A decision without resolution

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The long-awaited deal on the fiscal cliff was announced late in the evening on Jan. 1, averting the worst of the scheduled increases for taxpayers. Markets around the world responded positively, indicating relief that the crippling uncertainty had come to an end. But that rally is already slowing, as the deal’s failure to resolve issues around U.S. government spending has simply pushed the debate further into the future: Already, politicians are gearing up for the next round of discussion over the U.S. debt ceiling. Timothy Hopper, managing director and chief economist at TIAA-CREF, offers his perspective on opportunities for investors, the U.S. economic outlook, and the possibility of a downgrade in the U.S. debt rating if lawmakers cannot reach a timely compromise on the debt ceiling.

Your last update noted that the specifics of any deal would be less important than its ability to provide certainty for investors, businesses, and consumers. Does the American Taxpayer Relief Act announced on Jan. 1 accomplish that goal?

It offers some clarity, but it has also left a lot of open-ended questions. There were essentially six areas that the fiscal cliff deal needed to address, and it only covered five.

First, the current policy on marginal tax rates was permanently extended, up to a limit of $400,000 for individuals and $450,000 for married couples filing jointly. Other tax policy changes included an increase in taxes on capital gains and dividends/interest from investments, from 15% to 20% for this group; a permanent extension of current policy on estate taxes, with a $5 million exemption indexed for inflation and a 40% top rate; and the expiration of the two-year holiday on Social Security payroll taxes, which increases taxpayers’ obligation from 4.2% to 6.2% on the first $113,700 of earned income.

Second, the alternative minimum tax was permanently indexed to the inflation rate, with a 2012 exemption amount of $50,600 for individuals and $78,750 for married couples filing jointly.

Third, unemployment insurance benefits were extended for another year.

Fourth, the deal extends the so-called “doc fix” for another year, blocking a 26.5% cut in Medicare payments to doctors.

Fifth, the tax increases proposed in the Affordable Care Act 2010—commonly known as healthcare reform or “Obamacare”—will be implemented.

But the issue that the fiscal cliff deal leaves unresolved is that of budget sequestration, which represents the bulk of the spending cuts. And, of course, the fiscal cliff deal has not addressed the debt ceiling. We fully expect just as much political wrangling over these two issues in the coming weeks as we've seen with the fiscal cliff.

Essentially, the deal did not offer as much certainty as we would have liked, but it was about as much as we expected.

What will these measures—those that have been resolved and those that are still outstanding—mean for the U.S. economy in 2013?

Before the deal was announced, we had estimated 2.5% annualized average growth through 2013—with growth a little weaker in the first part of the year and picking up as the year progressed. Growth will still follow that trajectory, but we are now projecting closer to 2% than 2.5%. And, of course, we still don’t know what will happen in terms of the budget sequestration. Any additional cut in expenditures could cause more fiscal drag and slow growth further.

What has been the market reaction to the news?

There was an initial rally—not just in the U.S. but around the world—simply due to the fact that a deal has been reached, and that it is beginning to address the short-term problems in a way that won’t put too much drag on the economy in the immediate future. We expect that markets will remain upbeat in the near term.

But there are no long-term solutions on the table, and the deal adds roughly $4 trillion to the federal debt over a 10-year period. That is going to lead to considerable acrimony in Washington over the debt ceiling over the next few months, which brings us back to the same level of uncertainty that we were experiencing before the deal was announced.

Can the U.S. expect the same level of scrutiny from ratings agencies that we saw in August 2011, when Congress last clashed over the debt ceiling?

The ratings agencies have already indicated that they don’t want to see another intractable debate over the debt ceiling. The risk is that Congress will once again take us right up to or past the stated deadline. If the ratings agencies again perceive that policymakers are grandstanding to make political points rather than seeking credible solutions to solving our long-term debt problems, there could be negative repercussions for the nation’s credit rating.

How should investors be thinking about opportunities in this environment?

Equities should be the big winner in this picture, since the economy is now likely to grow faster than it might have had we gone over the fiscal cliff. The economy is still somewhat weak, but we’re not looking at a recession in the short term.

We can also expect continued low interest rates, at least in 2013 and into next year. That will be good news for dividend-paying stocks, which money managers use to create an income stream for investors in a low-interest-rate environment. Investors’ wariness of these equities may abate now that taxes on dividends have been capped at 20% (for individuals who earn more than $400,000 per year or married couples who earn more than $450,000), rather than the 43.4% rate that was on the table at one point.

Any guidance for investors as Washington begins the next round of debate over sequestration and the debt ceiling?

Given the uncertainty around those discussions, the best thing investors can do is avoid getting caught up in these short-term events. They should stay focused on the long term and ensure that they rebalance their portfolios to stay aligned with their tolerance for risk.