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OVER THE CLIFF…TO NO GROWTH WE GO

With the political environment decided for another two years, we can take some comfort in the age old human adage: “somehow, things never change.” Contrary to either side’s claim to a mandate, the bare and ugly fact remains that our country is evenly split between two opposing political views. The views are so fundamentally opposite that any compromise is hard to imagine. After all, we are not fighting about highway funds, or federal contracts here. The fiscal cliff negotiations are about whether we take a big step into socialism or remain capitalistic and free market oriented. Compromise, therefore, means that one or both sides must abandon basic beliefs and ideologies…highly unlikely. More likely is a “camouflage” compromise, kicking the can down the road toward another Greece.

Further complicating this issue is an emotional like/dislike factor emerging after months of damaging rhetoric from both sides. About the only clear conclusion we can draw from this election is that the majority of American voters dislike the “wealthy” along with those institutions associated with wealth.

It is easy to dislike those who flaunt wealth and exhibit a demeaning attitude toward others, but we must understand that wealth is an essential ingredient of a free economy. Likewise, free economies will always have the “less fortunate,” since men are not created equal. Nevertheless, we can expect policies to be tilted toward the current majority view. We do not see the Administration abandoning the redistributive view that helped win reelection for the Democrats and the Senate majority. Accordingly, the outcome of the fiscal cliff negotiations is likely to contain a negative outlook with respect to growth. The only question remaining to be answered is how negative, and when will it take effect? More importantly, who will be negatively affected and where is the silver lining?

The first and most obvious probability is that there is no middle ground to be found, thus forcing us over the fiscal cliff. Going back to the Clinton tax policies will mean a significant income tax hike for all Americans, virtually guaranteeing a recession next year. Also inherent in the Clinton tax package is a 55% hike in the capital gains tax, a 300% hike in the tax on dividends, and a 66% increase in the estate tax. Combined with these tax hikes is a sequester of Government spending of $1 trillion, mostly coming from Defense and Healthcare. This scenario is distinctly negative toward economic growth, and we give it a 40% probability of happening.

A second scenario would be to have the tax increases only apply to those making $200,000 and above ($250,000 married). The sequester of funds will be substituted with lesser spending cuts. Also imminent is a 25% increase in the inheritance tax. Since this is the President’s opening plan, we doubt that the Republican House will accept it in its entirety. The scenario resulting from this plan is also decidedly negative, but less so than the first scenario. We assign a low probability to its being accepted prior to December 31. After the new year passes, however, it is quite likely, as Democrats will present Republicans with a tax cut for those earning less than $250,000 along with a somewhat lower estate tax. After all, when have Republicans refused to sign a tax cut bill? In other words, the President’s proposal is more likely after going over the cliff. A combination of scenario one followed by scenario two next year is the most likely with a 50% probability.

An agreement to extend the fiscal cliff deadline for 3-6 months pending a more thorough overhaul of the tax code and spending plans is also a real probability. The excuse to do so will be the “lame duck” nature of the present decision makers. We frankly think this agreement is quite likely. It will probably come with a moderate lifting of the debt ceiling. We would expect a short term market rally to accompany this outcome. We assign a 40% probability to kicking this can down the road.

Lastly, there is always a chance that an agreement can be made, incorporating a higher threshold for the “wealthy”, i.e., $400,000 of income. We might also expect a lower corporate tax rate as a “throw in”, along with some foreign earnings tax to placate the President’s wishes. With such an agreement, we could also see a loss of tax deductions to offset income exceeding a certain level. Economic effects under this example will initially vary, with some losers and some winners. Because there are so many complexities involved with this scenario, we assign a low probably of such a compromise before Christmas.

As you can see, the various possibilities are all somewhat negative. Moreover, they point to a Federal Reserve Board that will continue to print money in an attempt to “reflate” the flattening economic tire. This reflation will come at a cost, however, and we need to put plans in place to protect clients’ wealth in the event of a dollar collapse.

The cost of massive reflation efforts is an inevitable devaluation of the dollar. Because of the dollar’s role as the reserve currency, however, this devaluation could be gradual and hidden from view as other currencies go “bust” first. For these countries playing the reflation game, it is a “race to the bottom,” and we probably will be among the last to hit bottom. Japan and France will likely drop before we do, but either failure will be a big negative for the stock market.

Because the world is becoming “dicier,” our search for ideal investments must now exclude companies with earnings vulnerability to weak foreign markets, as well as vulnerability to our own credit markets and increasing government regulation and control. This doesn’t leave us with a large sample to pick from insofar as long term investments are concerned. But there are companies, many of them small, which posses those special qualities that will allow them to grow in a negative or stagnant environment. We continue to hunt for these types of investments.

Additionally, we expect increasing volatility in markets as investors become pinched, or trapped in areas of the market that fall prey to the increasingly heavy hand of government control or regulation, forcing them to jump elsewhere in search of the “magic formula.” To the extent that we can anticipate these moves, there is money to be made. We hope to be able to capture these opportunities to enhance your rates of return.

The world has changed, but we are now dealing with fewer variables. This is a welcome respite from the very indefinite world that we have been forced to work in. Our confidence is high and we look forward to the many opportunities that lie ahead. To put it simply, when investors eventually identify and focus on the bright spots, there will be large upward moves in the chosen few as most of the money ends up chasing a few good ideas. We plan to be there first!

Best wishes for a healthy and happy holiday season.

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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