Fiscal Cliffhanger

So will we go over or won’t we?  Every day, it seems the answer is different.  Economic brinkmanship.  Today is the first time I heard serious talk of strategically going over the cliff to strengthen a negotiating position, reminding me of Henry Kissenger’s MAD Strategy (Mutually Assured Destruction) during the Cold War.  Today is also the last day for negotiations or voting before the Christmas break, making it look more and more likely that things will get worse before they get better.

There have been lots of commentaries about how ‘ordinary citizens’ should prepare for possible outcomes: higher taxes on some (maybe all?) of us and fewer government programs, but I haven’t seen much on how this might effect markets and portfolios.  How might a good risk manager go about analyzing this situation?

The first, and I think most important, thing to realize is that Risk Management is not about predicting what course Congress will take.  That’s a fool’s game in my opinion – not because experts/pundits can’t identify the most likely outcome, especially as we get nearer the New Year – but rather because it’s foolish to stake everything on “the most likely” outcome.  In other words, you should be prepared for all of the likely (and even some of the unlikely!) outcomes.  In that spirit, IA’s researchers identified three scenarios that experts agree are the reasonable ‘envelope of possibility’ for this situation.  We then took those scenarios and turned them into models for our clients to see for themselves just how bad things might get.  For those interested in even more “out there” scenarios, those too can also be easily modeled on an individual basis.  Our tools allow our clients to map out their own investment landscapes so they can see what actually matters for them.

Our quants came up with three scenarios to consider:

  • Kick the Can:” officially known as “Status Quo”, this scenario has Congress moving the deadline to some date in 2013.  Perhaps to July, perhaps to December.
  • Go Over the Cliff” is where Congress and the President fail to reach an agreement, and all the automatic tax hikes and across the board spending cuts are enacted just as the ball in Times Square welcomes the New Year.
  • The Grand Bargain,” which I call the “Glorious Solution” to imply its unlikelihood, is where Congress and the President put aside their politics and do what’s right for the country both in short and long terms.

I’m going to add a fourth:

  • “Botched Job:” Also known as “Lost Opportunity”, this is where Congress and the President come to some ‘middle of the road’ agreement that neither reduces the deficit nor increases revenue that much.  It will be hailed as a ‘reasonable compromise’ that prevent us from going over the cliff.  But it also prevents us from addressing the real problems of unfulfillable promises to retirees (retirement age must go up as we increase life span), unfunded entitlements, a soaring debt and increasing deficit.  But it lets us feel good in the short run, so that’s what we’ll probably do.

In the “Kick the Can” scenario not much changes.  By design, Congress and the President agree to simply delay the hard choices and leave all rates and expenditures the same.  It would have little effect on the economy, except that it perpetuates the current uncertainty.  We foresee no dramatic shifts in major markets, but we also don’t see any reason to celebrate.

In “Go Over the Cliff,” all of the automatic tax hikes have an immediate negative effect on the markets.  We further break this scenario into two parts, depending on what happens next.  For quite some time now, the US has been looked at effectively as the world’s “Safe Haven” for investments.  This means that when markets go into turmoil, investors buy US bonds, the US dollar, etc.  Essentially, the US is considered safe.  But we question, if we allow ourselves to go over the cliff, whether the US would continue to be the world’s safety blanket.  Might investors chose a different country as “safe?”

If the US continues to enjoy its status as the world’s Safe Haven, then the downturn we experience may be tempered:

  1. Further decreases in long term treasury yields as investor flock to safehaven assets.  This could be represented by a US Government Bond Index going up by 7% – 9%.
  2. Continuing low short term yields as Fed continues accommodative monetary policy.  We don’t project them getting much lower than currently held values.
  3. Significant widening of credit spreads on lower US growth prospects.  This could be modeled by a High Yield index dropping by 8% to 12%
  4. Significant decreases in equity markets on lower US growth prospects.  Leading US equity indexes could be down 15% to 25%
  5. Significant decrease in commodities markets driven by decreasing demand.  Similarly, commodity indexes could be down about 20%
  6. Significant strengthening of USD in as investors flock to safehaven assets.  US Dollar Funds or Indexes could be up about 5%.

However, if the US loses its “Safe Haven” status and investors around the world flock to some other country – say China or the UK perhaps – then we see a larger downturn being likely:

  1. Significant increases in long term treasury yields as investor sell out of treasuries.  Here, a US Government Bond Index might down 10% or more.
  2. Continuing low short term yields as Fed continues accommodative monetary policy.  Again, no big change expected.
  3. Significant widening of credit spreads on lower US growth prospects.  A High Yield Index could drop by as much as 20% or 25%.
  4. Significant decreases in equity markets on lower US growth prospects.  Stocks down 25%+
  5. Significant decrease in commodities markets driven by decreasing demand.  Commodities down similar to stocks: 25%+
  6. Significant weakening of USD in as investors seek safer assets.  US Dollar Funds down about 5%

On the other hand, if the Grand Bargain actually happened, it would be simply splendid.  In this scenario, the US Government makes meaningful reforms in its long term debt obligations and long term fiscal reform along the lines of the Simpson-Bowles plan which allows for the short-term stimulus to reinvigorate the economy.  In this case, we see:

  1. Further decreases in long term treasury yields, with US Government Bond Index up perhaps 8%
  2. Continuing low short term yields as Fed continues accommodative monetary policy, with no change to short term rates.
  3. Continuing low credit spread or even tightening corporate credit spreads, with a High Yield Index gaining as much as 20%.
  4. Significant increases in equity markets as confidence returns to US economic prospects, with prominent US Indexes up about 20%
  5. Significant increase in commodities markets driven by increased demand, again similarly tracking equities, up about 20%
  6. Significant strengthening of USD in response to improved US growth prospects, with the US Dollar Funds/Indexes gaining 5% or so.

Unfortunately, as we’ve watched the negotiations between the Congress and the White House, we see little reason to be hopeful for such an outcome. At this point, I think one of two combinations of the above scenarios is what lies ahead:

Botched Job: the President and Congress agree on a minimally acceptable set of steps to avoid going over the cliff before Jan 1 and markets have a mixed but not disastrous reaction.

Go over the Cliff, and then click ‘undo’: We come close to reaching an agreement but as of Jan 1 we officially “go over” only to have a resolution by sometime in early January.  This scenario causes markets to gyrate wildly starting January 2 – as described above – and may even see us lose that critical Save Haven status.  Resolving the issue, even a few days later, may seem like it should restore markets, but I think the damage will not be so easily undone.

Perhaps the biggest lesson from the Fiscal Cliff is that even the idea of near total self destruction doesn’t phase the US Government, and that they are willing to play a most dangerous game.  That very fact should bother us all.

One Response to Fiscal Cliffhanger

  1. roman voronka says:

    You had no place for commodities such as gold, silver, platinum (appropriate ETF’s) as partial insurors of value. I pose this as possible behaviorfor individual investor. Roman Voronka

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