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Jumping off the fiscal cliff

Emile Wallace-Waddell
Wednesday, December 05, 2012

AS the clock ticks closer and closer to December 31, 2012, the looming "fiscal cliff" draws nearer and nearer to investors and the American population on a whole, creating a worrisome economic environment. The term fiscal cliff was made popular by US Federal Reserve Chairman Ben Bernanke in his remarks while in the presence of Congress, and the terminology refers to a large number of expiring tax cuts and extensive government spending cuts which could possibly push the US into a recessionary period. Of note, the expiring tax cuts

and mandated spending reductions are worth approximately US$600 billion.

At the centre of the fiscal cliff are the tax cuts that were implemented by former President George W Bush in years 2001 and 2003, among others. These benefits include a lower tax rate and a reduced tax on capital gains and dividends. These Bush-era cuts along with the others are set to expire at the end of 2012 and have sparked deliberation in Washington over the budget and the economy between the Obama administration and Congress, in an effort to mitigate the effects of the fiscal cliff. There are some particular routes that Congress and the White House can take to address the impending situation.

Firstly, they can let the current policy scheduled for the beginning of 2013, which features a number of tax increases and spending cuts that are expected to weigh heavily on growth and possibly drive the economy back into a recession, go into effect. The result will be lower real income for citizens to spend which translates into less disposable income. With the population holding less money for expenditure, there will be reduced production due to the lack of demand.

In a situation like this, the economy would contract, reducing the country's growth prospects for 2013. Additionally, the labour market would suffer a similar set back, resulting in an upward push on the current 7.9 per cent unemployment rate. Despite the obvious effects of this contractionary fiscal policy, there is a bright side to the fiscal cliff. Though it may be a bit of "bitter medicine", the fiscal cliff could result in a reduction of the country's US$16-trillion debt. It would be a burdensome journey, but one with a very beneficial destination. It is believed that in the long run, going over the fiscal cliff will have beneficial repercussions for the country.

Secondly, the team could also approach the situation by opting for a path that would address the budget issues to a lesser extent; essentially having a smaller impact on growth.

Value investor James O'Shaughnessy's financial firm, O'Shaughnessy Asset Management, carried out a recent study weighing the advantages and disadvantages that arise from going over the cliff. Based on historical data, his firm purported that high or increasing tax rates have had a miniscule impact on the stock market. The study also alleged that dividend-yielding companies performed better when taxes were at their highest.

Despite the research done, the general sentiment is that the fiscal cliff is a bad thing, (I've never known of going over a cliff to ever be a good thing). With this in mind, what can investors do to protect their investments from the possible dangers presented, or better yet, capitalise on the effects of going over the cliff?

To answer the former, one can also avert the possible side effects of the fiscal cliff by investing in stocks which have proven their capability to weather financial turmoil. Blue chip stocks such as, Wal-Mart Stores, McDonald's and Pfizer have shown resilience in rough times. Now for the latter; if markets were to go on a pullback, this would present an opportunity for investors to capitalise on stocks that will now be trading at a discount. This gives investors the chance to own more stocks for their expenditure, resulting in the possibility of increased capital gains.

Essentially, the effects of the fiscal cliff all depends on the deal that Congress and the White House reaches. The talks commenced last week and we can only patiently wait to see what decision they will arrive at as the regulators continue to deliberate.

Emile Wallace-Waddell is the Research Administrator at Stocks & Securities Limited and can be contacted via ewallace-waddell@sslinvest.com

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