Investment Strategy Group

June 2012

Looking Over the U.S. Fiscal Cliff

Absent congressional intervention prior to year-end, over $600 billion (about 4% of U.S. GDP) of fiscal tightening is scheduled to take effect in the United States in early 2013. Dubbed the fiscal cliff by those in the financial community, the negative impact on growth caused by expiring spending and tax provisions has the potential to derail the ongoing recovery and, according to some observers, even tip the U.S. economy back into recession. The Congressional Budget Office, for example, believes real economic growth will contract at an annual rate of 1.3% for the first half of 2013 if Congress takes no action to prevent the upcoming tax hikes and spending cuts. While the fiscal situation in the United States is different from that of Europe, there is a key similaritythe potential trade-off between putting the country on a sustainable fiscal path and engendering an environment of stronger near-term growth.

Breaking Down the Costs

Under current law, a number of key tax and spending policies that have been enacted and/or extended over the past decade are set to expire on December 31, 2012. The expiration of provisions that have lowered income and payroll tax rates would, at least in theory, boost the federal governments revenues and reduce its budget deficit in 2013. However, the changes would likely also represent a drag on growth, which is cause for concern at this time of global economic uncertainty.
EXPIRATIONS COULD HAVE SERIOUS IMPACT 2013 FISCAL DRAG Changes in Specified Revenue Policies ($ billions) Expiration of income tax and estate and gift tax provisions; indexing the alternative minimum tax for inflation 221 Expiration of the reduction in the employees portion of the payroll tax 95 Other expiring provisions 65 Taxes included in the Affordable Care Act 18 Changes in Specified Spending Policies Automatic enforcement procedures specified in the Budget Control Act 65 Expiration of unemployment benefits 26 Reduction in Medicare's payment rates 11 Other changes in revenues and spending 106 Total Impact of Fiscal Cliff in 2013 607 Source: Congressional Budget Office.

The Investment Strategy Group provides guidance on asset allocation and portfolio strategy in support of Neuberger Bermans clients and investment professionals. Matthew Rubin Director of Investment Strategy Ing-Chea Ang Vice President Justin Gaines Associate

Credit Worries and Politics

If the fiscal restraint measures are eliminated in 2013 without imposing comparable restraints in future years, this could potentially jeopardize the U.S. credit rating.

Two issues complicate any decision to remove or offset part or all of the policies that are scheduled to take effect in 2013. First, the rating agencies have said that the current U.S. credit ratings are based on the expectation that the automatic spending cuts will not be reduced. In their view, reducing or removing these cuts calls into question U.S. policymakers commitment to reining in debt and managing the budget. If the fiscal restraint measures are eliminated in 2013 without imposing comparable restraints in future years, this could potentially jeopardize the U.S. credit rating. In addition, there is a strong probability that Congress will not take up the issue of the fiscal cliff until after the November 6 elections. If that is the case, Congress will have very little time in a lame duck session to reach a compromise on the expiring tax and spending provisions. The good news is policymakers have been able to work together in the past to pass legislation in lame duck sessions. In 2010, for example, the House and Senate met between November 15 and December 22, which resulted in a two-year extension of the Bush tax cuts, a temporary payroll tax cut and extended unemployment benefits.

Cliff-Hanger Could Mean Volatility

In a speech addressing the near- and longer-term prospects for the U.S. economy, Federal Reserve Chairman Ben Bernanke summarized the dilemma confronting policymakers today: To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over timeAlthough the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery. Bernanke gave this speech on August 26, 2011 in Jackson Hole, Wyoming, well before the fiscal cliff was coined and front-of-mind for investors. While near-term growth and longer-term fiscal sustainability are often viewed as a trade-off, the two dont need to be mutually exclusive. The best-case scenario will require a bipartisan solution, but we believe policymakers will be able to reach some compromise prior to year-end to minimize the fiscal restraint scheduled to occur next year, yet still develop a plan to reduce longer-term budget deficits. Unfortunately for investors, the uncertainty and last-minute nature of the fiscal cliff negotiations are likely to be another source of volatility in the financial markets in the latter half of this year.

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