The US fiscal cliff is coming 8230 but will Obama Congress push America over the edge

You are going to hear much more about the US fiscal cliff over the next two months. The fiscal cliff and subsequent bi-partisan talks will play a significant role (alongside Chinese monetary policy) in how financial markets trade into the end of the year.

What is the fiscal cliff?
The fiscal cliff refers to the imminent combination of $600bn worth of automatic spending cuts and tax rises that will start to come into effect at the end of the year and is expected to derail US growth as a result, unless President Obama and the Republicans (who maintained their control in the House of Representatives last night), can agree on a deal.

The US economy is currently growing at 2% annually according to most recent data, yet without a successful deal on the table, it is widely recognised that the implementation of spending cuts and tax hikes, most of which are a legacy issue that have been allowed to ‘roll over’, will likely put the US economy into recession.

You will remember in the summer of 2011, when the US economic and political spheres were teetering on the edge as politicians negotiated a temporary lifting of the US debt ceiling. We will undoubtedly start to see politics now start to make an unwelcome return to the financial markets.

So let’s look a little more closely at the issues:

Tax hikes
Income tax cuts made under the George W. Bush era are set to expire, having already been extended temporarily by Obama two years ago. This means that income tax will rise for everyone, with the lowest rate increasing from 10% to 15% and the highest rate increasing from 35% to 39.6%. Obviously a failure to make a deal on this front will immediately impact consumer spending habits and given that consumer spending accounts for roughly 70% of US economic activity, this is a significant issue.

Obama prefers to extend the Bush tax cuts for all individuals unless you earn over $200,000 a year or are part of a family which earns over $250,000 a year. They would still see their tax rates increased to cover the shortfall.

This is likely to be a hugely difficult issue to overcome. The Republicans, battered and bruised by Romney’s defeat to Obama upon which tax and jobs played a significant role in his election manifesto, are not going to roll over easily for President Obama here.

There are also a number of other tax issues that are a point of indifference between the Democrats and Republicans.

Cuts on capital gains tax (CGT) and dividends (another George W. Bush decision) will also expire this year. As a result, CGT will increase from 15% to 20% for the majority of US earners whilst the lower end of tax payers will have to pay 10% CGT, having grown accustomed to paying no tax at all on capital gained.

Dividend tax rates will also align themselves with the new rate of income tax. Again, as with income tax hikes, Obama only wants this to impact the top earners and is willing to negotiate to a 15% rate for most individuals but aligning the tax rate on dividends to that of income tax for those earning more than $200,000.

Aligned to the above, you also have additional tax charges for highest earners that will contribute to healthcare (3.8%). There are also several tax breaks for businesses or entrepreneurs which have expired or will expire that needs to be addressed.

Budgets and spending
The deal that helped to raise the US debt ceiling and prevent a shutdown of the US government meant that automatic spending cuts worth $1.2tn would come in automatically if Congress and Obama fail to reach an agreement on reducing the deficit by the start of 2013. And, lest we forget, the US is likely to breach the debt ceiling of $16.4 tn later this year too.

How will the market react?
We can expect volatility of course as investors react in their typical knee jerk ways to political opinions and rhetoric from both the House and President Obama.

Prepare for Ratings Agencies to become more vocal again
Consider the fact that we have not really heard anything from Ratings Agencies towards the US for quite some time. Remember that the S&P downgraded the US last summer at the height of the debt ceiling negotiations but the other major agencies did not follow suit.

Fitch Ratings recently warned that they could downgrade the US unless they address the tax hikes, spending cuts and debt ceiling. Moody’s are on the case too, warning in September that they would also cut the US credit rating if an agreement is not forthcoming between the two parties. If talks go down to the wire and political posturing becomes a common theme – as it likely will – the negotiations could well come at a premium to the markets and the US dollar.

Optimist or Pessimist?
It really does, however, depend on whether you sit in the optimist or pessimist camps. The optimist in me thinks that politicians, now safe in their seats and no longer fighting for re-election, may be somewhat more forthcoming. That alongside the fact that the President is at his most powerful for the first 90 days of office (somewhat less so for incumbents). Perhaps there may be more progress to be made in talks this year? Certainly a key undertone to talks last year was the fact that all parties wanted to save face given that Congressional and Presidential elections were a year away. That is not the issue this time around.

That said, the pessimist in me fears that politicians, who are licking their wounds from election defeat, will maintain a strong hand in negotiations, particularly given that this is an immediate opportunity for the Republicans manifesto to become reality now that the have failed to take back the White House.

Bernanke provides the Stop Loss | Double Dollar Impact
Of course, there is a fairly decent stop loss called the Federal Reserve. Bernanke’s position has been strengthened by Obama’s victory and should US growth start to fall back, this will ultimately keep unemployment high and give Bernanke extra juice to increase asset purchases further. This will impact the price of gold, US dollar primarily and also equities.

A failure of talks could give a double negative impact on the US dollar as it enforces more easing from the Fed and is likely to trigger moves by Ratings Agencies towards cutting the US credit rating. However, successful talks would likely be a double positive for the greenback as US growth could maintain (to a degree), whilst ratings agencies may not move to cut their US ratings and Bernanke is unlikely to be forceed into additional and elongated asset purchases.

So wherever you are watching developments from, be prepared to hear about the fiscal cliff progressively from now on.