August 6, 2012

America Needs a Fiscal Ladder, Not a Fiscal Cliff: J.P. Morgan Funds’ Kelly

Legislation to avoid fiscal cliff ‘very likely after the election,’ Kelly says

“What America needs is a fiscal ladder, not a fiscal cliff,”  David Kelly, chief global strategist for J.P. Morgan Funds, said Monday.

“This ladder,” he wrote in his Notes on the Week Ahead, “ought to be one where the deficit falls by about 1% of GDP per year, a pace that would cause the debt-to-GDP ratio to stabilize within four years.”

David Kelly, chief global strategist, J.P. Morgan FundsBut Kelly (left) warns in the note that such a plan needs to be designed carefully, as a ladder that “is missing a rung or two could still do significant damage to a slowly recovering U.S. economy.” Despite good earnings and “great” relative valuations for equities, Kelly tells investors to “be careful not to be too overweight equities until they get some reassurance that Washington knows what it is doing.”

Indeed, Kelly says that investors remain pessimistic, one reason being the fear of the fiscal cliff. Without new legislation by the end of the year, Kelly says that “the Bush tax cuts, the temporary payroll tax cut and extended unemployment benefits will all expire just as higher Medicare taxes and both rounds of severe cuts to discretionary spending agreed to last August take effect.”

According to the Congressional Budget Office (CBO), Kelly continues, “this would cut the budget deficit from 7.6% of GDP in fiscal year 2012 (which ends in two months) to 3.8% in fiscal 2013. Even this understates the extent of the fiscal cliff, as the 3.8% of GDP expected for fiscal 2012, includes three months before these changes are all scheduled to take effect. On a calendar basis, the projected drop in the deficit is closer to 5% of GDP.”

Legislation to avoid the full impact of these changes is very likely after the election, Kelly predicts. However, “it is critical that both sides look at the numbers carefully. The expiration of the payroll tax cut, on its own, would reduce the deficit by roughly $115 billion in calendar 2013, imposing a significant drag on the economy. The imposition of higher Medicare taxes should result in a further roughly $35 billion in revenue increases, while the end of extended unemployment benefits would remove further cash from the economy.”

In other words, he says, “even if all the Bush tax cuts were extended and none of the spending cuts agreed to last August were implemented, other scheduled policy changes could cut the deficit by more than 1% of GDP in calendar 2013, more than enough fiscal drag for a slow-moving economy.”

One of the dangers in the current environment, Kelly says, “is that a seeming compromise could be too severe.” For example, “consider an agreement that started by allowing the payroll tax cut and extended unemployment benefits to expire while raising Medicare taxes and then included some discretionary spending caps to please the Republicans and the expiration of Bush tax cuts for richer households to satisfy the Democrats,” he says. “Such an agreement could cut the deficit by 2% or 3% of GDP next year, which is probably too strong a dose of austerity for the economy to handle easily.”

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