Fiscal Cliff Divers

For those of you sporting a little gray hair (or in my case a lot of gray hair) might recall, ABC’s Wide World of Sports popularized cliff diving by the La Quebrada Cliff Divers of Acapulco, Mexico, during the1970s as one of the early extreme sports. To this day they perform dives from 125 feet off the cliffs of La Quebrada into water that can vary from 6 to 16 feet, depending on the waves. Obviously timing is crucial for these highly trained professionals, who even dive at night holding torches. 

One can only hope that our elected representatives in Washington can navigate the pending fiscal cliff with as much skill and expertise as the divers of La Quebrada. Past performance does not bode well for constructive compromise, however.

The term “fiscal cliff” was first coined by Federal Reserve Chairman Ben Bernanke in early 2012. As you might recall, in August 2011, Congress passed the Budget Control Act of 2011 to resolve the debt-ceiling crisis. This law provided for a joint select committee, or the supercommittee, to produce bipartisan legislation that would decrease the deficit by $1.2 trillion over the next 10 years. Also provided was the requirement that should congressional compromise not occur, automatic across-the-board cuts (known as sequestrations) split evenly between defense and domestic spending would be implemented.

Without the new legislation before year-end, many provisions of the act will automatically go into effect on Jan. 1, 2013. Some of the most important are:

• Expiration of the earlier Bush tax cuts continued in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.
• Across-the-board spending cuts to most discretionary programs as directed by the Budget Control Act of 2011.
• Reversion of the Alternative Minimum Tax thresholds to 2000 tax year levels.
• Expiration of the 2 percent Social Security payroll tax cut, most recently extended by the Middle Class Tax Relief and Job Creation Act of 2012.
• Expiration of the federal unemployment benefits, most recently extended by the MCTRJCA.
• New taxes imposed by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010.

According to the Congressional Budget Office, if Congress and the President fail to act, GDP in 2013 will be reduced by 0.5 percent from already anemic projections. That should only extend the duration of our extremely low interest rate environment.

The results of the recent elections (Democratic control of White House and Senate versus Republican control of the House) portends continued gridlock as each side fights viciously for its side.

So what actions should a portfolio manager take, and avoid, during this period of unprecedented fiscal uncertainty? Caution and patience should be hallmarks going forward.

Use extreme caution in purchasing secondary Build America Bonds in our current market place. As many of you recall, these bonds were issued in 2009 and 2010 when rates were higher and spreads were much wider. These bonds are currently trading at hefty premiums, which under a series of events, might be at risk. Examine the “make whole” provisions of your BAB holdings and understand the consequences of a call triggered by the so-called sequestrations. If you own BABs, check with your trusted investment adviser.

The process under which the BABs program currently operates is such that the issuer makes the semiannual interest payment and then receives a refund back from the federal government. To the extent that the subsidy is reduced, the issuers will need to offset the expected cash payments elsewhere in their budgets. An automatic sequester would lower that subsidy by 7.6 percent, which might cause market concern about an increase in BAB redemptions. While we view widespread refunding in the event of sequestration highly unlikely, some widening of spreads, and thus lower relative prices, in the BAB market could develop.

Portfolio managers open to a more patient approach should consider hybrid ARMs, particularly the 5/2/5 structure. The price stability of hybrid ARMs, and importantly the cash flow, can be welcome attributes when the markets inevitably experience even greater price volatility in the future.

Mark Tranckino is senior vice president, capital markets group, Country Club Bank, Kansas City.

Copyright (c) December 2012 by BankNews Media