The approaching U.S. fiscal cliff has been on the radar of every strategist and portfolio manager since the compromise was reached in 2011. If policymakers are not able to amend the current mix of changes, mandated spending and benefit cuts and the expiration of several tax cuts will create a significant drag on the economy.
A recent overview from Goldman Sachs makes clear just how much is at stake. If no changes are made to current law, the contraction in government fiscal policy is estimated to subtract more than 3% from U.S. GDP in the first quarter of 2013 alone. Continued effects in Q2 and Q3 would be on a similar scale. That’s the worst case scenario, which is unlikely to happen but provides a sobering point of reference. The best-case outcome, in which tax cuts, jobless benefits, and the “sequester” spending are all extended, would still see shrinking government act as a drag on GDP over the next year.
Effect of Government Fiscal Policy on GDP Growth
Source: Goldman Sachs
The scenario Goldman takes as a baseline includes a reduction in jobless benefits, the expiration of the payroll tax cut, an extension of income tax cuts, and a delay or reversal of the automatic spending cuts. Even in this scenario, Q1 of 2013 is expected to see a -1% GDP impact due to government contraction alone.
The medium-term consequences of the decisions made this fall will be analyzed extensively, but investors should prepare now for some likely short-term scenarios. Certain factions within Congress have made it clear in recent years that their primarily goal is to make government as dysfunctional as possible (“starve the beast,” etc.), and during the debt ceiling debate in 2011, it became clear that some junior, populist members were genuinely unaware of the devastation that would have been caused by a voluntary default. We can expect a replay of the same rhetoric this year and every year until enough voters and representatives understand that, as a reserve currency issuer:
- the Unites States is in no way similar to Greece, Spain or any other individual European member state;
- the United States budget is not meaningfully similar to an individual household budget;
- the often-invoked “bond vigilantes” have been entirely absent from the market for U.S. sovereign debt;
- all evidence shows that the free market is begging (via ever-lower rates) for the U.S. to issue more debt, not less;
- and that the only plausible scenario in which the United States will ever struggle to pay its debts is if Congress voluntarily forces us to default.
The most likely scenario in advance of the fiscal deadlines is another game of political chicken, and given the extreme downside risk to GDP, we can anticipate a widening of risk assessments. If option implied volatility remains low, investors should consider buying protection in the form of puts and collars well ahead of the deadlines. Additionally, traders can anticipate a greater risk premium to be priced into equity index options if negotiations stall or look more combative than expected; on the assumption that, in the final moment, Congress will not destroy the economy voluntarily, this risk premium should be sold. We will have many opportunities to revisit this issue in the coming months, but it is better to start thinking about portfolio positioning now.