The Politics of Uncertainty

In a move reminiscent of the 11th hour deal to extend the George W. Bush-era tax cuts one year ago, the House of Representatives today struck a $1 trillion deal to avert a government shutdown, although Congressional Democrats and Republicans are still negotiating over a bill to extend the payroll tax cut.

Political parties are always eager to please constituents in an election year, and recent polls suggest about 60 percent of Americans support an extension of the payroll tax cuts and extended unemployment insurance benefits for another year. Although we’re only receiving piecemeal details of this breaking news, the deal may include the passage of a continuing resolution that would prevent the US government from shutting down at least through the end of the fiscal year next September.

In a normal political environment, one might expect a relatively quick deal to extend such popular measures. But after the contentious, and some might say dysfunctional, debate over raising the US the debt ceiling this summer, uncertainty surrounding the extension of even these popular measures has been high.

The key sticking points sound familiar: Democrats insisted the $200 billion price tag of these extensions be funded by a tax on wealthier Americans, a measure unacceptable to many Republicans. Similarly, the GOP wanted to pay for the extensions with spending cuts unpopular with Democrats.

There was also a proposal to attach the bill to an approval for the Keystone XL pipeline designed to carry oil from the Canadian oil sands region into the US market. That pipeline is popular with Republicans and opposed by many Democrats. Keystone is also a contentious issue for the Obama Administration, one they’re not keen to reopen until after the 2012 election cycle.

Although it’s difficult to predict the outcome of Washington’s political horse trading, a possible compromise would see Democrats drop their insistence on a tax for higher income Americans, while Republicans would drop the association with the Keystone XL pipeline. The measures would then be “funded” through a freeze on federal workers’ pay, higher costs for Fannie Mae and Freddie Mac insurance and wireless telecommunications spectrum auctions.

Whatever you think about the proposed stimulus measures, the key consideration in the short-to-intermediate term is the upside impact on the economy. There’s no doubt that lower taxes across the board and unemployment benefits would help economic growth. But if those benefits are offset by higher taxes or reduced spending elsewhere, any positive effect would be offset or even reversed.

The short-term good news is that the proposed offsets–frozen federal pay and wireless spectrum auctions–don’t represent a particularly meaningful fiscal contraction. These measures are accounting gimmicks rather than actual cuts. The other point to note is that historically tax cuts or tax hikes tend to impact the economy more quickly than spending hikes or austerity measures.

That means that a looming fiscal headwind that would immediately hit the economy in early 2012 has been eliminated.

Longer term, there are two major concerns for the US’ fiscal health. First and foremost, as I will explain in greater depth in your next issue of Personal Finance, my biggest concern for the second half of 2012 is the approaching barrage of new taxes that will commence in early 2013. The expiration of the Bush-era tax cuts means higher nominal tax rates, the elimination of lower taxes on “qualified” dividends and higher capital gains taxes. In addition, starting in 2013 the US faces a number of new taxes associated with the Patient Protection and Affordable Health Care Act of 2010, popularly dubbed “Obamacare.”

In addition, the agreement to raise the Federal debt ceiling in August included several automatic spending cuts to defense and other areas that will kick in by 2013.

These fiscal headwinds will go into effect if the government takes no action. These aren’t academic threats, but a hard reality unless the government passes a new law to limit or postpone these taxes.

This raises the stakes and uncertainty surrounding the 2012 election cycle. The political calculus reckons that lawmakers have little incentive to compromise before the elections in November. Any “fix” would have to be deferred until the post-election lame duck session, never an ideal time for the country to make momentous decisions.

There are several post-2012 scenarios to consider, although it’s all but impossible to make political predictions this early in the season. One of my favorite indicators in this regard is the political prediction market, where participants commit real money to their political prognostication. Historically, Intrade has proved at least as accurate as the polls in determining a likely outcome to a presidential election. At this point, Intrade sees Mitt Romney as the most likely GOP candidate and puts his odds of winning the presidency about even with Obama’s reelection. Whether 2013 brings a President Romney or another four years of Obama, neither party is likely to capture outright control of Congress and the Presidency.

I suspect that if the economy remains weak, the government will postpone scheduled tax hikes. But that extension may not come until the last minute–November or December of 2012. And that’s not the only uncertainty or question facing investors. Would a second Obama term be more hostile to high-income taxpayers? What sort of spending cuts would we see from a Romney Presidency?

I truly wish market action were more tied to economic fundamentals and earnings than to the latest political news from US and the EU. But that’s just not the case at present. It’s not my job to comment on politics but the market will remain worried about these issues, particularly in the second half of next year. It would be irresponsible of me to ignore the politics entirely.

The US economy is clearly accelerating into the end of the year and fourth-quarter annualized growth of 3.5 percent is a possibility. The deal to extend payroll and unemployment benefits should help to extend US growth trends into the New Year. Even after all the hits it has taken, the US economy is still among the strongest and most versatile in the world. But uncertainty in 2012 has the potential to reduce economic growth in the second half.

I continue to recommend a three-pronged strategy: Buy high-yield safe havens, take advantage of panicked selloffs to accumulate growth names and consider a few hedges. My favorite high-yield safe havens include master limited partnerships (MLPs) and a selection of US income trusts that we will profile in an upcoming issue of Personal Finance.