The “Fiscal Cliff” is the popular term used to describe the conundrum that we face at the end of this year when the terms of the Budget Control Act of 2011 are scheduled to go into effect. This Act’s combination of higher taxes and spending cuts would have a dramatic effect on the economy and the market. This dilemma was created in August 2011 during the budget deal when tough decisions about revenue and spending were postponed until after the recent election because neither side wanted to jeopardize their chances in the election.

We believe now is the time to fix our long-term structural problems with spending. Why? Because with this lame duck Congress, many lawmakers can concentrate on taking action that is in the country’s best interest as opposed to what is in the best interests of their re-election campaign. Distilled to its essence, there are three choices: 1) reach a deal that raises some taxes, but makes fundamental changes to our entitlement programs – Medicare, Medicaid and Social Security (i.e., the Simpson/Bowles debt commission recommendation); 2) kick the can down the road further by extending the Bush tax cuts temporarily with no spending cuts and agree to deal with the issues after the new Congress has been sworn in; or 3) go over the Fiscal Cliff.

Here are what we believe to be the ramifications of each scenario:

1) Reach a long-term deal – best case scenario. Both sides must compromise. Republicans must accept some level of higher taxes on the “wealthy” and the Democrats must agree to long-term structural reforms that reduce future obligations for Medicare, Medicaid and Social Security. If spending for these programs is not reduced, it is not a question of “will we go bankrupt,” but “how soon will we go bankrupt.” This is not a red or blue issue, but a United States issue. Studies have shown that raising taxes above a certain level does not increase revenue and could well mean lower revenue. The Laffer curve demonstrates this point – this link is the best explanation we have seen on this subject. To date, several Republicans have come out and said they are willing to consider an increase in taxes on the wealthy. We are encouraged that they will only do this if there are spending reductions to entitlement programs. A problem so far is that only a few Democrats have publicly said they are willing to put entitlements on the table. For example, Dick Durbin – #2 Democrat in the Senate – has indicated he does not want entitlements to be on the table during Fiscal Cliff negotiations. He wants to create a commission that recommends changes to the entitlement programs a year from now. With an election eleven months after such a report would be complete, there is a strong chance that no action would get taken. What politician in their right mind would vote for entitlement reform so close to an election? This is a time in history when President Obama and John Boehner need to show leadership and convince members of their own parties to give in for the good of the country.

2) Kick the can down the road – worst case scenario. If the Bush tax cuts are extended and spending cuts delayed until a later date, uncertainty will continue to reign. As we know from how the market has been reacting recently, this is not a good situation.

3) Go over the Fiscal Cliff – middle of the road scenario. Although raising taxes and implementing spending cuts in this economic environment would cause short-term pain, the spending cuts would be good for the long-term financial stability of the country.

At the present time, none of us know what the outcome of these negotiations will be. We wish we did. It can be argued that in re-electing President Obama, America has said it is time to tax the wealthy. At the same time, it can be said that America re-elected a Republican controlled House of Representatives to ensure fiscal stability – the House is responsible for Federal government spending. Neither party was given a mandate. Both parties need to compromise to reach an agreement that is in the best interests of our country – not necessarily the best interests of their re-election campaigns. Difficult decisions can, and have been made during lame duck sessions of Congress. The new movie “Lincoln” is the story of how President Lincoln and leaders in the House of Representatives passed the 13th amendment to the Constitution – the one that abolished slavery – during a lame duck session. Another great movie on political courage is “Amazing Grace,” which tells Britain’s story of how it abolished slavery. The outcome of this debate will have a long-lasting effect on America’s future and we hope that our leaders demonstrate political courage to do what is needed.

Market Implications

There is uncertainty regarding the outcome of this debate. Frankly, the debate itself is causing uncertainty. In the past few days, the stock market has risen when a lawmaker has said something encouraging and has fallen when a lawmaker has said something discouraging. Add to this the pesky debt ceiling debate that will rear its ugly head shortly as the Federal government runs out of money during the last week of December. There is great concern that one or both political parties will use this time to wreak havoc in the market to get what they want. Keep in mind that it was only four short years ago that Rahm Emanuel said “you never want a serious crisis to go to waste” during the stimulus debate.

If the can gets kicked down the road further or if we go over the Fiscal Cliff, fear will hit the financial markets and the stock market will fall. If a deal gets done that does not include entitlement reforms, it will have long-term negative financial consequences and, we believe, cause a sell-off in the stock market. Anyone investing cash in the stock market now is making a bet. May we suggest a trip to Vegas instead? At least there you get free drinks when you gamble.

Sincerely,

Your THOR Team