The recent market sell-off has not been about the re-election of President Obama but rather the repositioning of assets by professional investors in anticipation of three key events coming between now and the end of this year – the “fiscal cliff”, the debt ceiling and the expiration of the Transaction Account Guarantee (TAG). Each of these events have different impacts on the economy and the financial markets – but the one thing that they have in common is that they will all be battle grounds between a dividend House and Senate.

While there has been a plethora of articles, and media coverage, about the upcoming standoff between the two parties – little has been written to cover the details of exactly what will be impacted and why it is so important to the financial markets and economy.

Fiscal Cliff

One of the primary reasons for the market sell off since the announcement of QE3 has been in anticipation of the some of the largest tax hikes in the history of America which will take place at the end of the year. These tax hikes will impact families and businesses, the middle class and the rich, the economy and the markets.

In 2001, and then again in 2003, President Bush and Congress enacted tax cuts to help restart the economy post the tech bubble, 9/11 terror attack and recession. Primarily these tax cuts were focused on small business owners, families, and investors and, while dubbed the “Bush Tax Cuts” became the “Obama Tax Cuts” when they were extended in 2010.

On January 1, 2013 the biggest hit to the economy will come from the increase of personal income tax rates. The top income tax rate will rise from 35 to 39.6% which is a 13% increase in taxes for the majority of small businesses that create roughly 70% of the employment in the U.S. However, more importantly, the lowest rate will jump a whopping 50% from 10 to 15%.

At the same time many of the itemized deductions and personal exemptions will also expire which has the same mathematical impact as higher marginal tax rates. The table below shows the effective changes.

The important point not to be missed is that higher taxes are likely coming regardless of any potential “deal” in regards to the “fiscal cliff.” Higher taxes means less dollars going to consumption which is what creates the much needed demand on businesses to warrant increased employment and production. Higher taxes on businesses reduces the dollars available for capital investments, expansions and production. The net effect of higher marginal tax rates combined with new, or higher, taxes will slow economic growth and reduce revenue to the government.

Furthermore, higher tax rates on savers and investors, will reduce dollars flowing into the financial markets as dollars seek the lowest cost of investment. Furthermore, with interest rates already low, rising taxes makes capital investments less profitable. Therefore, capital will remain mired in “cash” rather than being deployed in productive investments which would spur future economic growth.

Obama stated repeatedly during the Presidential debates that he would not raise taxes on the“middle class” yet there are twenty new, or higher, taxes in Obamacare that will impact a broad cross section of the population. Some of these have already gone into effect such as the tanning tax, the medicine cabinet tax, the HSA withdrawal tax, W-2 health insurance reporting, and the “economic substance doctrine”, however, more will go into effect on January 1st including the Medicare Wage and Salary Tax and the Medicare Investment Tax as detailed in the table above. Furthermore, medical device manufacturers will have to pay a new 2.3% tax on their products which will ultimately be passed along to the middle class through higher premiums. Industry analysis suggests that this tax alone will lead to losses of more than 43,000 jobs and over $3.5 billion in compensation.

Lastly, one of the biggest tax tragedies coming from Obama’s healthcare plan is the “Special Needs Tax”. There are thousands of families with special needs children in the United States, and many of them use FSAs to pay for special needs education. Under current tax rules families can make unlimited contributions to FSA’s to fund a broad spectrum of needs from treatments to education. Under Obama’s new plan these FSA’s will be capped at $2500 and then indexed to inflation after 2013. This is an effective $13 billion tax hike for these families.

The impact of all of these taxes is that there will be less money for individuals and businesses to spend and invest in the coming months ahead if the “fiscal cliff” occurs in full. This equates to roughly a $537 billion dollar hit to GDP in 2013, equivalent to a 3.5% reduction, which would push the economy into a deep recession.

Debt Ceiling

At the same time as Congress will be discussing what taxes to raise, keep or reduce – they will also be forced to deal with an impending debt ceiling debate. As a brief reminder the “debt ceiling” debate during the summer of 2011 pulled the financial markets lower by 10% in just three short weeks as the stand off between the House and Senate led to threats of U.S. default and ratings downgrades. With the Treasury Department once again warning congress that the debt ceiling will be hit by the end of November, well before the original estimation of 2013, the stage is already set for another showdown between President Obama and the conservative Republicans.

The debt ceiling is a statutory limit set by Congress. The statutory limit of debt issuance by the Government has been raised over the years by Congress as the country has grown. A common misconception is that by raising the statutory limit that Congress is authorizing NEW spending – this is not the case. Congress must raise the statutory debt limit to cover spending that Congress has ALREADY committed to spending such as Social Security, Medicare, and Defense.

The chart below shows the history of Federal debt issuance as compared to the statutory limits set by Congress.

The problem, of course, is in the acceleration of spending. While the current Administration is busy convincing the American public that the “rich” just need to pay their “fair share” the simple reality is that the U.S. faces a “spending problem.” While increasing taxes sounds like a simple solution on the surface, as discussed above, it leads to lower economic growth rates as each dollar that is diverted into taxes removes a dollar from savings or productive investments.

Currently, it requires every dollar of revenue brought in from taxes just to cover non-discretionary spending. This leaves all discretionary spending coming from the issuance of additional debt. From 1993 to 1997, during the Clinton’s two terms as President, the debt ceiling was raised 4 times for a total increase of $1.8 trillion. President Bush then raised it during his two terms 7 times for a total of $5.37 trillion. Obama, during just one term as President, has increased the debt ceiling 6 times for a total of $5.08 trillion. The current run rate of debt increases is clearly unsustainable in the long term.

The negative impacts of debt on economic growth are not widely discussed (see Debts and Deficits: Killing Economic Prosperity) but prior to 1980 it took roughly $0.50 of debt to create $1 of eocnomic growth. The current Administration has increased Federal debt 45%, along with roughly $29 trillion of other funding, bailouts and stimulus, to garner a total of 7.1% economic growth during that period – or roughly $5.40 of debt for each $1 of economic growth. That really isn’t a good return on investment.

The last debt ceiling debate ended with a steep market sell off, contracting economic growth and a downgrade by Standard & Poors of the U.S. debt rating. In the end the debt ceiling was increased. No budgets were adopted. Spending continued and debt now exceeds 100% of GDP at $16.25 Trillion.

The battle lines are once again being drawn with the Republican controlled House pushing back against the Democratic Senate demanding cuts in spending, tax code reform and no increases in taxes. The Senate wants the debt ceiling raised without spending cuts and tax rate increases. Fitch and Moody’s has warned of downgrading U.S. debt if the “fiscal house”is not put in order but Obama is demanding higher taxes on the “rich” and is unwilling to compromise on entitlement programs.

For investors this is round two of the same boxing match that ensued last year. Ultimately, the debt ceiling will be raised. The U.S. will NOT default on its debt (we are a sovereign currency issuer and as such can print money to meet our obligations) and the U.S. will not go bankrupt. However, the rhetoric of such things happening, combined with the potential delay of resolving the “fiscal cliff,” could well create a sharp selloff in the financial markets.

TAG

While everyone is afraid of falling off the “fiscal cliff” there’s another issue looming large into the end of the year that could put further financial strains on the economy and the financial markets. The Transaction Account Guarantee (TAG) program, which was initiated at the height of the credit crisis when depositors were fleeing banks for fear they would go under, is set to expire at the end of this year.

The TAG program was put into place by the FDIC to up regular deposit insurance from $100,000 to $250,000 and unlimited insurance for all non-interest bearing transaction accounts. It is the second part that’s most important as it comes to an end.

When the unlimited insurance expires the cash of corporations, businesses and depositors, which totals more than $1.4 trillion, becomes uninsured. This could create some serious negative repercussions for small to medium size financial institutions which could be impacted by deposits fleeing into the safety of short-term U.S. Treasuries.

There are two negative consequences for the economy and the financial markets. The first is that many small and medium size financial institutions could face solvency issues leading to another, yet much smaller, financial crisis in the U.S. Secondly, the too-big-to-fail (TBTF) banks which are primarily responsible for the last credit crisis are likely to become too-BIGGER-to-fail. As the unlimited insurance on their deposits expires businesses will move money elsewhere, and since the Government has already proven that they will not allow the biggest banks to fail, they are the most likely recipients of fund flows.

The problem, for the financial system and the economy, is that as TBTF banks continue to swell the risk of another financial catastrophe increases. As the guarantees vanish depositers will likely move money to money market funds which requires fund managers to invest that capital for a return. With an ever increasing cash balance the options for investment becomes more restricted and requires excessive risk taking. History, as a guide, tells us that the TBTF banks are not good risk managers, aka JP Morgan’s London Whale, and the next time a financial crisis occurs – a bailout may simply not be an option.

For individuals this also means that borrowing and transaction costs will continue to escalate. This cost, like higher taxes, reduces the savings available for consumption and investment leading to reduced aggregate end demand and lower economic growth.

Likely Outcome

These are the three big risks going into the end of the year as I see them – and each one has the ability to impact the financial markets and the economy. Combined they could be disastrous.

While it is highly expected that the Obama, and the Senate, will find common ground with the Republican led house – this is an assumption that I would not be so sure of. Congressional elections are coming up very soon and the “Tea Party” candidates were sent to Washington with a mandate to get Washington into fiscal order. The House already rolled over once during the previous debates in 2011 on the promises of spending cuts being made. The Administration failed to follow through. Therefore, it is highly likely that this particular debate on the fiscal cliff, and the debt ceiling, could turn out much more contentious than expected.

Do not misunderstand me. A deal will eventually be reached and the debt ceiling will be raised. The U.S. will not default on its debt and the country will not be forced into bankruptcy. However, the impact to the financial markets, and ultimately the economy, from a prolonged battle could be far more damaging that investors currently believe.

Furthermore, taxes will go up in 2013, of this I am sure. The reality is, however, that most of the current tax rates will likely be extended short term along with a deferral of the taxes imposed by ObamaCare into 2013. There will also be spending cuts that will agreed to which will likely be more symbolic in nature than effective. Reduced defense spending is almost a given but that will have a direct, and negative, impact on economic growth.

The financial markets and economy are currently under attack from a recession in Europe, a slowdown in China, rising costs, high “real” unemployment, and the potential for sharply rising taxes at a time when income growth is stagnant. The risks of a recession are rising as earnings are rapidly deteriorating – quite simply this is a formula for a more protracted market correction.

I remain hopeful that our elected leaders will allow cooler heads to prevail and that they will begin to work towards solutions that alleviate some of the risks of economic contraction while setting forth logical plans for fiscal reform. However, while I am hopeful of such progress,“hope” is not an investment strategy to manage portfolios by. If I am right things are likely to get worse before a resolution is reached – but maybe that is why the “investment professionals” have already been heading for the exits.

Images: Flickr (licence attribution)

About The Author

Lance Roberts – Host of Streettalk Live

After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.