Investors could be in for a bumpy ride the rest of the year as politicians navigate a difficult path toward a solution to what is being billed as the fiscal cliff of $720 billion in expiring tax cuts and mandatory spending cuts. In this interview with The Gold Report, John Mauldin, author of Thoughts from the Frontline, shares his insights on some of the possible twists and turns ahead and how investors can brace themselves for whatever comes.
The Gold Report: Hello, John. Now that we know who will be president, investors are turning their attention to the so-called fiscal cliff facing the country in January. The combination of the expiration of the Bush-era tax cuts and mandatory spending cuts could cost a combined $720 billion or an estimated 4.6% of the U.S. gross domestic product (GDP), according to some estimates. It could sidetrack the tenuous recovery or even bring on a new recession. Leaders of both parties have been talking about the need for bipartisanship to deal with the problem. On Nov. 20, you are hosting “The Post-Election Economy” video event, featuring Mohamed El-Erian of PIMCO and Barry Ritholtz of The Big Picture. It is billed as “A Clear-Eyed Analysis of the Risks and Opportunities for Investors.” What do you see as the options politicians have for coming to terms with a combined financial hit of the business and alternative minimum tax hikes and defense and Medicare spending cuts, which could add $3,500 to the average family’s Internal Revenue Service bill, or even more for high-income earners?
John Mauldin: You’re right, JT, that this could result in a very catastrophic recession, one that is avoidable. You just can’t take that much out of the economy at one time without having an impact. We do have to cut $1 trillion (T)/year out of the deficit. That’s a significant number. You just cannot do it all at once; you want to do it over time.
TGR: But wouldn’t ripping the bandage off quickly to reduce the debt be better than crafting a compromise or slowly extracting billions over time and stretching out the pain?
JM: No. Ask Greece, ask Spain how that works out. I don’t want to get into too much wonky economics, but basically if you pulled 6% of government spending out of the economy at one time in a combination of tax increases and spending cuts, you reduce GDP by about that much. That’s going to reduce the amount of tax revenues you get, which makes the problem worse. You get into a spiral. That’s precisely what Spain and Greece are facing.
Fortunately, the U.S. is not at the end of our debt supercycle. We still have the ability to go to the markets and borrow money. Spain and Greece don’t. We can afford to take some time. I’m not saying that there are no consequences. It’s not a choice of pain or no pain; it’s what kind of pain we want and when we want to take it. But taking it all at once, at the level of debt we’re at, would mean an extremely serious recession, as bad as or worse than 2008. Unemployment could become 12–13%. Revenues would go down on employment spending. Welfare would go up. It would be more difficult to come out of it.
The reality is you would have to raise taxes far more and cut spending far more to try to do it all at once than if you just said, OK, let’s do it in a matter of, say, a 1% headwind to the economy. It doesn’t make it so difficult that we can’t recover and overcome that.
TGR: Is that the worst-case scenario, doing it all at once? Or is there a compromise that’s even worse?
JM: Not doing anything would be the worst thing of all. The fiscal cliff would throw us into a serious recession. Trying to do it all at once would result in an even more serious recession. Kicking the can down the road means we would be OK for a year or two, but at some point, the bond market says, you guys aren’t being serious about this. It will watch Europe implode, Japan become a bug in search of a windshield and then start calling the U.S. to task for its lack of seriousness in dealing with the deficit. That becomes the worst-case scenario. That means we become Greece or Spain. It is hard to imagine that the U.S. could get there, but our size just means that we can probably go longer and the fall will be much deeper and more painful.
We have to do everything we can to avoid that type of catastrophic situation and in a way that lets people know exactly how it’s going to be done. Congressional leaders know this. What they are disagreeing on is the ratio of tax cuts to spending increases and how they’re going to handle healthcare. That’s been the issue for the last four years. There’s nothing new about this. There is actually less need to kick the can down the road today than there would have been if Romney had been elected. Then you would have been left to try to avoid the pain from a different set of bills. With Barack Obama reelected, the cast of characters is pretty much not going to change. That doesn’t mean they can’t kick the can down the road. Congress certainly has the potential to do that. The real makings of this deal should be much larger than $4T. We need something like $8–9T pulled out of the deficit over the next 10 years.
TGR: You mentioned Medicare. Is that the most difficult and important thing to deal with, that and entitlements like Social Security?
JM: Absolutely. Social Security, as Alan Greenspan recently said, can be solved in 15 minutes and still have 7 minutes for pleasantries if you had the right people in the room. It’s a pretty straightforward problem. Everybody knows the solution; they just don’t want to do it. You change the way you calculate the benefits a little bit. You raise the retirement age a few more years. You maybe raise taxes a little bit and you are there. You don’t have to get drastic. You don’t have to take retirement age to 75 or recalculate benefits by a half point. You just tack another couple years on it. That’s the easy one.
Medicare is a problem. Everything else you can arm wrestle with. But Medicare is an emotional issue. Everybody wants more healthcare. I totally get it. I have seven kids, and some of them have health issues. It’s difficult to find a solution that works for anyone. There are two viewpoints. Some people want to just fund it all and have a European-type system. We don’t have a European-style consumer. We don’t have a European-style medical establishment. To pay for that is going to cost a great deal of money. To not pay for it is unacceptable to what now seems to be a majority of Americans. So that’s an impasse. That’s why it’s so difficult.
TGR: And you can’t stop people from getting older.
JM: We can hope that medical technology will make some things cheaper and make us healthier. But hope isn’t a strategy.
TGR: So Medicare is the toughie. What about quantitative easing (QE)-infinity? What impact will that have on the problem and what role will it play in the solution?
JM: If they come up with a solution, that’s by definition going to be deflationary. It’ll shock people, but the Federal Reserve is going to be able to print more money than most of us could possibly imagine and get away with it. By getting away with it, I mean it not being immediately inflationary. Eventually, the economy will start growing again and when it reaches the +3% inflation cliff, it will become a problem. So the Fed will have to pull QE off the table, which will provide its own headwind for growth.
Coupled with the number of boomers retiring, which creates its own negative mechanism, I see the next decade as a muddle-through world. If someone came to me today and said for the rest of this decade, you could lock in 2% growth, I’d say take it. I’d be ecstatic. By the way, when I said that in 2002, people said, “Oh, John, you’re such a bear. You’re so gloomy.” Well, as it turned out, the actual returns were 1.9%. So 2% would have been a good trade. But that was what I expected, and that’s what I expect now.
TGR: Are you saying that you’re expecting deflation after a compromise is made followed by inflation or hyperinflation?
JM: Not hyperinflation. Hyperinflation is a political decision. We just don’t have the type of government that will allow a hyperinflation. I know that a lot of people want to talk about that because it makes great conspiracy theories. We are all upset about what the government is doing, how Ben Bernanke is running it and how Obama wants to make a Socialist empire. . . That is just not the way the U.S. works. I was just in Argentina last week. The U.S. is not Argentina. Now, that’s not to say we’re not going to have a 4, 5 or 6% inflation. If it got to 10%, however, it would be considered completely out of control. The government would clamp down and we would have a recession. That would really be inflationary. But we’re not going to get to some hyperinflationary moment. We’ll have a reckoning long before that.
TGR: You have brought up Argentina and some of the other countries that have had debt issues. Is this cliff a U.S. problem or will what happens here affect the rest of the world and some of the countries that already are on their own precipice?
JM: It absolutely will affect the world. We’re a huge part of the world economy. We’re the engine of the world. The U.S. slowing down is going to affect everyone, just as when Japan begins to hit its wall next year, it’s going to affect the rest of the world. Japan is not Greece. Japan makes a difference. Japan is a big country economically. Europe is a big, big world economically, and the entire continent is falling into recession. These things will have an impact on global growth.
TGR: What impact will they have on precious metals’ physical prices?
JM: In terms of what currency? That’s the question. If the U.S. puts itself on a path to a controlled deficit, I actually think the dollar becomes much stronger and gold in dollar terms will be challenged. Gold in euro terms or yen terms will be a very good buy. It’s the nature of the currencies and the way those countries will have to respond to their particular crisis.
If the U.S. doesn’t deal with its deficit, all bets are off. By the way, I will be buying gold if the price goes down. I don’t buy gold as an investment. I buy gold as central bank insurance. Even though I sound optimistic and am saying that we will solve this, at the end of the day, I just don’t trust the bastards, and I want some insurance.
TGR: I know you’ve said you’re an optimist except when you aren’t. In light of how close the politicians came to the edge during the debt ceiling debate last year and the devastating impact that had on the stock market, why do you think they’ll come up with a solution this time?
JM: They’re facing a calamity if they don’t. The impact on the stock market was temporary, and the politicians weren’t responding to that. Doesn’t the uncertainty make the market even more volatile?
Volatile and jittery is one problem. An economic potential for a recession or a depression is a completely different matter. Business cycles are business cycles. Stupid government policies are the things that make for really difficult economic times.
TGR: So what makes you think this time there will be less drama and, therefore, fewer dramatic headlines to respond to?
JM: I didn’t say there would be less drama. I said we’ll solve it. There will be lots of drama. There will be posturing, finger pointing and name calling. All sorts of issues will come to the front.
TGR: But in the end, you think they will come to a solution that will not go over the edge or kick the can down the road?
JM: I hope we don’t kick the can down the road. I don’t see them taking us over the edge. It’s such utter folly that it’s just hard to imagine. I’m going to interview the chiefs of staff for Senators Harry Reid and Rob Portman for the video event next Tuesday. They both get the problem. Their bosses understand it. They know what they’re facing. They just have different ways they want to solve the problem. That’s where the arm wrestling comes in. And they both know that if they don’t solve it, it will be a crisis.
TGR: Would you be willing to name a date when you think a deal will be reached?
JM: If you held a gun to my head, I would say whatever the last possible date is; if it’s Dec. 31, then a deal would be reached Dec. 31.
TGR: In light of what could be a very volatile rest of the year, how can investors protect themselves or even profit from each of the different scenarios we have talked about today?
JM: That’s one of the things we’re going to be talking about with my friends—Barry Ritholtz of FusionIQ, Mohamed El-Erian of PIMCO, Gary Shilling, Rich Yamarone of Bloomberg. In general, you really have to pay attention to the headlines. You have to look through the smoke. If they kick the can down the road, you have to protect yourselves from possible inflationary issues and a bond debacle on the horizon.
If Congress and the president deal with it in time and in size, then we have deflationary pressures in front of us. To tell an investor right now it’s going to be one or the other is simply a guess. The politicians don’t know. They know what they need to do. They know they need to solve the total problem. This $4T that was on the table two years ago doesn’t solve the problem. It only gets us halfway there.
TGR: What if the politicians decide to let the economy just go over the cliff? What would you do to your portfolio?
JM: If the politicians decide to go off the cliff, I would get deflationary. I would reduce my equity exposure to negative, let alone neutral. That’s an economic disaster.
TGR: If the politicians come to an agreement that deals with entitlements and deals with taxes, what does that mean for investors?
JM: That’s actually quite bullish for the economy. That doesn’t mean we won’t have recession. There are no easy solutions here but long term, I think that’s quite bullish.
TGR: What if dealing with taxes means raising taxes on high net-worth individuals and/or changing capital gains taxes?
JM: If they increase the capital gains tax, that’s going to mean pressure on the stock market. That will reduce the value of equities, and reduces the value of potential profits. If they allow dividends to rise to regular rates, that’s going to significantly impair seniors and income portfolios. I don’t have an easy solution here.
TGR: So without certainty, how are you adjusting your portfolio?
JM: I’m not really adjusting it. I’m still investing in hard assets, technology, fixed income, small businesses, stuff that’s optimistic in the long term and protective in the short term. I try not to buy anything that I can’t have enough staying power to handle for the long run. I’m probably a little bit more liquid.
TGR: Is there an indicator, a headline or a decision that you are looking for before buying or selling physical gold or equities?
JM: I’m buying physical gold every month. I’ve been buying the same amount on the same day of the month every month for years now. I don’t think there’s a single indicator. There is just a confluence of things. The world is just not so simple that you get a single indicator. If anybody tries to give you some kind of simplistic answer, laugh, close your portfolio and walk away.
TGR: Thank you for your insights, John.
John Mauldin will be a featured guest, along with Mohamed El-Erian, Barry Ritholtz and other top economic faculty, in a FREE online event that will air on Tuesday, November 20th at 2 p.m. Eastern. This free event, The Post-Election Economy, will answer your questions about what to do with your money after the election. For more information or to register, click here.
John Mauldin is a world-renowned economist and financial writer of the New York Times best-selling books Bull’s Eye Investing, Just One Thing and Endgame. His most recent book is The Little Book of Bull’s Eye Investing. Mauldin’s free weekly e-letter, Thoughts from the Frontline, is one of the most widely distributed investment newsletters in the world. Launched in 2000, it was one of the first publications to provide investors with free, unbiased information and guidance.
Mauldin is also the chairman of Mauldin Economics, a company created to provide individual investors with his big-picture thoughts on the global economy as well as actionable investment and trading strategies typically deployed by institutional money managers on behalf of their high-net-worth clients, but at a fraction of the cost.
Mauldin is the president of Millennium Wave Advisors, an investment advisory firm registered with multiple states. His track record of success vetting and consulting with money managers spans over three decades. His passion is to understand the world of economics, investment, politics and science, and determine how it may all come together in the future. As a highly sought-after market pundit, Mauldin is a frequent contributor to publications such as The Financial Times and The Daily Reckoning, and is a regular guest on CNBC, Yahoo! Daily Ticker and Breakout, and Bloomberg TV and Radio.
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