­ber 31, leav­ing an es­tate of US$3 mil­lion, that num­ber would de­crease to US$1.9 mil­lion if the per­son died in Jan­u­ary.

Would you choose US$1.1 mil­lion in tax sav­ings or a few ex­tra days with your loved one? You may scoff at the idea, but there is suf­fi­cient ev­i­dence to sug­gest that tax rates and fis­cal in­cen­tives ac­tu­al­ly skew the tim­ing of es­tab­lished death and birth pat­terns in dif­fer­ent parts of the world.

Much ado

So that we are clear the fis­cal cliff is some­thing of a mis­nomer. This ar­ti­cle was writ­ten be­fore the end of 2012. I am pret­ty cer­tain the US is still a nor­mal func­tion­ing econ­o­my at the time you are read­ing this. The tax is­sues and bud­get cuts are ex­pect­ed to im­pact the econ­o­my over time.

Most econ­o­mists es­ti­mate that if all changes come in­to ef­fect, it will have a drag on US gross do­mes­tic prod­uct (GDP) of around 3.5 per cent. For an econ­o­my that has been grow­ing at less than three per cent com­ing out of the fi­nan­cial cri­sis of 2007/2008, that sug­gests a tip back in­to re­ces­sion. A mild re­ces­sion is cer­tain­ly not the end of the world.

The fi­nan­cial mar­kets have been able to look past the me­dia hype and so with one trad­ing day to go at the time of writ­ing, the US stock mar­ket is flat for De­cem­ber. That clear­ly is not a sign of pan­ic. At this point, it is worth not­ing while in­vestors have con­tin­ued to run scared by one head­line af­ter an­oth­er, those that stayed the course should be count­ing some hand­some re­turns over the past year. The Dow Jones In­dus­tri­al Av­er­age was up around 6.5 per cent for the year and the S&P 500 al­most dou­bled that to post over 12 per cent gains year on year.

Af­ter more than four years in the post-cri­sis era, in­vestors should by now come to ap­pre­ci­ate their in­vest­ment de­ci­sions should not be based on the head­lines of the day, but rather the fi­nan­cial ob­jec­tives they a seek­ing to ac­com­plish and be guid­ed ac­cord­ing­ly.

If the US econ­o­my falls in­to re­ces­sion again, then one can ar­gue that the debts of the US gov­ern­ment can be seen as more risky. That should cause bond yields to rise. How­ev­er, once again, the mar­ket re­ac­tion has been mut­ed. At the be­gin­ning of 2012, the yield on ten-year US trea­suries was 1.89 per cent. As at Fri­day, the yield was 1.74 per cent, this means that in­vestors are de­mand­ing less of a re­turn to­day than at the start of 2012.

Se­ri­ous chal­lenges

Look­ing in­to 2013 the is­sue is less about the "fis­cal cliff" and more about un­der­stand­ing there are still se­ri­ous chal­lenges that need to be ad­dressed. First up, the US has once again hit its debt ceil­ing on De­cem­ber 31, so this adds more noise to the equa­tion. Re­mem­ber the dra­ma of Au­gust 2011 and the im­pact on the fi­nan­cial mar­kets. The re­al num­ber here is that in 16 months the US na­tion­al debt has in­creased by US$2.1 tril­lion. This is, of course, an un­sus­tain­able path. As a side, not to be out­done, Japan­ese debt is ex­pect­ed to sur­pass US$1 quadrillion yen by the end of the first quar­ter of 2013.

In­creas­ing tax­es and re­duc­ing ex­pen­di­ture is one way of re­duc­ing these tril­lion dol­lar deficits, but this will have a re­al im­pact on re­al peo­ple and here­in lies the po­lit­i­cal cost of any ac­tion tak­en. What lies ahead is a re­al co­nun­drum.

Dur­ing the past four years, US un­em­ploy­ment was ap­proach­ing dou­ble dig­its. That amount of slack in the labour mar­ket meant that wage growth for those em­ployed was al­so chal­lenged. Imag­ine an in­crease in tax­es in such an en­vi­ron­ment. More than that, the busi­ness en­vi­ron­ment has changed in a post-fi­nan­cial cri­sis world. In the face of tepid top line growth, cor­po­ra­tions have man­aged to re­duce costs through sub­stan­tial labour re­duc­tions. This re­dis­tri­b­u­tion from labour to cap­i­tal is go­ing to man­i­fest it­self in a trend of ris­ing in­equal­i­ty.

The dis­cus­sion about in­come equal­i­ty of­ten grabs the head­lines, but there is an­oth­er is­sue of debt in­equal­i­ty. With the de­cline in re­al wages, high­er un­em­ploy­ment and re­duc­tion in ben­e­fits, many try to sus­tain their lifestyle through bor­row­ing. Es­sen­tial­ly, the wealthy are lend­ing to those with in­come deficits con­tin­u­ing the cy­cle that lead to pre­vi­ous fi­nan­cial col­lapse.

At the na­tion­al lev­el, there is an ur­gent need for the US to in­crease rev­enues and in­creased tax­es, at least in the short term, may do just that. Cur­rent­ly, rev­enues in the US are at 16 per cent of GDP, which is the low­est lev­el in 60 years. Now con­sid­er the grow­ing lev­els of en­ti­tle­ments in the US and the ag­ing pop­u­la­tion and once again the chal­lenges are ap­par­ent.

At the end of the day, the temp­ta­tion is to kick the can down the road in terms of rolling back the tax in­creas­es and lim­it­ing the bud­get cuts. Most times when this is done, it is un­der the as­sump­tion that such mea­sures will stim­u­late eco­nom­ic growth and the rev­enues de­rived from such growth will be suf­fi­cient to over­come the fis­cal deficits in­curred over the short term. The re­al­i­ty is this ar­gu­ment is flawed at best and risky at worst.

Back in 2001, the Con­gres­sion­al bud­get of­fice in the US pro­ject­ed a US$5.6 tril­lion sur­plus over the en­su­ing ten years. In­stead over the pe­ri­od a deficit was ac­tu­al­ly record­ed in the amount of $6.2 tril­lion. That rep­re­sents an US$11.8 tril­lion turn­around from the pro­ject­ed fig­ure.

Bro­ken down in­to its var­i­ous com­po­nents re­flects the dif­fi­cul­ties with pre­dic­tions and in­vestors should be guid­ed by this re­al­i­ty as they are bom­bard­ed by pre­dic­tions for 2013 and be­yond.

In the first in­stance, the 2001 as­sess­ment did not ac­count for two re­ces­sions in the US, one of which was a near de­pres­sion. Nor did the as­sess­ment an­tic­i­pate the ex­oge­nous shocks of a post-Sep­tem­ber 11 world, fight­ing two wars and the funds re­quired to bail out fi­nan­cial in­sti­tu­tions fol­low­ing the events of 2007. Then there is the ever present risk of po­lit­i­cal ex­pe­di­en­cy over sound fis­cal pol­i­cy. This is ev­i­denced here by the GW Bush tax cuts com­ing, as it were, in the mid­dle of the wars and in­creased ex­pen­di­ture on home­land se­cu­ri­ty.

The re­al­i­ty, there­fore, is that while the fis­cal cliff may be noth­ing more than a me­dia cre­ation borne out of po­lit­i­cal shenani­gan,s there are still re­al and present dan­gers to the US and by ex­ten­sion the glob­al eco­nom­ic out­look.

The grid­lock over the fis­cal de­bate is then go­ing to flow in­to a grid­lock over the debt ceil­ing, then the de­bate over what ad­just­ments are re­quired to gen­er­ate a bal­anced bud­get over the medi­um term, which will lead to the ten­sions over en­ti­tle­ments and tax re­form agen­das.

If all these con­tentious is­sues amal­ga­mate, then it could have a desta­bil­is­ing ef­fect on the fi­nan­cial mar­kets. For the time be­ing, many will hope that good sense will pre­vail for hope is the one thing that is preva­lent at the start of a year. 2013 promis­es to be a very in­ter­est­ing ride.

Wel­come aboard, and God's bless­ings and best wish­es to all for 2013.

Ian Nar­ine is a bro­ker reg­is­tered­with the SEC.