News Analysis date published New: 
Friday, July 20, 2012 - 13:00
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Friday, July 20, 2012 - 13:04
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Friday, July 20, 2012 - 13:00

Warning: Here's How the "Fiscal Cliff" Could Ruin Your Portfolio

Friday, July 20, 2012 - 1:00pm

Imagine a train speeding down a track, just a few miles away from a wall that it will crash into. You can't see the wall yet, but you're told it's there anyway. As the train chugs down the track, the wall gets closer until it comes into view. Before long, that wall appears bigger and bigger until it is right in front of the train. By that time, there's no way to stop the train in time and you can only hope that the damage isn't catastrophic.

That's the game Washington is playing with our economy.

Policy makers have frittered away ample opportunities to address our nation's soaring budget deficit, failing to agree on a package of spending cuts and tax hikes that will close the gap and avert a crisis. Now, as we head into the summer, the budget deficit remains quite large, and the train is on auto-pilot. By the end of this year, a range of automatic spending cuts will kick in and a series of tax breaks will expire, leading to the newly-popular phrase "fiscal cliff."

Should you be concerned? If you have a stake in the U.S. economy or have funds in the stock market, then yes, you should be very concerned.

A huge brake on the economy
Believe it or not, the stunning run of budget deficits during the past decade has actually been good for the economy. It's simple math. The government has pumped more money into the economy than it has extracted, which has supported all kinds of sectors from defense to healthcare to technology to education.

We can all agree that it's wise to eliminate our budget deficits so we don't leave an even bigger mess to the next generation, but it's crucial to understand that reversing our nation's massive debt load, which now exceeds $15 trillion, means that the government not only needs to cut spending in line with tax revenues but actually to a level below that to start paying down the debt. It's as if the government will put its foot on the economy's brakes for a long time to come.

Before I go any further, let's take a moment and think about just how big a number that is. Sometimes we tend to get desensitized to large numbers, so let's take a look at the actual number to understand just how many zeroes we're talking about: $15,000,000,000,000. [For an even scarier picture, take a look at the U.S. debt clock.]

But we're not even talking about that just yet. Right now, we're trying to figure out how to balance a budget, let alone run a surplus. To start that process, those automatic spending cuts and tax increases will kick in on Jan. 1, 2013. How much money are we talking about? $600 billion. Sadly, not only might that force an already-weak economy into recession, but it won't even completely close the budget gap.

That $600 billion equates to roughly 3.5% of gross domestic product, which means it would take an economy growing at that rate down to zero growth. An economy growing in the 1.5% to 2.5% range in 2013, which now looks increasingly likely, means the 3.5% drag would push us into recession. And as we're seeing in Europe, economic contraction reduces government revenue, making the goal of a balanced budget even more elusive.

Don't think this is an issue to worry about in six months. Analysts at Societe Generale (SoGen) predict the "uncertainty surrounding the cliff will remain unresolved at least until November, and possibly until early 2013. This could begin to weigh on growth in the second half of 2012."

If there's a will, there's a way

Now that we're all sufficiently scared, let's take a look at how we might avert such a mess. As of now, Republican members of Congress appear disinclined to strike a deal with President Obama on hopes that Republican presidential candidate, former Massachusetts Gov. Mitt Romney, will win the election in November and they can craft a more appealing deal after that. After the election takes place, a short-term extension that buys more time will likely be agreed upon, regardless of who occupies the Oval Office next January. At that time, the process will also begin to more seriously address the long-term deficit.

Let's run through the two scenarios...

An Obama win
If president Obama wins the election, then a number of members of Congress are likely to realize that four more years of blocking tactics would surely lead us to some sort of fiscal Armageddon. The bond markets have shown remarkable patience as we've run up deficits so far, but further deficits are likely to trigger an exodus of bond buyers as they come to doubt whether Uncle Sam will ever meet its obligations without some sort of write-down. As a result, some taxes will be raised, or at least some tax loopholes will be closed, perhaps in line with the recommendations of the Simpson-Bowles task force.

Some of these loopholes involve corporate taxes, such as tax credits for research and development initiatives. Yet some of the loopholes may hit consumers directly, as I noted last year in this article.

A Romney win
It's crucial to distinguish between Mitt Romney the politician and Mitt Romney the free enterprise advocate. The former has taken stances that will secure votes, while the latter is interested in creating the most stable backdrop for businesses. That means a clear plan to tackle the deficit, which even Mr. Romney would concede in a private moment, cannot be done with spending cuts alone.

In effect, Washington is likely to get serious about a solution in the first half of 2013, which should boost the investment climate for businesses. Yet as noted earlier, such a climate, by definition, entails a drag on the economy.

My prediction: The current program of extended unemployment benefits and payroll tax cuts (worth around $125 billion annually) will not be extended. Nor will the Bush-era tax cuts for households making more than $250,000 ($75-100 billion). However, an extension of the Bush-era tax cuts for households making less than $250,000 (nearly $100 billion by fiscal 2014, according to the Congressional Budget Office) will likely get continued bipartisan support.

Risks to Consider: This analysis assumes that cooler heads will EVENTUALLY prevail, but Washington has snatched defeat form the jaws of victory many times before.

Action to Take --> Inaction is not an option. Regardless of the ultimate solutions devised, we already know what investments to avoid. As I noted in this article, defense stocks and other companies that do a lot of business with the government may suffer a great deal of pain in coming years as revenues shrink.

You can no longer afford to ignore this issue. As noted earlier, fears of the looming fiscal cliff may start to impede economic growth as early next quarter as companies start to defer long-term spending. Track events closely to see what type of eventual compromise may take shape. In an ideal world, Congress won't wait until the lame-duck session after the election and will take action earlier. But to paraphrase a former government official, "we're stuck with the Congress we have, not the one that we want."

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.