[BUBUIOC INC.] Answers to 7 key fiscal cliff questions

[BUBUIOC INC.]

It is no wonder that investor apprehension about the fiscal cliff has grown, as the seriousness of the issue is coupled with headlines calling for a “debtpocalypse,” “taxmageddon,” and “fiscal cliff diving.” Before getting carried away, remember it’s important to keep perspective. With that in mind, we asked Fidelity’s public policy and economic experts to answer real questions we heard from our customers.

Why are investors so concerned about the fiscal cliff?

Dirk Hofschire, senior vice president, asset allocation research: When you talk about the fiscal cliff for the U.S., you have to step back and remember that we went through a really traumatic financial crisis in 2008. It was worse than anything we’d seen since the Great Depression. When you have something like that happen, it’s a bit like having a heart attack. You go into the hospital. You need emergency treatment—that’s when the monetary and fiscal response comes in. It’s like medicine that gets the patient back on his or her feet. But in the aftermath, it usually takes a period of years for the economy to fully recover and normalize.

When we look at the U.S. over the past three or four years, it has been a process of repair. It’s been gradual but things have been getting better. For instance, the housing market is now getting back on its feet and unemployment has been coming down, even though it’s been very slow. The fiscal cliff represents a threat to disrupt that trend, and if that happens, the U.S. would probably go into a recession. It would be very traumatic for the financial markets, certainly, but it would be worse for the medium-term fiscal outlook. So what I root for in this type of situation is some longer-term agreement that does address the deficit, but without doing it all overnight, because if you take the medication away too quickly, you risk putting that patient back in the hospital.

What are the chances that we go over the fiscal cliff?

Shahira Knight, vice president, government relations and public policy: I do not think that even the party leaders could tell us exactly how this is going to get resolved, when it’s going to get resolved, or even if it is going to get resolved before the end of the year.

I think they’re just starting the debate, trying to size each other up, and figure out what their own members are willing to accept and vote for. I think what we do know is that they’re looking at a temporary solution, so we shouldn’t necessarily expect to see some grand $4 trillion deficit reduction deal in the lame-duck Congress. Rather, the goal of a temporary deal is really two fold—one, to avert the cliff, so we don’t have this huge economic shock at the beginning of the year, and two, to put in place a credible framework to address long-term deficit reduction next year. I think both sides are willing to compromise under certain conditions, and whether or not we’re going to see a deal now or later really depends on whether those conditions are acceptable to the other side.

The fiscal cliff includes an increase in capital gains tax rates. Could that change cause a stock market sell-off?

Hofschire: When you look back at changes in capital gains laws throughout history, you usually see some impact the year before they go into effect. People try to harvest some of those gains, and you see an uptick in capital gains revenue because of that selling. But when you look back in the years where you had that heavy selling, it didn’t mean the market went down. Taxes are one of the considerations among many things that are going on here with the economic environment, the political environment, and with sentiment and everything else. So, you could see some selling as a result of that, but it doesn’t mean, in and of itself, that it will be large enough to drive the markets down. It’s probably going to be more dependent on the outcome of the fiscal cliff, how the economy holds up, and a lot of other things.

Do you think tax reform will do away with itemized deductions like municipal bond income exemptions and charitable contribution deductions?

Knight: Various tax provisions may be impacted both in the short term and the long term. In the short term, there is a growing acknowledgement that any deal to avert the fiscal cliff will require higher tax revenue and the burden should fall on higher-income households. The President has defined “high income” individuals as individuals making $200,000 or more and couples making $250,000 or more, though I think those thresholds could change in the negotiations. One of the proposals that the lameduck Congress could look at is the idea of reducing or capping the value of itemized deductions. If this were to happen, everything from the charitable deduction to the home mortgage interest deduction could be impacted. The interest exemption on municipal bonds is not an itemized deduction, but Congress could choose to treat it that way. So there is a possibility that, in the short term, as part of the fiscal cliff resolution, higher-income people could see their itemized deductions trimmed.

In addition, one of the 2001 tax cuts was the repeal of the Pease limitation, which reduced the value of itemized deductions if a taxpayer’s income exceeded certain thresholds. That limitation on itemized deductions has been repealed, but it might come back next year.

In the long term, the question is whether or not itemized deductions or the municipal bond interest exclusion are eliminated or fundamentally changed. I think that’s a question for tax reform, which might be on the table next year. So if the government really tries to reform the individual side of the tax code, that’s when you might see something like the reduction or elimination of the exemption for interest on muni bonds. The Simpson-Bowles deficit reduction committee recommended that this exclusion be eliminated on a prospective basis as part of a deficit reduction and tax reform package. I haven’t seen a lot of traction for that in Congress yet, but a lot of lawmakers say that if tax reform is a serious endeavor next year, everything has to be on the table, including charitable deduction and muni bonds.

What might happen to dividend stocks if tax rates change?

Hofschire: Well, obviously there is some near-term uncertainty with tax rates. You don’t know if the dividend tax rates are going to go up at the end of the year, as currently legislated, or not, and by how much. But I think the bigger issue is a long-term trend that started over the past couple of years where people are now, for a variety of reasons, looking more to equities to get some income into their portfolio. I think that’s just the beginning of a long-term trend for a variety of reasons, including today’s low-yield environment, demographics, and all the cash on corporate balance sheets. None of those things are going to go away, no matter what happens with taxation, so it is possible that we get a blip in that trend if those tax rates go up. But I think it would be nothing more than a blip because, even if tax rates go up, dividend-yielding stocks likely still will not be disadvantaged versus bond income. I think that people will keep making the decision to try to source income from a wider variety of assets no matter what.

Do the country’s fiscal challenges mean the dollar will struggle?

Karthik Rathmanathan, senior vice president and director of bonds: While the dollar has made some improvements recently, we have generally had a declining dollar for the last 10 to 12 years. I think at some point, as we look at the euro and as China stops appreciating its currency, or even slows it, the dollar may be a beneficiary. In my opinion, the dollar has room to actually appreciate. I think many investors have had a very beneficial time in local currency markets, they benefit from an appreciating currency as well as low inflation. That was driven in part by China. If they stop depreciating their currency to increase exports, there are potentially going to be competitive devaluations across the region and the dollar could benefit from that.

Do we have to worry about inflation?

Hofschire: I don’t have a particular worry about inflation going up a lot over the next year or two. We do have an extraordinary monetary policy, but we don’t have tight labor markets. So we have high unemployment, which means wages aren’t going up, and in a service economy like that of the United States, if you don’t get wage inflation in some way it’s hard to get sustained broad-based inflation. The other thing we don’t have is what economists call velocity, which means the Federal Reserve is creating money but banks are not necessarily using it to increase lending massively. And, until that happens, all that money being created by the Fed isn’t necessarily inflationary either. So the next couple of years, I’m not particularly worried about it.

I think the big challenge over time is going to be trying to wind down and normalize those monetary policies. That has to happen at the right time, and in a way in which we don’t have a significant acceleration of inflation. The big thing that I would say from a portfolio construction/asset allocation standpoint is you don’t need particularly high inflation to have a difficult time getting positive, real returns out of some of the lower-yielding, high-quality areas in the bond market. So even in today’s low-inflation environment you do have to think about inflation risk and consider diversifying your portfolio in areas that can get a positive, real return.

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Posted By BUBUIOC INC. to BUBUIOC INC. at 12/05/2012 08:00:00 AM