Waiting for certainty

December 11, 2012

Click here for a downloadable version (PDF)

Markets are riveted as Democrats and Republicans negotiate to avoid the fiscal cliff—the damaging mix of tax hikes and spending cuts that will kick in at year end if an agreement is not reached and that could send the U.S. economy into recession. But according to Timothy Hopper, managing director and chief economist at TIAA-CREF, some harm to the economy is now inevitable—and, indeed, has already occurred. Until politicians in Washington, D.C., give the nation more certainty about tax, spending and regulatory policies, the damage to the economy will continue to mount.

How important is the December 31 fiscal cliff deadline?

It’s important from a tax perspective. Tax increases will affect everyone across the board. We’re not just talking about Bush-era tax cuts and Clinton-era tax rates. There’s also the alternative minimum tax, which is set to be applied to millions more taxpayers in 2013, and the holiday on the payroll tax that funds Social Security, which was reduced in 2011 and is scheduled to rise next year. As a result of this enormous impact, the reality is that the fiscal cliff is already here. It’s not December 31. It’s now. It was yesterday. It was two months ago. There is a tremendous uncertainty that leads consumers and companies to pull back. That can’t be stressed enough.

Article Highlights

  • The uncertainty around the looming fiscal cliff has already caused consumers, businesses, and investors to slow spending and inhibit growth.
  • It’s unclear what asset classes could benefit if equity investors pull back from traditionally defensive stocks, which pay dividends.
  • Accelerated dividend payments are draining capital from corporations.
  • Although the fiscal cliff is causing uncertainty, what is most important for investors is to focus on the long term.

Have investors pulled back as well?

Many observers believe that the selloff in equities we saw at the end of October and beginning of November related to the broader market’s worry that the fiscal cliff is looming. The selloff priced in the belief that an agreement may not happen. But whether it’s completely priced in is very difficult to call. There are a few trading days after Christmas and before New Year’s, and we could see some heightened volatility in that period if it looks like there will be no deal.

Are there asset classes that might be considered safe havens, which could benefit from the uncertainty?

You would think that money would flow into traditionally defensive stock categories. The problem is that defensive stocks pay dividends and dividend tax rates are one of the big tax uncertainties. Without an agreement, dividend tax rates will go from 15% to as high as 43.4%. So the question is: Are investors going to behave in a traditional fashion? We’re in uncharted territory here.

In fact, haven’t many of these defensive stocks announced that they are paying out special dividends in advance of potential new tax rates?

That’s correct. They’re accelerating dividend payments this year, which will actually have a negative effect on the economy in 2013 even if Congress reaches an agreement soon. These accelerating dividend payments are sucking capital out of companies—capital that they could use efficiently to grow their businesses. They’re putting that money in the pockets of people, who are probably not going to reinvest in equity markets very quickly. As a result, the growth rate of the economy is going to suffer. That’s what I mean when I say the fiscal cliff has already arrived.

In what other ways are we already experiencing the fiscal cliff?

Even though we’ve not hit the December 31 deadline, companies in America are acting as if we have or are going to. They’re dragging down growth by becoming more conservative, slowing down activity, and generally not making long-term capital investment decisions until they know the tax rate they’re going to pay. So there has already been some damage, and there is more with every passing day.

So the uncertainty around the fiscal cliff is almost as bad as the event itself on December 31.

We have no certainty around spending policy, no certainty around tax policy or regulatory policy. Consumers and business people want and need certainty. The day a deal is finally announced, there will be volatility and then some transition as the markets evaluate the deal. But what’s more important, looking long-term, is that the deal, whatever its specifics, leads to less uncertainty. As long as a deal creates more clarity, that will likely provide some stability for markets going forward.

So investors need to keep thinking long-term?

Yes. As a rule, it’s best not to be hyper-focused on short-term events. Investors who are overly focused on the short term are prone to making decisions that take recent events into account, but may introduce new risk into a portfolio. A long-term focus is more likely to lead to stronger returns in the long run.