Fiscal cliff outcome may surprise
A lame-duck deal on Washington's debt ceiling is still the most likely scenario, but US election results have boosted the chances of extreme developments.
We wrote recently that our base case for a fiscal cliff resolution – regardless of the election outcome – was a short-term, "mini” deal that largely kicked the can down the road on the majority of the key items. While this remains our base case, we can afford to have a more nuanced view now that the election outcome is known, including our opinion that there is now a greater likelihood of so-called tail events related to the fiscal cliff resolution, which will have implications for markets and for our positioning.
Our base case: still the most likely scenario
We have long maintained that Congress and the president – irrespective of the election outcome – would find a way to largely avert the fiscal cliff in a lame-duck mini deal that would reflect about 1.5 per cent of GDP in fiscal contraction in 2013 (versus the near 5 per cent of GDP in contraction that would take place if they did nothing). We continue to believe that this is the most likely scenario – our base case – considering the individual provisions that comprise the fiscal cliff; specifically, there is significantly more agreement than disagreement among Democrats and Republicans on everything from extending the Bush tax cuts for the middle class to letting the payroll tax cut expire, not to mention a long history of similar "kicking the can down the road” agreements hammered out in past lame-duck sessions (remember the Bush-era tax cut extension of December 2010).
Now that the election outcomes are known, with a largely status quo Congress and Administration, we think there will likely be a deal not only on those issues of agreement, but also some sort of compromise on the handful of outstanding fiscal cliff issues that looked more intractable before the election – notably, the Bush tax cuts for the upper income earners and sequestration, the across-the-board spending cuts agreed to as part of the debt ceiling resolution in summer 2011. In addition, we believe that coupled with a mini deal, there will likely be a commitment or (optimistically) a process established for broader structural reform in 2013.
But while we believe the above scenario remains the most likely one, we also believe the tails – the chances for the more extreme outcomes – remain consequential following the status quo election.
The increased left tail: inaction
Although we long believed that letting the economy "go off the cliff” was a possibility, we believe that the probability of this – while still unlikely – is higher after the election than it was before. Why? Because without a meaningful shift in the composition in either chamber of Congress and the White House, the players who are negotiating the fiscal cliff deal are largely the same ones who have come close to driving our country to the brink in other, similar negotiations – whether in April 2011 when the government almost shut down over budget issues or in summer 2011 when the country came close to defaulting on its debt because of a lack of willingness to compromise on the debt ceiling. Unfortunately, the dynamics of polarisation and partisanship that played a role in these past dysfunctional negotiations still exist and may have gotten worse after the recent election in the House of Representatives, where the Tea Party insurgency still holds and there are fewer moderate members within both parties.
The wider right tail: a grand bargain
On a more optimistic note, we also think that the "right tail” possibility of a positive outcome of a fiscal cliff resolution has increased after the election. Why? It is widely known that second-term presidents are largely interested in their legacies – spearheading noteworthy, bipartisan and lasting accomplishments for the history books.
This was the case for President Reagan, who in 1986 helped to push through landmark tax reform; it was also true for President Clinton, who worked with a Republican Congress in his second term to pass balanced budget legislation and children’s health insurance reform. Today, there is broad agreement that the country’s fiscal path is untenable. Since the fiscal cliff forces many of these issues, one could easily see President Obama staking his legacy here and pushing for a "grand bargain” in short order to address the short-term needs of the fiscal cliff and the longer-term issues of our unsustainable debt burden.
Of course, whether Congress will cooperate with the president under this scenario is the big if; and recent history is far from reassuring on this. But this is not all bad news either. The partisan dynamics in the House notwithstanding, there is arguably a larger coalition of moderate members in the Senate than before the election who just won very close races. There are also many senators who are looking at very close senate races in the 2014 election and may be more inclined to compromise than before. If there is broad coalition between the president and the Senate, you could easily see the House having to relent to a larger deal, especially if the president dangles the carrot of future corporate tax reform in front of them.
What are the investment implications?
Thus far we have essentially laid out three extremely divergent, yet possible paths for the resolution of the fiscal cliff – our base case of a mini bargain or, if you are less charitable to our politicians, a 'kick the can' deal that entails 1.5 per cent of fiscal contraction in 2013 without meaningful long-term reform; a left tail outcome that entails paralysis and economic malaise; and a right tail outcome that surprises the market with compromise from both sides of the aisle. In other words, we do not know with a very high degree of confidence what the future holds and investors need to be conscious of the full range of potential scenarios.
In many ways, handicapping the fiscal cliff would have been much easier had there been a Republican sweep of the White House, Senate and House of Representatives. In this environment, it would have been unlikely that a Republican driver would have driven a car with two Republican passengers off of a cliff. It would have also been unlikely that the resolution would have been a balanced approach that included both spending cuts and revenue increases. Given the actual election outcome, though, we are left with a complicated situation where the outcome is compromise, collapse, or continuance of the same short-sighted approaches used to tackle previous fiscal stand-offs.
How do we think investors should position given such a wide distribution of outcomes?
Our base case scenario, the most probable of the outcomes, calls for a defensive approach to risky assets. Fiscal contraction of 1.5 per cent of GDP is a significant drag, considering that the economy is currently only growing at a 2.0 per cent annualised rate. This contraction more than erases the expected boost to growth from an improving housing market and mutes the impact of policy accommodation from the Federal Reserve.
Furthermore, while our base case of a short-term deal addresses the immediacy of the massive fiscal cliff, it does so in a manner that delays the inevitable confrontation with unsustainable debt dynamics. Uncertainty is not removed, it is simply prolonged – again suggesting a continuation of economic sluggishness as business leaders remain timid about investing and hiring with such an uncertain future.
Additionally, a short-term deal, even if coupled with a promise or process for future reform, does little to tackle the fundamental issue that the expected paths for tax revenues and for entitlement spending just do not harmonise. Investors should continue to favour those trades that may benefit from the dichotomy between extremely proactive monetary policy and chronically irresponsible fiscal policy. These include Treasury curve steepeners, underweight US dollar positions, and overweight commodities, TIPS and other real assets.
Finally, investors need to be conscious of how their portfolios may perform not just in the most likely scenario, but also in the tail scenarios.
Typically, we spend much of our time fixated on the left tail outcomes. However, despite the fact that we view each of the fiscal tails as having a similar probability of materialising, this is one of the several instances where particular attention needs to be paid to the right tail. Our defensive portfolio described above, coupled with our view that monetary accommodation would continue to serve as a policy backstop to asset price declines (aka "The Bernanke Put”), leaves us well positioned to weather the left tail outcome. However, it is the right tail outcome of a credible grand bargain with a meaningful trigger that will likely be a much greater surprise to a market that has become conditioned to gridlock in Washington.
Investors, including ourselves, have been preparing for the possibility of a fiscal cliff for months. It is the grand bargain that will catch the market most off guard. The reduction of uncertainty that accompanies a grand bargain, along with the massive liquidity provided by the Fed, the housing market which is finally showing a pulse, and the excess idle cash just resting on the sidelines all provide for a potentially intoxicating risk-on cocktail if Washington finds a way to surpass low expectations. Considering the relatively low level of volatility, particularly for out-of-the-money calls, this right tail can be hedged against relatively inexpensively via the equity volatility market.
In the end, while the election outcomes have not changed our base case outlook for the partial resolution of the fiscal cliff, it has made the likelihood of the so-called tail events higher. Investors should tighten their seat belts and prepare for an especially volatile few months ahead.
Libby Cantrill is a senior vice president based in New York. Josh Thimons is an executive vice president and portfolio manager at Pimco's Newport Beach office. © Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.