Notes from the USA – a guest post

President Obama’s re-election race, which was widely expected to be a closely fought one, ended up being a no-contest. May be hurricane ‘Sandy’, and the President’s response to it, helped his cause. May be the electronic media overhyped the closeness of the race to gather more eyeballs. Whatever may be the reason, the uncertainty of who will be the next President is over.

Stock markets in US and Europe were expected to celebrate the re-election because of the ‘known Devil’ syndrome. Instead they have fallen into a deep funk. Why? It is partly due to the ‘sell-on-news’ strategy adopted by traders. But also because of the impending US ‘Fiscal Cliff’.

Not sure what the US ‘Fiscal Cliff’ is? KKP’s guest post explains the importance of the ‘Fiscal Cliff’, and why all investors should remain cautious till that enormous cliff is negotiated.

-----------------------------------------------------------------------------------------------------------------------------------------

Is Humpty Ready to Roll Down from the Enormous US ‘Fiscal Cliff’?

Christmas lights are on, and Christmas carols are being played in stores……the mood is very festive and people are in a shopping mood thinking about the gifts they want to buy for their loved ones, extended family and friends. While all of this is going on in the minds of the consumer, the Congress and Senate have four weeks until Christmas and their leaders and the president are expecting a deal to be sealed before then. Optimists are shooting for a framework which sets future debt-reduction targets, with detailed tax and spending changes to be approved next year but possibly some initial savings enacted immediately. Absent action by lawmakers and President Barack Obama, roughly $600 billion in tax increases and spending cuts will start to hit households and companies in early January.

The United States is on course to slash its budget deficit nearly in half next year. Closing the gap that quickly is precisely what the Washingtonians refer to as going over a ‘fiscal cliff’. Dropping the deficits is good news on the other side of the cliff, but will guarantee triggering a recession which is where we would see the world economies (humpty) being pushed down the hill from the cliff!!!!! The sign is as clear as the one below, but what is being done about it today? Politicians who are already well-off themselves, and have a job and pension for life, are just talking about it…

Obama and top lawmakers are working hard to push Congress and Senate to produce an agreement that takes a serious bite out of the government's growing $16 trillion pile of debt and puts it on a true downward trajectory. Although like previous times, they might not reach any conclusions initially. If so, it might just get us to an accord heading off massive tax increases and spending cuts that begin to bite in January - that's the massive ‘fiscal cliff’ that everyone is talking/worried about. It is a series of cuts designed in the Bush era (prior to Obama’s election) that happens to have an ending date of Dec 31^st, 2012. Unless re-enacted, these cuts expire and take a big bite from consumers and businesses. But at the same time, a huge amount of revenue is added to the budget if the Bush tax cuts expire. That would reduce the deficit significantly. The same goes for the cuts in domestic spending, including defense, that are part of the ‘fiscal cliff’. Those cuts would also substantially trim projected deficits for years to come, and this is what some of the politicians are drooling about!

“The U.S. fiscal cliff is deeper than advertised,” said PIMCO’s Gross, whose firm oversees $1.9 trillion, in a tweet. “It’s a Grand Canyon. Washington will defer entitlement cuts and raise revenues only marginally.”

O’Neill, chairman of Goldman Sachs Asset Management, warned clients in a note that market momentum was quickly turning down on fears of policy gridlock, unless something is done quickly. “The world and the U.S.’s own people need Washington, D.C. to be sensible,” wrote O’Neill. “We had a rehearsal of life without a fiscal package in August 2011, and it wasn’t very pleasant.”

• Treasury Doesn’t Collect More Taxes — Should we cross the fiscal cliff, income tax rates that were initially lowered by George W. Bush would reset to levels not seen since 2001. A family with a household income of $72,000 would owe a top marginal rate of 28 percent instead of the current 15 percent. Most Americans pay their taxes by having a pre-determined sum withheld from their paychecks, and with a no-decision or delayed decision, employees will have to change their withholding and get smaller paychecks. Now, everyone knows what happens with smaller paychecks.
• Spend Now, Cut Later — Congress approves agency budgets, but the White House often decides how to “apportion” money over the course of the year. Budget office does not have to instantly demand that agencies meet the combined $109 billion worth of cuts to Defense and domestic programs next year. Obama could fund some agencies at their current levels, while planning for later cuts that—if a deal is reached—might never be needed.

In short, there is a lot at stake with this ‘Fiscal Cliff’ that we have been talking/hearing about for the last 4-12 months. According to Mohamed El-Erian, CEO of the world’s largest bond fund, PIMCO, (who I respect a lot including his boss Bill Gross and listen to everything both of them have to say):

"We would contract our GDP by 1 to 2 percent. Our unemployment rate -- stuck at 7.9 percent -- would go up to at least 9 percent. Our long-term unemployed, currently 41 percent of the unemployed, would be unemployed for even longer resulting in greater atrophy. Our youth unemployment, we have 24 percent of 16-19 year olds out of jobs, would go up. And at that age, if you are unemployed for a while, you become unemployable -- meaning a lost generation.”

So, I agree that it is not a risk that US based Washington politicians should be taking very lightly and trying to make decision under duress and in ‘overtime mode’ (past deadlines). All of the past issues of raising debt limits, increase in the pool of credit for banks ($700Bn), and the $40Bn per month Quantitative Easing (#3) are all perfect examples of quick, broad-brushed decisions. We have a debt problem that is so huge that it is not something that can and should be solved with such blunt instruments that have a broad and indiscriminate effect on a variety of economic fronts (without specific targets).

Mohamed El-Erian’s recommendation is that we need to have serious adults craft a serious and balanced plan for the next decade that will give markets confidence that we can bring our debt under control -- and that will give Americans confidence that we're doing so in a fair way.

Solutions to such long term problems that will impact every American -- and people all over the world -- should not be crafted in a matter of hours or days. Politicians in Washington need to think about the big picture, and not solve our long-term debt problem like a student cramming for an exam he/she is not prepared for. This will get you past the current course and exam to be called a literate, but are you educated to make a career out of your learning?

You decide how to invest based on this short and long term issue that US and EU governments ponder upon every 2-3 months. Caution is the word since all of our investing today comes with a huge amount of volatility that is unknown from one day or week to another. Invest wisely, carefully and for the long haul. Trust nothing and be ready for a new tomorrow, everyday.

-----------------------------------------------------------------------------------------------------------------------------------------

KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.