Fiscal cliff deal leaves U.S. economy on slippery slope

Scott Macey
Scott Macey

The fiscal cliff resolution approved by Congress provided a short-term boost to markets on Wednesday, but did little to offer long-term solutions on the national debt and spending reductions or to alleviate concern about future tax bills that could put retirement and investment tax incentives at risk.

Falling short of a grand bargain to address a looming federal budget deficit and comprehensive tax reform, the deal mainly raised tax rates for high-income earners.

It also boosted the capital gains tax rate, including carried-interest tax paid by general partners in private equity and other alternative investments to 20% from 15%. That, combined with a 3.8% surcharge to pay for affordable health care, represents a 58% tax hike on capital gains, said Steve Judge, president and CEO of the Private Equity Growth Capital Council.

Mr. Judge said his group will be urging “that any tax reform effort in 2013 be about crafting policies that incentivize economic growth.”

Russ Koesterich, managing director and chief investment strategist at BlackRock (BLK), said the deal was “very imperfect,” but was “better than nothing.” It still leaves a fiscal drag on the economy and will not stabilize the debt-to-GDP issue or provide a long-term solution as the deal did not address spending cuts and entitlement reform, he added.

Mr. Koesterich said 2013 will be a decent year for the economy if the debt ceiling is settled. “There are fewer downside risks, but it will still be a sluggish recovery in the U.S.”

One positive surprise from the deal was making many of the tax provisions permanent so as to avoid another discussion a year from now, Mr. Koesterich said.

While the country avoided a major risk of heading back into recession, the current trajectory of debt growth could result in a decline in credit quality as not enough was done to control debt growth, said Robert Tipp, managing director and chief investment strategist at Prudential Fixed Income.

“It has produced a reasonable, good economic backdrop in the short and intermediate term with modest growth, low inflation and high liquidity,” Mr. Tipp said.

Mr. Tipp said there will likely be bouts of volatility around the debt ceiling, but there is a positive underlying environment and investors are not overly invested in risk assets right now.

“Investors will be anxious on one hand, but once you get past the debt ceiling, you have some good economic visibility, better than we have had for some time,” Mr. Tipp said. “We will be free to trade on economic fundamentals for a bit.”

Mr. Koesterich said the markets had a “knee-jerk reaction” on Wednesday, similar to the announcement of the latest round of quantitative easing, and he expects it will fade quickly with the debt ceiling debate around the corner.

On Wednesday, traditional and alternative money managers and bank stocks were up, largely by multiple percentage points, outpacing the 2.5% gain the S&P had.

Geoff Manville, principal, government relations, at Mercer, said how long the market rally survives will depend on spending cuts and the debt ceiling negotiation.

He said the fiscal cliff deal “proves that anything with retirement income that raises money has legs” for future negotiations. The resolution allows active 401(k) participants to convert some of their balances into Roth accounts, which are not tax-deferred contributions.

Mr. Manville said Congress is intent on tax reform this year and it will be interesting to see how markets react to proposals with benefit incentives that Congress might tap into in order to substitute lower tax rates across the board.

David Kelly, managing director and chief global strategist at J.P. Morgan Funds, a unit of J.P. Morgan Asset Management (JPM), expects slow economic growth in the first half of the year as a result of the payroll tax hit on consumers. The fiscal cliff deal allowed the two-percentage-point payroll tax cut to expire, raising taxes on most Americans. However, he said the resolution will prevent another recession and is a “significant step toward fiscal balance.”

With just two months left to go on a stopgap spending authorization for federal agencies and programs, “we know that more than half of the House feels pretty strongly about spending cuts,” said Scott Macey, president of the ERISA Industry Committee. “If you look at the revenue side, I suspect there'd be major concern to do further cuts on (tax) rates, and they could start to limit or phase out deductions” including for retirement contributions from both employers and employees.

The next round of budget negotiations will be tougher, agreed Judy Miller, director of retirement policy for the American Society of Pension Professionals & Actuaries. “The administration made it clear that they want more revenue in the next round … and they have proposed a 28% cap” on the tax exclusion for retirement contributions.

“Nothing's sacrosanct at this point, and we can understand how anything could be on the table,” Mr. Macey said. “We just hope nothing's done in a rush.”