Fiscal cliff? Taxmegeddon? Either way, the simultaneous expiry of tax provisions and the across-the-board spending cuts (known as sequestration) sounds ominous. And they are. Collectively, these provisions would represent a fiscal tightening of 4%-6% of GDP in 2013 if Congress were to do nothing, more than enough to sink the already fragile U.S. economy into a recession.

Still, when we look at how the fiscal debate is likely to play out, rather than how it should play out, our base case is the fiscal cliff will likely be resolved in a short-term deal before the end of the year, making what was a cliff more like fiscal black diamond – still dangerous, but not likely to land the economy in a body cast. It will still be precarious to navigate and will be essential to positioning portfolios for both alpha generation and risk mitigation, particularly as the process to reach a compromise might not be linear and likely will weigh on markets as we get closer to the end of the year.

What is the fiscal cliff?
The “fiscal cliff” has been defined as many things, but most commonly refers to the following:

- the expiring Bush tax cuts that were put into place in 2001 and 2003 and extended in 2010;

- the expiration of the alternative minimum tax (AMT) patch, a technical necessity since the AMT is not indexed for inflation;

- the lapse of the payroll tax cut, the 2% reduction in employee payroll taxes in place for the past two years;

- the expiration of unemployment benefits;

- the imposition of new taxes from the Affordable Care Act , namely a 0.9% increase in the payroll tax and 3.8% tax on investment income for those making more than $200K/$250K;

- the expiration of a series of business friendly tax provisions, called “tax extenders;”

- the “sequester” or the required spending cuts in defense and non-defense spending;

- and the “doc fix,” another technical budget issue that will reduce physicians’ reimbursements for Medicare patients.

The net impact of all of these provisions? The Congressional Budget Office (CBO) estimates the budgetary impact would be 5.1% of GDP in calendar year (CY) 2013 should the fiscal cliff be fully realized.

Is there hope for compromise?
While recent Congressional inaction and the partisan rhetoric might suggest a compromise on the fiscal cliff before year-end is improbable, a compromise, especially one that is hammered-out after the election, looks less elusive if each element of the fiscal cliff is considered independently. In fact, Republicans and Democrats agree on the vast majority the fiscal cliff elements.

 

 

The biggest area of disagreement, of course, is whether the Bush income tax cuts for those making more than $250,000 should be extended, which is not insignificant (estimated at $55 billion, without consideration for AMT effects, in CY 2013). However, while the Democrats seem particularly dug-in on not extending income tax cuts for high wage earners, they have shown some room for compromise on capital gains and dividend taxes, most recently by sponsoring a plan that sets dividend and cap gains both at 20% for high wage earners (instead of letting dividends revert to ordinary income, or 39.6% for high wage earners).

Similarly, there is clear support from both sides to find a way to address sequestration. The Budget Control Act, the deal that resulted from the 2011 debt ceiling debate imposes $110 billion of cuts in 2013, equally across defense and non-defense programs; this effectively represents an across-the board cut from domestic discretionary spending of 8.5% and most alarmingly, 10% from defense spending for CY 2013. This “sequester” trigger was designed to be unpalatable to Congress – it was intended to induce Congress to find cuts on its own via the Congressional Super Committee. But with the failure of that committee last year, Congress is stuck with their worst-case scenario, which provides incentive on both sides of the aisle to find a way out.

On every other item, there is relatively clear agreement: both sides will support an extension of the AMT patch and the doc fix (as they have for the majority of the last ten years): both will support an extension of the pro-business tax breaks and the new taxes from the Affordable Care Act will likely be enacted. Interestingly, where both parties have disagreed historically – on the issues of the 2% payroll tax cut and unemployment insurance – there now seems to be consensus: neither the White House nor Democrats in Congress seem to be pushing for these provisions to be extended (at least as of now).

How important is the election?
The election is clearly important in many respects, but as it relates to a short-term deal that addresses the components of the fiscal cliff, the potential outcomes for a short-term deal are not all that different under various election scenarios, particularly as a lame duck deal would be handled by the current Congress, not those who will be elected in November and don’t join until January. What the election will determine will be the commitment on all levels of government to enact balanced, structural deficit reform in 2013 and beyond after the short-term issues of the fiscal cliff are addressed.

Our base case
So what does this mean? If history is any guide, each party will wait until the last minute to compromise. Sound familiar? It should.

The lame duck tax deal in 2010, the deal to avert a government shutdown in April 2011, the debt ceiling deal in August 2011 and the February 2012 payroll tax cut deal were all hammered out at the last minute. This suggests the most likely scenario is an eleventh-hour deal that avoids the cliff but still reflects roughly 1.5%-1.7% in fiscal drag from a combination of spending cuts and tax provisions (almost certainly including a lapse in the payroll tax cut, unemployment insurance and some sort of deal on Bush tax cuts and the sequestration). A short-term deal for CY 2013 will likely be accompanied by a promise for future tax reform.

The left tail: inaction
Of course, there is the possibility that partisanship trumps reason and a compromise is not reached by the end of 2012. Similarly, there is the possibility that policymakers deliberately let all of the tax cuts expire on December 31, 2012 and wait until 2013 to address them. In this way, in the new year, lawmakers could claim to be actually cutting taxes rather than just extending current tax cuts. The uncertainty associated with this inaction would weigh heavily on the markets, making it a risky option. Even in this scenario, a resolution that would extend at least some of the tax cuts and tackle at least some of the sequester, not to mention address the other tax provisions, would likely still happen eventually, even though the timing would be unknown.

The right tail: a grand bargain
Discussions of a “grand bargain” – a large-scale compromise that addresses the country’s structural debt and deficit issues in a long-term, balanced manner – still abound on the Hill, and there has been some meaningful work along this front. However, the notion that a grand bargain could be enacted in the six weeks between the election and the end of the year seems highly improbable. While a short-term fix could be accompanied by a promise for a grand bargain down-the-road, we have heard this before, with no result, so we are skeptical.

How to position, given our base case?
In many ways positioning for our expected outcome of the fiscal cliff is more challenging than positioning for one of the more extreme outcomes. A head-first launch off the fiscal cliff would clearly call for a “risk-off” positioning, as the significant fiscal drag in 2013 would, with near certainty, send the U.S. economy spiraling into recession. Equities would likely suffer, credit spreads would widen and long dated Treasuries would benefit from a risk-averse shift of capital from investors. Likewise, positioning for a grand bargain would have clear “risk on” financial market implications. Compromise on long-term entitlement and tax reform, coupled with avoidance of near term and draconian fiscal contraction would provide a boost of confidence both to the markets and business leaders. Equities would likely benefit, animal spirits would be ignited and capital flows would flee the safe haven of Treasuries in search of higher return investments. Furthermore, fiscal reform would lift some of the burden from monetary policymakers, perhaps even allowing for withdrawal of monetary accommodation sooner than the market currently anticipates.

With a base case scenario in the muddled middle, however, we expect fiscal contraction without fiscal catastrophe. While short-term accommodation, without a meaningful long-term accord is messier, we nonetheless see a number of interesting opportunities we are deploying across portfolios.

The yield curve should remain steep
Our forecast indicates that markets, over the short-run, should expect “more of the same” from Washington – that is, just enough compromise to avert disaster but not enough compromise to affect reform: In this environment, business uncertainty remains high as the fiscal cliff of 2012 is simply replaced with the fiscal cliff of 2013. The debt ceiling debate of 2013 simply becomes the debt ceiling debate of 2014. If fiscal agents fail again to affect meaningful reform, and instead keep the pressure on the Federal Reserve to maintain ultra-accommodative policy it is supportive for intermediate Treasuries, as policy makers both directly and indirectly inhibit real economic growth, while monetary policy makers extend their commitment to zero interest rate policy: this suggests expressing a yield curve steepener – that is a portfolio positioned overweight Treasuries with intermediate maturities (i.e., 5 to 10 years), while simultaneously underweight Treasuries with longer-dated maturities (i.e., 30 years).

While “more of the same” from Washington is supportive for intermediate Treasuries, it is much less favorable for longer-term Treasuries. It both delays and deepens the inevitable confrontation the United States must have with its long-term unsustainable debt dynamics. Thus far, the Federal Reserve purchase of Treasuries has helped to keep the bond vigilantes at bay. The relative woes of European peripheral nations have taken the spotlight away from the United States, at least temporarily. However, the dizzying cocktail of a high initial federal debt-to-GDP ratio, annual deficits persistently in excess of 7%, deteriorating demographics and growth prospects, and escalating entitlements and other contingent liabilities inevitably must be addressed. Ultimately, we believe the most likely “way out” entails a dose of inflation and a dose of financial repression. Both antidotes suggest an underweight of longer-dated Treasuries.

In order to “inflate” its way out of debt, the government may tolerate a higher inflation rate in the future

 

 

Supply and demand related tactical Treasury strategies
In this base case the Department of Treasury will need to sell a lot of Treasuries and the Federal Reserve will need to buy a lot. Since the onset of the financial crisis, annual gross Treasury securities issuance has approximately quadrupled in order to accommodate unprecedented fiscal stimulus. With fiscal policymakers now locked in gridlock, the Fed has recently been the only policymaker attempting to stimulate the economy. Part of the Fed’s unconventional policy stimulus has been the purchase of Treasury securities. The Fed’s balance sheet, over the same time period that issuance quadrupled, has essentially tripled in size. And perhaps surprisingly, the buyer of Treasuries (the Fed) does not transact with the seller of Treasuries (the Treasury Department), so as to maintain the perception of central bank independence.

These large supply and demand waves in the Treasury market created by the Federal Reserve and Treasury create opportunities for investors. The opportunities are enhanced by the fact that global banking institutions, both via self-directed deleveraging and increased regulation forced upon them, have decreased in their role as intermediaries. In some of our levered portfolios, we explicitly buy and sell Treasury securities to capture dislocations created by the governmental buyers and sellers. In other portfolios, we use Treasury auctions and Fed buy-backs as liquidity events to more efficiently buy and sell duration at attractive entry and exit points.

Uncertainty creates opportunities in volatility
The uncertainty surrounding the election in November and the state of the fiscal cliff at the end of December create a unique opportunity in the volatility markets. Even in normal years, many volatility markets see heightened volatility in December relative to the first few months of the subsequent year. The common logic behind the seasonality is that December is a time for defensiveness. By December, investors have either had a good year and they are looking to lock in profits or a bad year that is insurmountable and they are looking to just survive into the new year. This defensive behavior creates greater swings in asset markets – investors do not want to step in front of a moving train when they are in defense mode. Since the financial crisis, interest rate markets have seen a 22% higher level of realized daily volatility in December vs. the preceding November and following January. In addition to this traditional seasonal pattern, we expect volatility in the latter part of this year to be particularly intensified – as the election, fiscal cliff and debt ceiling all offer the potential to roil markets. The interest rate markets, however, imply a relatively linear path of volatility throughout the fourth quarter of this year and first quarter of next year. An interest rate option that expires on New Year’s Eve has essentially the same implied volatility as one expiring on Halloween and one expiring on Valentine’s Day. This is an opportunity for levered investors to express a relative value view (owning the New Year’s Eve option vs. the others) or for more traditional investors to purchase tail protection to avoid being short volatility during the potentially volatile months of November and December.

Putting it all together
We have been living in the New Normal environment of slower growth and heightened uncertainty for several years now, and PIMCO’s outlook argues for much of the same going forward. While Congress has undeniably contributed to the uncertainty in the U.S., we are hopeful that it will nevertheless be able to fashion a resolution on the fiscal cliff before the impact of not doing so starts to weigh on markets and overall confidence. In the interim, we believe that the uncertainty in the markets creates meaningful and attractive investment opportunities.