Download Will the US Jump Off the “Fiscal Cliff”?

June 2012
Will the U.S. Jump Off the “Fiscal Cliff”?
By: James R. Solloway, CFA, Managing Director, Senior Portfolio Manager




4.
5.
Large spending cuts and tax increases set to kick in on January
1, 2013 could be detrimental to the U.S economy.
6.
SEI believes U.S. legislators will find a way to avoid the worst-case
scenario.
It will not be possible to make intelligent, high-probability7.forecasts regarding how they will do so until after the
8.
November elections.
In the meantime, political posturing will rattle the financial9.markets and frustrate investors.
“
“Under current law, on January 1, 2013, there's going to
be a massive fiscal cliff of large spending cuts and tax
increases,” Federal Reserve Chairman Ben Bernanke
recently told the House Financial Services Committee.
The media and various pundits have been using the
quote as a mantra to herald the arrival of a financial
apocalypse in the U.S.
The fiscal cliff to which Bernanke refers is comprised of
three distinct items:



Sun-setting of Bush-era tax rates;
Expiration of Obama-era stimulus measures;
Implementation of across-the-board spending cuts
(the so-called sequester under the debt ceiling
agreement of 2011).
Prior legislative compromises over U.S. fiscal policy
have set the stage for the automatic spending cuts and
tax hikes.
It’s Not the Fall That Hurts—It’s the Landing
The looming austerity measures are relevant to investors
for several reasons, including;
1. The U.S. has outperformed most other developed
markets in recent years, which may be due in large
part to the fact that its major political parties have
been unable to agree on austerity measures
designed to lower its national debt level.
2. The resulting fiscal deficits have helped support
domestic economic activity while other regions—most
notably Europe—are flirting with recession as both
their public and private sectors try to de-leverage.
3. As a result, any sharp, sudden reduction in federal
deficits could seriously undermine the U.S.
economy. If this occurred, it would echo the U.S.
recession of 1937, caused by premature policy
SEI / Commentary / ©2012 SEI
tightening during an ongoing recovery from the
Great Depression. Because financial markets tend
to be forward-looking, any uncertainty around how
the fiscal cliff will be dealt with could keep markets in
risk-off mode until there is greater clarity.
The timing and magnitude of any resulting shocks are
subject to debate, but the near-term implications are
clearly negative. For example, the Congressional Budget
Office predicts a loss of 3.6% from gross domestic
product (GDP, a measure of national economic activity),
which falls near the median of most forecasts. When
compared to first-quarter GDP estimates of a 3.6%
compounded annual rate, it becomes clear that the fiscal
cliff is quite capable of tipping the U.S. economy back
into recession.
Our View
SEI believes investors would be better served if
legislators focused on the little-mentioned second part of
Bernanke’s quote, in which he stated, “I hope that
Congress will look at that and figure out ways to achieve
the same long-run fiscal improvement without having it
all happen at one date." We suspect January 1 will
herald the arrival of neither a financial apocalypse nor
long-run fiscal improvement for U.S. investors.
Unfortunately, 2012 is a major election year, so
uncertainty is likely to rule between now and November,
which could keep market volatility elevated. Depending
on whether control of the Executive and Legislative
branches remains divided between Democrats and
Republicans or is handed to a single party, potential
responses to the fiscal cliff, as well as their timing, could
take a variety of forms.
Our current working assumption is that control of the
government will remain divided between Democrats and
1
Republicans. If it does, the negotiations are likely to be
messy and contentious, but some resolution could occur
during the post-election, “lame duck” session of
Congress. If Republicans hold the House of
Representatives and win control of the Senate, they
might have greater leverage for forcing compromise by
the Obama administration (though we do not expect
President Obama to become as accommodative as
President Clinton was in his second term). If
Republicans sweep the presidency and Congress, a
resolution is likely to be pushed into 2013, with plenty of
trial balloon proposals being floated in the interim.
Unfortunately, it will not be possible to make intelligent,
high-probability forecasts until the outcome of the
November elections are known. Political poll-watching
will be very important for this reason. A one-party win
would be a surprise, but could happen if we see the sort
of visceral anger displayed by voters in the fall of 2010.
Overall, we believe concerns over the fiscal cliff are
probably overwrought at this point. There is likely to be a
great deal of game playing, public pandering and
backroom dealing, but U.S. constituencies as a whole
are probably not lobbying hard for near-term fiscal
austerity. As a result, we expect the fiscal cliff to be dealt
with—however messy the process may be—in time for
the U.S. economy to avoid recession and continue its
muddle-through pace of growth. While this does not lead
us to expect a runaway bull market in risky U.S. assets,
we do not currently place a high probability on a new
bear market either.
In our view, the ultimate long-term, bull-case scenario
would involve entitlement reform, such as raising the
minimum retirement age for Social Security benefits,
coupled with comprehensive tax reform of the type last
seen in 1986. Lower and better harmonized tax rates
with fewer loopholes would result in a fairer, pro-growth
tax code.
Our Funds
We view events in Europe and the near-zero yields on
U.S. Treasury securities to be far more relevant to our
investment strategies than the noise emanating from
Washington over the fiscal cliff. Accordingly, our Funds:





Have little or no exposure to Greece;
Are underweight Europe in our equity Funds;
Are overweight Europe in our fixed-income Funds;
Are underweight U.S. Treasurys;
Are underweight the euro.
We believe that short-term turmoil created by concern
over the fiscal cliff underscores the importance of goalsbased investing. Investors who have a primary objective
of avoiding short-term volatility should not have a
significant portion of their portfolio invested in stocks.
This material represents an assessment of the market environment at a specific point in time and is not intended
to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the
reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed
as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the
date of this material that the securities mentioned remain in or out of the SEI Funds.
SEI Investments Management Corporation (SIMC) is the adviser to the SEI Funds, which are distributed by SEI
Investments Distribution Co. (SIDCO). SIMC and SIDCO are wholly-owned subsidiaries of SEI Investments
Company. For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management
Corporation has ultimate responsibility for the investment performance of the Fund due to its responsibility to
oversee the sub-advisers and recommend their hiring, termination and replacement.
To determine if the Fund(s) are an appropriate investment for you, carefully consider the investment objectives,
risk factors and charges and expenses before investing. This and other information can be found in the Fund's
prospectus, which can be obtained by calling 1-800-DIAL-SEI. Read it carefully before investing.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject
to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency
values, from differences in generally accepted accounting principles or from economic or political instability in
other nations. Bonds and bond funds will decrease in value as interest rates rise.
Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest
directly in an index. Past performance does not guarantee future results.



Not FDIC Insured
No Bank Guarantee
May Lose Value
SEI / Commentary / ©2012 SEI
2