The results from the U.S. election are settled, and the focus has shifted to the "fiscal cliff"-a package of significant tax hikes and spending cuts scheduled to take effect in 2013. Prior legislative compromises over U.S. fiscal policy have set the stage for automatic spending cuts and tax hikes. SEI has addressed the fiscal cliff before; however, a brief recap may be in order.

The fiscal cliff refers to:

·         Sun-setting of Bush-era tax rates

·         Expiration of Obama-era stimulus measures

·         Implementation of across-the-board spending cuts (the so-called sequester under the debt-ceiling agreement of 2011).

The looming austerity measures are relevant to investors for several reasons, including:

 

1. The U.S. has outperformed most other developed markets in recent years, which may be due in large part to the fact that its major political parties have been unable to agree on austerity measures designed to lower its national debt level.

2. The resulting fiscal deficits have helped support domestic economic activity while other countries-most notably in Europe-are flirting with recession as both their public and private sectors try to de-leverage.

3. As a result, any sharp, sudden reduction in federal deficits could seriously undermine the U.S. economy. If this occurred, it would echo the U.S. recession of 1937, caused by premature policy tightening during an ongoing recovery from the Great Depression. Because financial markets tend to be forward-looking, any uncertainty around how the fiscal cliff will be dealt with could keep markets range bound until there is greater clarity.

The timing and magnitude of any resulting shocks are subject to debate, but the near-term implications are clearly negative and quite capable of tipping the U.S. economy into recession.

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