Fiscal Cliff, Compromise or Confrontation

Almost immediately following the close of Tuesday's election polls, U.S. stock futures went into a tailspin, a signal that investor uncertainty about the outcome of the election had been replaced by growing concerns about the pending fiscal cliff and its impact on the American financial markets and economy. On the day following the election, the Dow fell below 13,000 for the first time in three months.

Leading investment expert and author Reto Gallati has been warning investors about the need to resolve this issue for some time now. Gallati, formerly the head of investments and chief risk officer at Nuveen Investments, notes that the pending expiration of the Bush Tax Cuts and the sequestration process would be a doomsday scenario which can only be averted with strong political will and bipartisanship.

"The negative market reaction following the election was a direct reaction to the changed political landscape and concerns about whether any type of consensus can be reached in timely fashion given the polarized climate in Washington,” said Gallati.

So what are the odds that a newly elected Barack Obama and an ideologically split Congress can reach an agreement? Gallati believes that one of four scenarios may unfold:

  • Congress and the President could agree to punt the issue into 2013 by signing a temporary measure allowing the tax cuts to remain in effect for a temporary period Tax increases would be averted and the spending cuts could be delayed until after the inauguration and a new Congress is elected in 2013.
  • Congress and the President reach an agreement containing a combination of tax increases and spending cuts. In this instance, the core of the fiscal cliff will be avoided and the key issues of the budget cuts will be pushed further out.
  • Congress and the White house fail to reach an agreement and America's economic recovery goes over the cliff.
  • A grand bargain is reached between Congress and the President, in which both political parties agree on a compromise that addresses fiscal issues, spending cuts and taxes.

"Avoiding the fiscal cliff will require the kind of political leadership we haven't seen up until now,” said Gallati. "However, the stakes are too high to fail.  Solving this problem would enable the market to once again focus on fundamentals, and open the door for billions of dollars of investor money sitting on the sidelines to return to the financial markets.”

Gallati believes that the optimal outcome would be scenario four - both parties working together to resolve the fiscal cliff. Obviously the worst outcome would be scenario three - a disagreement over the path and we fall over the cliff. According to his analysis, such a scenario could cost the American economy 4 to 5 % GDP growth and would trigger a recession.

In Gallati's view, the most likely outcome is scenario 2, which is a compromise on modest tax increases and budget cuts to remove the budget deficit partially. It will allow both parties to move to a middle ground and agree on a solution, temporarily. The structural issues behind the budget deficit can then be effectively pushed out to the next generation of politicians, maybe even the next President in 2016.

"Outstanding investment professional. One of the few I have encountered who are able to transition between quantitative and fundamental, both with respect to risk and alpha."