by Philip Moeller
As 2012 draws to a close, people in or nearing retirement face a stunning set of uncertainties about their finances and even basic health and retirement benefits. Congress has left Washington for the Christmas break without passing any measures to delay or soften the effects of the so-called fiscal cliff. Perhaps it might still act before the end of the year, but don't count on it. Odds are that the new Congress that takes office next year will take action to prevent the very worst outcomes. But after years of gridlock, should we really expect things to get better?
Here are eight pressing money and benefit issues that are barreling down on seniors. All of them are bad news. And while there aren't a lot of places to hide, it's important for anyone trying to build or conserve a retirement nest egg to develop contingency plans.
1. Tax rates. The Bush tax cuts expire December 31. All income tax brackets will shift upward--the 10 percent bracket disappears and the new lowest tax rate will be 15 percent. The 25 percent bracket becomes 28 percent; 28 percent becomes 31 percent; 33 percent moves to 36 percent, and 35 percent will be 39.6 percent. The capital gains tax rate will rise to 20 percent from 15 percent, and dividend taxes will soar, moving from being taxed as capital gains to being treated as ordinary income.
2. The Alternative Minimum Tax. The AMT was aimed at preventing wealthier taxpayers from using deductions and other tax benefits to escape their fair share of taxes. However, the qualifying income levels were not indexed for inflation. Congress has thus had to enact an AMT "patch" each year to help millions of taxpayers avoid extra taxes Congress never intended for them to pay. There is now no patch in place for 2012 income taxes. That's right: the taxes that are due on this year's income. Even if Congress does something soon, tax-filing season likely will be delayed. If Congress does not approve a patch, the number of taxpayers hit by AMT payments will rise from 4 million to 34 million.
3. Social Security COLA. Fiscal-cliff negotiations between the White House and Republicans reportedly included the Obama administration's acceptance of a new formula for setting the annual cost of living adjustment (COLA) for Social Security beneficiaries. Called the chained CPI, it may, as supporters and many economists claim, represent a more accurate cost of living measure than the index now used to set each year's COLA. But it would also cut effective Social Security benefits by more than $20 billion a year after it has been in place for several years. It would also raise income-tax bills by reducing the size of the automatic inflation adjustments the tax brackets use to determine different income tax rates.
4. Estate taxes. Estate and gift tax rules are now unusually generous. Individual estates up to $5.12 million (double that for a couple) avoid all estate taxes, and amounts above these levels are taxed at 35 percent. This is also the rate for gift taxes. Without action by Congress, the estate-tax exclusion will plunge to only $1 million in 2012, and the tax on larger estate values will be 55 percent.
5. Medicare taxes. Medicare taxes will rise on wealthier wage earners in 2013. This change is part of the Affordable Care Act and not part of the fiscal-cliff impasse. Medicare payroll taxes, now set at 1.45 percent of payrolls, will rise another 0.9 percent on wage incomes above $200,000 in 2013 ($250,000 for couples). These same income limits will be used to trigger a 3.8 percent annual tax on net investment income. The proceeds will be used to help fund health-reform changes.
6. State insurance exchanges. When health reform is fully implemented in 2014, older people not yet eligible for Medicare will have guaranteed access to health insurance regardless of any preexisting conditions, at rates that are held down by rules limiting age-based premium hikes. These benefits will be delivered in large measure through new state-based insurance exchanges. These exchanges are supposed to be set up in 2013 so they can be fully operational before the end of the year. However, most states have decided not to build their own exchanges but to let the federal government do it for them. Odds of this work being done in time, let alone being done well, are seen as very small.
7. Medicaid expansion. In 2014, health reform would provide expanded healthcare to currently uninsured, lower-income Americans through a massive expansion of Medicaid at the state level. The federal government would pay all added expenses for three years and states would never pay more than 10 percent of the expenses from the expansion. Still, many states have spurned the act's offer of expanded coverage, saying they do not like the potential for higher state expenses and the rules that come with the expanded services.
8. The doc fix. In a 1997 law, Congress tied Medicare's payments to physicians to the growth of the economy. Medicare cost increases, including physician expenses, regularly exceed overall economic growth. Under the law, Medicare payments to physicians would have to be cut each year were it not for periodic Congressional action to override the cuts. Without another fix, doctors will see a 27 percent cut in their Medicare payments next year, and an unknown number of them would stop taking Medicare patients. Like much else in Washington, the doc fix has become part of the broader fiscal-cliff debate.
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Sunday, December 30, 2012
Friday, December 28, 2012
Six Tax Issues to Watch in 2013
With the "fiscal cliff" and tax hikes looming, Americans are facing a number of insecurities about their tax lives in 2013. Market Watch's Christopher Noble looks at what tax issues will affect you the most and what you can do about them right now.
Thursday, December 27, 2012
Your One-Week Year-End "Fiscal Cliff" Money Plan
By now, we thought the path forward would be clear and the usual six-day flurry of tax-focused check writing and income-shifting could commence.
But we're still in wait-and-see mode; watching to see what happens next. Either Washington will rush through a year-end package of tax and spending cuts or we will plunge over the so-called "fiscal cliff" of tax increases and sharp spending cuts. Even if that happens, President Obama and Congress could agree on a retroactive package early next year that would limit the repercussions of the over-the-cliff scenario.
So, what do you do now? Avoid placing huge bets and consider these moves while you're watching your government in (in)action.
Stash cash for January. It's probably going to be a rough month. Even if there's an 11th hour cliff plan, it is unlikely to reinstate the 2 percentage point cut in Social Security payroll taxes that all workers have been benefiting from for the last two years. That means families with median household income of $50,500 will take home $84 less a month in 2013 than they did in 2012.
Furthermore, January is always a month of reckoning with holiday bills, high heating costs, a resetting of health insurance deductibles and scant balances in flexible spending accounts. So, you're going to need cash. You may even hold on to some money you don't need to disburse until April (like Roth individual retirement account contributions), just to make sure you will have enough on hand to get through January.
Shift income based on your income. If you live in a high-tax state, have kids and make between $33,750 and $49,500 ($45,000 to $76,000 for couples), you are a sitting duck for the alternative minimum tax. Originally conceived as a method of insuring that rich people don't get out of paying taxes altogether, the AMT has morphed into an extra tax that penalizes large families and those who pay high local taxes. Congress usually mitigates that by "patching" the AMT rules so they only apply to higher incomes; in 2011 the AMT hit singles earning more than $48,450 and couples earning $74,450. Without a patch moving those numbers up by roughly 2 percent for 2012, they will fall all the way back to $33,750 for singles and $45,000 for couples. It's not entirely clear that a patch can be passed to be effective retroactively for tax year 2012. That is true even though the Internal Revenue Service and TurboTax are already acting like the patch will emerge.
To play that cautiously, don't race to pay your state property taxes before the end of the year. While that could cost you money in April because you will have lower deductions, it will secure your deductions for next year and perhaps protect you from the AMT in 2012, should the patch fail to materialize.
Feel confident that you'll get patched? Write the check now.
Sell. If you have not been part of all the selling on Wall Street, there is still time. Your capital gains will be taxed at a rate of 15 percent or less if you sell before the end of the year. In 2013, that rate stands a decent chance of going up to 20 percent. There's no harm in taking the gain now; you can re-buy the same security right away if you want to keep holding it.
Write the charity checks. If you itemize deductions they will offset income taxes for 2012, and there's certainly plenty of need wherever you look now. If you are wealthy, you stand a decent chance of having your deductions clipped next year, so you might as well write the checks now.
If you're retired, don't itemize deductions and have been turning over your required minimum IRA distribution to a charity, don't expect the same tax break you got last year. That provision - to allow non-itemizers a tax-free IRA withdrawal if it goes to charity - expired at the end of last year. Maybe it will come back, but that's a very long shot now. Write the check anyway, if you just want to be charitable, but not if you can't afford it without the write-off.
Plan to be frugal. There's no version of a "fiscal cliff" resolution that ends with a more expansive government fiscal policy. Either your benefits will be clipped -- in the form of less college financial aid, curtailed Social Security benefits and the like -- or your taxes will go up. Over the long term, items like deductions for mortgage interest on second homes and employer write-offs for health insurance could be in play. Consumers already have shown themselves to be more frugal than they used to be -- holiday-linked retail sales growth slowed significantly once the fast-track "fiscal cliff" fix went off the rails. Households have been paying down debt for much of the last five years. It couldn't hurt to keep that up for a while.
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Tuesday, December 25, 2012
Nine Daily Habits That Will Make You Happier
by Geoffrey James
These minor changes in your daily routine will make a major difference in your life and career.
These minor changes in your daily routine will make a major difference in your life and career.
Happiness is the only true measure of personal success. Making other people happy is the highest expression of success, but it's almost impossible to make others happy if you're not happy yourself.
With that in mind, here are nine small changes that you can make to your daily routine that, if you're like most people, will immediately increase the amount of happiness in your life:
1. Start each day with expectation.
If there's any big truth about life, it's that it usually lives up to (or down to) your expectations. Therefore, when you rise from bed, make your first thought: "something wonderful is going to happen today." Guess what? You're probably right.
2. Take time to plan and prioritize.
The most common source of stress is the perception that you've got too much work to do. Rather than obsess about it, pick one thing that, if you get it done today, will move you closer to your highest goal and purpose in life. Then do that first.
3. Give a gift to everyone you meet.
I'm not talking about a formal, wrapped-up present. Your gift can be your smile, a word of thanks or encouragement, a gesture of politeness, even a friendly nod. And never pass beggars without leaving them something. Peace of mind is worth the spare change.
4. Deflect partisan conversations.
Arguments about politics and religion never have a "right" answer but they definitely get people all riled up over things they can't control. When such topics surface, bow out by saying something like: "Thinking about that stuff makes my head hurt."
5. Assume people have good intentions.
Since you can't read minds, you don't really know the "why" behind the "what" that people do. Imputing evil motives to other people's weird behaviors adds extra misery to life, while assuming good intentions leaves you open to reconciliation.
6. Eat high quality food slowly.
Sometimes we can't avoid scarfing something quick to keep us up and running. Even so, at least once a day try to eat something really delicious, like a small chunk of fine cheese or an imported chocolate. Focus on it; taste it; savor it.
7. Let go of your results.
The big enemy of happiness is worry, which comes from focusing on events that are outside your control. Once you've taken action, there's usually nothing more you can do. Focus on the job at hand rather than some weird fantasy of what might happen.
8. Turn off "background" TV.
Many households leave their TVs on as "background noise" while they're doing other things. The entire point of broadcast TV is to make you dissatisfied with your life so that you'll buy more stuff. Why subliminally program yourself to be a mindless consumer?
9. End each day with gratitude.
Just before you go to bed, write down at least one wonderful thing that happened. It might be something as small as a making a child laugh or something as huge as a million dollar deal. Whatever it is, be grateful for that day because it will never come again.
Sunday, December 23, 2012
Friday, December 21, 2012
Retirement Tax Deadlines for 2012
by Emily Brandon
In order to get tax breaks for saving for retirement in a 401(k) or IRA, you need to meet certain deadlines. Retirees also need to pay attention to specific dates to avoid tax penalties. Here are some important dates to keep in mind for tax year 2012:
Dec. 31, 2012. Contributions to 401(k)s, 403(b)s, 457s, and the federal government's Thrift Savings Plan are generally due by Dec. 31, 2012. Workers can defer taxes on up to $17,000 in their 401(k) in 2012, or $22,500 for workers age 50 and older.
Retirees older than age 70 1/2 generally must take required minimum distributions from their traditional 401(k)s and IRAs by the end of the calendar year and pay the resulting income tax on the withdrawal. The tax penalty for failing to withdraw the correct amount is a 50 percent excise tax on the amount that should have been distributed. People who are still working after age 70 1/2 and don't own 5 percent or more of the business sponsoring the retirement plan can delay distributions from their current 401(k), but not IRA, until they actually retire.
Feb. 1, 2013. Survivors of Hurricane Sandy may be allowed to take 401(k), 403(b), 457, and Thrift Savings Plan hardship distributions and loans to pay for storm-related expenses or to assist a son, daughter, parent, grandparent, or other dependent who lives or works in the disaster area until Feb. 1, 2013. The usual six-month ban on new 401(k) contributions after a hardship distribution will also be temporarily suspended for people impacted by the storm. However, regular income tax, and for people under age 59 1/2, the 10 percent early withdrawal penalty will still apply to these hardship distributions.
April 1, 2013. If you recently turned age 70 1/2, you have until April 1 to take your first required minimum distribution from your retirement accounts. For example, a retiree whose 70th birthday was on July 1, 2011 and who reached age 70 1/2 on Jan. 1, 2012 must take his first required minimum distribution by April 1, 2013. However, if you delay your first distribution until 2013 you will need to take two distributions in the same year, because the second and all other subsequent distributions will be due Dec. 31. Two required withdrawals in a single year can result in a significant income tax bill for some people.
April 15, 2013. Retirement savers have until April 15, 2013 to make 2012 IRA contributions. Workers can contribute up to $5,000 to a traditional IRA, Roth IRA, or combination of the two accounts in 2012, and employees age 50 and older can deposit $6,000. For contributions made between Jan. 1 and April 15, 2013 you will need to specify which tax year you want the deposit to count toward. If you fail to select a year, the financial institution may automatically apply the transaction to the calendar year in which payment was received. You can claim an IRA contribution on your tax return before the money is actually in your account, but the deposit needs to take place by April 15, 2013 at the latest.
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In order to get tax breaks for saving for retirement in a 401(k) or IRA, you need to meet certain deadlines. Retirees also need to pay attention to specific dates to avoid tax penalties. Here are some important dates to keep in mind for tax year 2012:
Dec. 31, 2012. Contributions to 401(k)s, 403(b)s, 457s, and the federal government's Thrift Savings Plan are generally due by Dec. 31, 2012. Workers can defer taxes on up to $17,000 in their 401(k) in 2012, or $22,500 for workers age 50 and older.
Retirees older than age 70 1/2 generally must take required minimum distributions from their traditional 401(k)s and IRAs by the end of the calendar year and pay the resulting income tax on the withdrawal. The tax penalty for failing to withdraw the correct amount is a 50 percent excise tax on the amount that should have been distributed. People who are still working after age 70 1/2 and don't own 5 percent or more of the business sponsoring the retirement plan can delay distributions from their current 401(k), but not IRA, until they actually retire.
Feb. 1, 2013. Survivors of Hurricane Sandy may be allowed to take 401(k), 403(b), 457, and Thrift Savings Plan hardship distributions and loans to pay for storm-related expenses or to assist a son, daughter, parent, grandparent, or other dependent who lives or works in the disaster area until Feb. 1, 2013. The usual six-month ban on new 401(k) contributions after a hardship distribution will also be temporarily suspended for people impacted by the storm. However, regular income tax, and for people under age 59 1/2, the 10 percent early withdrawal penalty will still apply to these hardship distributions.
April 1, 2013. If you recently turned age 70 1/2, you have until April 1 to take your first required minimum distribution from your retirement accounts. For example, a retiree whose 70th birthday was on July 1, 2011 and who reached age 70 1/2 on Jan. 1, 2012 must take his first required minimum distribution by April 1, 2013. However, if you delay your first distribution until 2013 you will need to take two distributions in the same year, because the second and all other subsequent distributions will be due Dec. 31. Two required withdrawals in a single year can result in a significant income tax bill for some people.
April 15, 2013. Retirement savers have until April 15, 2013 to make 2012 IRA contributions. Workers can contribute up to $5,000 to a traditional IRA, Roth IRA, or combination of the two accounts in 2012, and employees age 50 and older can deposit $6,000. For contributions made between Jan. 1 and April 15, 2013 you will need to specify which tax year you want the deposit to count toward. If you fail to select a year, the financial institution may automatically apply the transaction to the calendar year in which payment was received. You can claim an IRA contribution on your tax return before the money is actually in your account, but the deposit needs to take place by April 15, 2013 at the latest.
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Wednesday, December 19, 2012
Friday, December 14, 2012
What Fiscal Cliff May Mean To You - Risk To The Economy And Stocks Are High If All Tax Hike And Spending Cuts Take Effect
Without congressional action, up to $600 billion of expiring tax cuts, new taxes, and automatic spending cuts are set to take effect at the end of 2012 or beginning of 2013. If they hit all at once, the impact could amount to as much as 4%-5% of GDP, according to our research, the equivalent of falling off a “fiscal cliff.” Some experts anticipate the economy would experience a significant slowdown and there would be major consequences for financial markets.
What are the odds that Congress will fail to act? And what could the range of possible congressional actions mean for the economy, and the financial markets? Could we experience a repeat of last year’s debt ceiling drama and credit rating downgrades?
We gathered four Fidelity experts to answer these questions and more.
Capitol scenarios
Federal Reserve Chairman Ben Bernanke and a number of observers have used the term “fiscal cliff” to describe several big fiscal events set to occur in the U.S. at the end of this year and in early 2013. Among them:
Scenario 1: punt
A likely scenario is that Congress and the president agree to punt the issue into 2013. If this occurs, the tax cuts will not expire, tax increases won’t take effect, and the spending cuts will be delayed until after the presidential inauguration and new Congress arrives in 2013.
Scenario 2: modest compromise
Congress and the White House reach compromises on some tax and spending provisions, with the election having a significant impact on what those compromises might be.
Scenario 3: over the cliff
A less-likely scenario, I think, is that Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures. The economy goes over the cliff.
Scenario 4: grand bargain
In my view, the chance of a grand bargain taking place after the election and before the end of the year is a long shot. In this scenario, Congress and the White House would reach a deal addressing tax, spending, and fiscal issues for the medium to long term.
In addition to the fiscal cliff, the U.S. will again approach the debt ceiling early next year. While the sequence of events puts the debate over the fiscal cliff before the debt deadline, the two issues are likely to be intertwined.
The outcome of the 2012 elections matters, but the resolution of these issues is tough regardless of whether Democrats or Republicans are in control. That’s because they reflect longstanding philosophical differences between the parties about the proper role and size of the government, and how to grow the economy.
Debt ceiling dynamics
The debt ceiling is once again going to be a line in the sand. While it may be reached shortly after the elections, Treasury has a number of tools to postpone an actual showdown this year. The Treasury has signaled the debt ceiling wouldn’t be hit until early 2013, but there may be potential market disruptions before then. More importantly, we’re going to have to first address the proposed tax increases and spending cuts by December 31.
Normally, the debt ceiling is simply a blame game between Congress and the incumbent president about spending cuts and tax increases. It usually comes down to the wire, but there’s resolution. Last year, however, was different. New members of Congress wanted spending cuts; others openly talked about the prospect of defaulting on debt.
The market ramifications were quite disruptive. Long-term interest rates rose on fears of default while the cost for investors to insure against a default increased as well. We also saw dislocations in the stock markets. Then Standard & Poor’s unexpectedly downgraded U.S. debt from its premier Triple A status - something that Moody’s has said is a possibility as we approach the fiscal cliff.
Perhaps I’m an optimist, but I believe between now and early 2013 certain back-channel discussions probably will take place to address tax reform, spending cuts, and revenue increases. Perhaps, in early fall, we might see proposals coming from Washington that may actually prove to be positive steps forward rather than the worst-case scenario.
Best for bonds
If the government does nothing and the spending cuts and tax increases take effect, we get a big fiscal contraction. As painful as that is, I think it’s a very good scenario for the bond market. That's because the fiscal contraction likely means slower growth and lower inflation, which means lower bond yields. Furthermore, this scenario would likely lead to considerable policy uncertainty as market participants would expect some sort of policy U-turn in the near future; that uncertainty could lead to a flight to quality, further supporting Treasuries.
The worst scenario for bonds would be the grand bargain between the White House and Congress because that presumably would result in less abrupt fiscal adjustments, with a softer impact on the economy. In that scenario, you could get a sell-off in bonds, but it might be healthy, as it would unwind some of the risk premium already priced into Treasuries.
The other two scenarios - punting decisions into 2013 or muddling into a compromise - will have a far more nuanced impact. If there is a sense that Washington is kicking the can down the road, then we could see downgrades by the rating agencies, which in turn could lead to forced selling by certain investors. But that isn’t a foregone conclusion. Last year, for example bonds actually did quite well after S&P cut the U.S. debt rating.
Remember that there’s a difference between getting a downgrade by investors, which could lead to higher yields, versus a downgrade by a rating agency. The downgrade from investors comes when they decide that there’s no credible way to get the ratio of debt–to-GDP on a sustainable path in the long run; we haven't had that yet. What we’ve had is a downgrade by one rating agency, which was a shock to consumer and investor confidence. So, it led to a sell-off in stocks and other risk assets and a flight to quality, namely bonds, whose downgrade ironically had sparked the whole selloff.
Whether that happens again depends on how the markets read these events, especially in the case where a negotiated outcome is muddled.
Stock market fallout
In the worse-case scenario - if we fall off the fiscal cliff - the impact will be quite large. The more fiscal austerity that kicks in, the bigger the effect it has on economic growth. Depending on how you measure it, the automatic spending cuts and tax hikes would cut as much as 4%-5% of GDP. If you consider that the economy is growing around 2% a year, that would be enough to throw us back into recession.
According to our research, corporate earnings could decline by double digits, perhaps as much as 20% or more. If this happened, it would have a tremendously negative impact on the stock market and other riskier asset categories.
Keep in mind, any time you move from a very large deficit back to a path of sustainability, it is going to require the government to eventually shore up its balance sheet. The key here going forward is the balance - trying to get a gradual reduction in government spending that allows for the private sector to fully resume its role as the primary growth engine of the economy.
The most likely political scenarios would push off most of the fiscal pain beyond the beginning of 2013. That would obviously be a lot more manageable from an economic standpoint, but it’s important to keep in mind how they go about it. If it looks like we’re just kicking the can down the road and have no plan of ever addressing the problem, it will be very negative from a confidence standpoint. We need to at least have an appearance of progress toward grappling with it early on in 2013.
We have to remember, the debt problem has been a dark cloud over investor psychology, and business and consumer sentiment, for a while now. So the closer we can get to a medium term, long-term resolution, the more we have the opportunity to remove that dark cloud.
What I’m looking for are some main attributes of a deal. First, is it truly sustainable over the long term? Are we addressing things like entitlements, which are really the 800 pound gorilla? Second, is it something that can get us a more efficient tax system? Does it include some tax reform that could actually make our economy more productive, broaden the base, and simplify the tax code? Third, we also have to be careful that we’re not balancing the books at the expense of undoing positive infrastructure, research, and other things that governments historically have funded and are important for the long term trajectory of the U.S. economy.
I think anything that moves us toward a resolution that has some of those attributes can turn the sentiment around, and possibly even improve the long-term outlook for the U.S. economy.
What are the odds that Congress will fail to act? And what could the range of possible congressional actions mean for the economy, and the financial markets? Could we experience a repeat of last year’s debt ceiling drama and credit rating downgrades?
We gathered four Fidelity experts to answer these questions and more.
Capitol scenarios
Federal Reserve Chairman Ben Bernanke and a number of observers have used the term “fiscal cliff” to describe several big fiscal events set to occur in the U.S. at the end of this year and in early 2013. Among them:
- The expiration of the Bush-era tax cuts at the end of 2012, including current lower tax rates on capital gains, dividends, income, and estates, as well as number of other measures.
- The expiration of fiscal stimulus measures, such as the payroll tax cut and extended unemployment benefits.
- Spending cuts scheduled to be triggered automatically in January 2013 as a result of the failure of the deficit reduction super committee last year.
Scenario 1: punt
A likely scenario is that Congress and the president agree to punt the issue into 2013. If this occurs, the tax cuts will not expire, tax increases won’t take effect, and the spending cuts will be delayed until after the presidential inauguration and new Congress arrives in 2013.
Scenario 2: modest compromise
Congress and the White House reach compromises on some tax and spending provisions, with the election having a significant impact on what those compromises might be.
Scenario 3: over the cliff
A less-likely scenario, I think, is that Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures. The economy goes over the cliff.
Scenario 4: grand bargain
In my view, the chance of a grand bargain taking place after the election and before the end of the year is a long shot. In this scenario, Congress and the White House would reach a deal addressing tax, spending, and fiscal issues for the medium to long term.
In addition to the fiscal cliff, the U.S. will again approach the debt ceiling early next year. While the sequence of events puts the debate over the fiscal cliff before the debt deadline, the two issues are likely to be intertwined.
The outcome of the 2012 elections matters, but the resolution of these issues is tough regardless of whether Democrats or Republicans are in control. That’s because they reflect longstanding philosophical differences between the parties about the proper role and size of the government, and how to grow the economy.
Debt ceiling dynamics
The debt ceiling is once again going to be a line in the sand. While it may be reached shortly after the elections, Treasury has a number of tools to postpone an actual showdown this year. The Treasury has signaled the debt ceiling wouldn’t be hit until early 2013, but there may be potential market disruptions before then. More importantly, we’re going to have to first address the proposed tax increases and spending cuts by December 31.
Normally, the debt ceiling is simply a blame game between Congress and the incumbent president about spending cuts and tax increases. It usually comes down to the wire, but there’s resolution. Last year, however, was different. New members of Congress wanted spending cuts; others openly talked about the prospect of defaulting on debt.
The market ramifications were quite disruptive. Long-term interest rates rose on fears of default while the cost for investors to insure against a default increased as well. We also saw dislocations in the stock markets. Then Standard & Poor’s unexpectedly downgraded U.S. debt from its premier Triple A status - something that Moody’s has said is a possibility as we approach the fiscal cliff.
Perhaps I’m an optimist, but I believe between now and early 2013 certain back-channel discussions probably will take place to address tax reform, spending cuts, and revenue increases. Perhaps, in early fall, we might see proposals coming from Washington that may actually prove to be positive steps forward rather than the worst-case scenario.
Best for bonds
If the government does nothing and the spending cuts and tax increases take effect, we get a big fiscal contraction. As painful as that is, I think it’s a very good scenario for the bond market. That's because the fiscal contraction likely means slower growth and lower inflation, which means lower bond yields. Furthermore, this scenario would likely lead to considerable policy uncertainty as market participants would expect some sort of policy U-turn in the near future; that uncertainty could lead to a flight to quality, further supporting Treasuries.
The worst scenario for bonds would be the grand bargain between the White House and Congress because that presumably would result in less abrupt fiscal adjustments, with a softer impact on the economy. In that scenario, you could get a sell-off in bonds, but it might be healthy, as it would unwind some of the risk premium already priced into Treasuries.
The other two scenarios - punting decisions into 2013 or muddling into a compromise - will have a far more nuanced impact. If there is a sense that Washington is kicking the can down the road, then we could see downgrades by the rating agencies, which in turn could lead to forced selling by certain investors. But that isn’t a foregone conclusion. Last year, for example bonds actually did quite well after S&P cut the U.S. debt rating.
Remember that there’s a difference between getting a downgrade by investors, which could lead to higher yields, versus a downgrade by a rating agency. The downgrade from investors comes when they decide that there’s no credible way to get the ratio of debt–to-GDP on a sustainable path in the long run; we haven't had that yet. What we’ve had is a downgrade by one rating agency, which was a shock to consumer and investor confidence. So, it led to a sell-off in stocks and other risk assets and a flight to quality, namely bonds, whose downgrade ironically had sparked the whole selloff.
Whether that happens again depends on how the markets read these events, especially in the case where a negotiated outcome is muddled.
Stock market fallout
In the worse-case scenario - if we fall off the fiscal cliff - the impact will be quite large. The more fiscal austerity that kicks in, the bigger the effect it has on economic growth. Depending on how you measure it, the automatic spending cuts and tax hikes would cut as much as 4%-5% of GDP. If you consider that the economy is growing around 2% a year, that would be enough to throw us back into recession.
According to our research, corporate earnings could decline by double digits, perhaps as much as 20% or more. If this happened, it would have a tremendously negative impact on the stock market and other riskier asset categories.
Keep in mind, any time you move from a very large deficit back to a path of sustainability, it is going to require the government to eventually shore up its balance sheet. The key here going forward is the balance - trying to get a gradual reduction in government spending that allows for the private sector to fully resume its role as the primary growth engine of the economy.
The most likely political scenarios would push off most of the fiscal pain beyond the beginning of 2013. That would obviously be a lot more manageable from an economic standpoint, but it’s important to keep in mind how they go about it. If it looks like we’re just kicking the can down the road and have no plan of ever addressing the problem, it will be very negative from a confidence standpoint. We need to at least have an appearance of progress toward grappling with it early on in 2013.
We have to remember, the debt problem has been a dark cloud over investor psychology, and business and consumer sentiment, for a while now. So the closer we can get to a medium term, long-term resolution, the more we have the opportunity to remove that dark cloud.
What I’m looking for are some main attributes of a deal. First, is it truly sustainable over the long term? Are we addressing things like entitlements, which are really the 800 pound gorilla? Second, is it something that can get us a more efficient tax system? Does it include some tax reform that could actually make our economy more productive, broaden the base, and simplify the tax code? Third, we also have to be careful that we’re not balancing the books at the expense of undoing positive infrastructure, research, and other things that governments historically have funded and are important for the long term trajectory of the U.S. economy.
I think anything that moves us toward a resolution that has some of those attributes can turn the sentiment around, and possibly even improve the long-term outlook for the U.S. economy.
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