Look Out!

“Fiscal Cliff” has become common nomenclature for market bears, referring to the expiration at the end of 2012 of tax cuts enacted under President George W. Bush together with automatic spending cuts resulting from the debt ceiling fight should no political alternative be reached. The impact of the cliff would be a fiscal shock on the order of $300 billion to $600 billion in just one year which economists generally agree could have a substantially negative impact on the economy in 2013. If lawmakers take no action, the economy would likely enter recession in the first half of next year, contracting at an annual rate of 1.3%, according to the nonpartisan Congressional Budget Office.

Timeline And Elements of the Fiscal Cliff

What's happening when?
The Fiscal Cliff has two elements:
1. The “Sequester” Backlash: When the Federal budget super committee was unable to reach a deal on spending last year, many of the postponed budget decisions were set to go into effect at the beginning of 2013. The automatic spending cuts set to kick in on January 2, 2013, would cut $1.2 trillion dollars total in spending, the majority of the cuts split between defense and domestic spending. In addition, the Federal government will reach the “debt ceiling” at the end of 2012.

2. Expiring Tax Breaks:  Several tax breaks and other benefits are set to expire:

  • The Bush Tax Cuts: The expiration of these Tax Cuts could affect taxpayers across the board. This issue is sure to result in some form of gridlock; Republicans are in favor of extending all the tax cuts, while Democrats only want to extend the cuts for those making under $250,000 a year.
  • Emergency Unemployment Benefits End: An end for benefits could result in the loss of unemployment income for millions of Americans, many of whom rely on it for bills and living expenses.
  • Payroll Holiday Tax Ends:  The expiration of these cuts, instituted by President Obama for middle class workers, could result in up to a 2% tax increase for workers.
  • Measures to Protect the Middle Class From AMT (Alternative Minimum Tax): When these expire, middle class families will see a hike in their federal taxes.

What the Fiscal Cliff Means for the Economy

Is this another example of fear mongering by the media, or a legitimate economic crisis waiting to happen?

Recession: Aside from the expiring tax cuts and federal agency slashing, the CBO sees the U.S. economy contracting at a 1.3% annual rate in the first half of the year from lawmakers’ inaction. According to the CBO:

Given the pattern of past recessions … such a contraction in output in the first half of 2013 would probably be judged to be a recession.

Dirk Hofschire, Fidelity’s senior vice president of Asset Allocation Research  underscores that the impact of falling off the cliff will be quite large:

The more fiscal austerity that kicks in, the bigger the effect it has on economic growth. Depending on how you measure it, the automatic spending cuts and tax hikes would cut as much as 4%-5% of GDP. If you consider that the economy is growing around 2% a year, that would be enough to throw us back into recession. According to our research, corporate earnings could decline by double digits, perhaps as much as 20% or more. If this happened, it would have a tremendously negative impact on the stock market and other riskier asset categories.

Potential Growth Scenario: But on the flip side, growth to 2.3% may return in the year’s second half. Chad Stone, chief economist at the Center on Budget and Policy Priorities recently wrote via the Washington Post:

While the limit on spending authority will be imposed at the beginning of the year, the actual reductions in spending will occur over the course of the year and into subsequent fiscal years. Once again, only a fraction of the impact occurs in the first month or so, although expectations of the cutbacks can affect the behavior of government contractors and others in advance of the actual cuts.
Short Term Fix Possible: What if there is a short-term deal?  That would buy time by extending a few tax cuts while postponing spending cuts until the new Congress convenes in 2013.  A precedent for this was the 1995-96 shut down with Democratic President Clinton and the Republican Congress. The two camps couldn’t reach a legislation agreement for the funding of government departments and agencies.  Facing strong pressure to reach agreement and get the government moving again, the shutdown only lasted 21 days.
Slight Employment Declines: The fiscal cliff will certainly suppress employment. It is already clear to students of economics, as may become more clear to average Americans facing the fiscal cliff, that the politicized term “job creators” does not really refer to employers, since the real job creators are the middle class. Since employers only hire as a last measure in response to increased consumption, there is no record of tax cuts having driven employment and abundant research showing that it does not.
So it makes sense that American employers have not yet gone to a defensive recession-mode, but are prepared to reduce hiring or staffing if need be, while counting on the U.S. Congress to strike a last-minute deal. For now, U.S. companies are focused on the more immediate threats from Europe’s unfolding debt crisis and China’s slowing economy. But 2013 looks particularly unclear, and another recession would almost certainly cause employers to cut hiring or staffing.

Questions over taxes and spending have caused some small firms to take steps to protect their interests, said Richard Curtin, an economist at the University of Michigan who oversees a quarterly survey conducted by small businesses group Vistage International. “This is a concern especially if you don’t think the same party is going to win both houses and the presidency,” he added.

“What I see among industry contacts is a lot of neutrality,” said Russ Williams, CEO of Archer Malmo, an advertising and public relations firm in Memphis, Tennessee. “I don’t see anybody real optimistic or doing a whole lot of hiring,” he said. “But I also don’t see anybody real pessimistic or cutting back drastically like we saw in the prior 36 months.”

What are the Odds of A Pre Election Compromise?

Some say that a fiscal cliff isn’t likely because of the election, and there should be a last-minute compromise since neither side wants to look like a bad guy in this economy and risk being remembered as the party who pushed the economy over the proverbial fiscal cliff.
The Brookings Institution in a July 10, 2012 Opinion piece, The Fiscal Cliff: A Hard Landing Becomes More Likely, disagrees:

 The process is mired in distrust, animosity, and ideological warfare. In the short lame-duck session, the environment could hardly be worse for solving the complicated fiscal problems by compromise. Except for spending bills, like the Transportation Act, compromise has become a lost art. Well defined, highly divisive positions that have defied serious negotiation for 2 years are unlikely to be moved substantially in a month. It has become increasingly apparent that not all, nor even the major pieces, of the fiscal puzzle can, or will, be fitted together between election day and New Year’s Eve. The people, the rating services, the markets and our creditors may wish for the magic solution, but our system, now in a full-scale shooting war, is probably not going to be able to deliver the full package.

Is A Partial Solution Possible? What about a partial solution, including a down payment on the deficit, temporary extensions, and promises of future debt stabilization backed by believable enforcement provisions? Brookings says that this will not be much easier since the elements that make up the cliff are numerous, complex and highly political. They include:

Possible Scenarios

According to Fidelity, a sudden impact isn’t necessarily going to happen, with four possible scenarios, including some soft landing opportunities that could reduce the sudden impact of the cliff.

  • Likely Scenario 1: punt – A likely scenario is that Congress and the president agree to punt the issue into 2013. If this occurs, the tax cuts will not expire, tax increases won’t take effect, and the spending cuts will be delayed until after the presidential inauguration and new Congress arrives in 2013.
  • Likely Scenario 2: modest compromise – Congress and the White House reach compromises on some tax and spending provisions, with the election having a significant impact on what those compromises might be.
  • Less Likely Scenario 3: over the cliff – If Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures, the economy goes over the cliff.
  • Least Likely Scenario 4: grand bargain – The chance of a grand bargain taking place after the election and before the end of the year may be a long shot. In this scenario, Congress and the White House would reach a deal addressing tax, spending, and fiscal issues for the medium to long term. In addition to the fiscal cliff, the U.S. will again approach the debt ceiling early next year. While the sequence of events puts the debate over the fiscal cliff before the debt deadline, the two issues are likely to be intertwined.

The resolution of these issues is difficult regardless of whether Democrats or Republicans are in control because the issues reflect longstanding philosophical differences between the parties about the proper role and size of the government, and how to grow the economy.

Democrats Likely To Force a Last Minute Compromise

New Resolve: Congressional Democrats say they are prepared to go over the so-called fiscal cliff at the end of the year if Republicans continue their opposition to more revenue from top earners, allowing the George W. Bush-era tax cuts to temporarily expire for everyone on Dec. 31 and accepting scheduled spending reductions, including for Pentagon programs favored by Republicans.

Democrats say their party blinked two years ago by not separating lower rates for the richest taxpayers from those for the middle class, and have taken a tactic from the anti-tax Tea Party lawmakers who had the leverage in 2011 as they brushed aside warnings about a debt default if Congress blew its August deadline.  Last time, Tea Party leaders called the predictions of credit downgrades and interest-rate spikes fear mongering, and their strategy proved mostly successful as House Republicans won the last-minute agreement with Democrats, even though the Tea Party allies had wanted far deeper cuts.

But Democrats maintain that they have the leverage to prevail this time, saying no deal on taxes and spending would be better than a bad deal. The President has indicated he would veto a bill to extend lower tax rates for the richest Americans, and Senate Democratic leaders Harry Reid and Charles Schumer have been resolute in recent caucus meetings, warning members against voting for a compromise that fails to include tax sacrifice from the nation’s highest earners, according to leadership aides.

Maryland Representative Chris Van Hollen, the top Democrat on the House Budget Committee, said talks will go into 2013 if there’s no agreement on revenue:

This is the Republicans’ choice, either they can provide tax relief to 99 percent of the American people or we’ll get it done after the end of the year.

Democrats feel they have the upper hand because they’ll allow more than $600 billion in tax increases and spending reductions to temporarily take effect in January rather than accept another deal with no tax increases. The idea is that if Republicans refuse to budge in negotiations to avert a so-called fiscal cliff following the November election, Democrats will quickly force them into a New Year compromise on tax cuts for families making less than $250,000 a year that would be made retroactive to Jan. 1, avoiding the type of economic risk that accompanied the debt-ceiling showdown. They say this wouldn’t risk economic damage, if both parties compromise by early February.

Also, some Democrats say the automatic spending cuts would be economically preferable to another agreement with Republicans that lacks revenue.

Republicans Released From the Anti-Tax-Increase Pledge: If lower tax rates expire on Dec. 31, lawmakers would have a new tax baseline in January that would free Republicans from an anti-tax-increase pledge that is viewed as an impediment to a compromise on raising revenue. If all of the tax rates expire, any new tax policy would technically be scored as a tax cut, not a tax increase. Then new rates could be made retroactive, wiping out tax increases for middle and lower-income earners.

What Will Be May Already Be

According to John Melloy, executive producer of CNBC‘s Fast Money & Halftime, the much-discussed “Fiscal Cliff” is already here, according to economists and investors, as businesses curb spending in anticipation of the higher tax rates and reduced spending set to be enacted at the end of this year. According to Bank of America Merrill Lynch economist Michelle Meyer at  in a report to clients, businesses have already started to curb investment and hiring plans in the face of this tightening of fiscal policy, further cutting into GDP:

The fiscal cliff is not just a year-end story. We expect the uncertainty shock to be realized in the coming months, escalating before the election.

In fact, Bank of America believes that the first quarter economic growth of 1.9% will be the best three-month period of the year, with 1.5% annual growth in the second quarter and just a 1.3% GDP in the current quarter.

So, while President Obama has attempted to assuage some of this concern by saying he would like to extend the tax cuts for families making less than $250,000 a year, the market appears to buy into the conventional wisdom that a compromise plan has a slim chance of passing Congress in an election year. As a result, stocks remained low based on commentary like Bank of America’s.

Final Word: What the Fiscal Cliff Means to You

Whatever solution Washington hammers out, the current economic downturn and unemployment won’t be resolved by the stroke of a pen. There is no political magic wand, and long-term economic and political factors need to be resolved.

The impact of the expiring Bush era tax cuts is hard to assess, and the adverse effects of the tax hikes could be offset by the benefits of reduced government borrowing with taxes resulting in increased revenue.

With Europe contracting, China beginning an economic reversal, healthcare costs on the rise, and the continued contraction of the middle class who are the real drivers of domestic economic growth and job creation, economic growth will be weak, and the current political deadlock provides no clear path to meaningful stimulus.

Speaking of China, where growth disappointed in the first quarter and is likely to be soft again in the second quarter, leading indicators suggest slow growth, but no immediate meaningful deceleration. They are likely to have a soft landing in the back half of the year, with growth reducing from 10% to around 8% following the pending leadership transition in the fall, for which we believe Chinese officials will take whatever steps necessary to ensure a reasonably smooth transition, including keeping growth at a respectable rate. And as is the case with other emerging market countries—notably Brazil—China has the fiscal and monetary flexibility to provide further stimulus. In the run-up to the transition, we would expect additional steps, such as cuts in the reserve requirement and targeted stimulus aimed at consumption, to ensure a soft landing. They will muddle through.

And so will the US. The same headwinds that have inhibited the recovery since 2009 remain in place. Debt levels in the developed world are still too high and the deleveraging process is likely to continue to exert a headwind for the foreseeable future. US consumer debt levels, while lower, are still extremely high by historical standards, and are unlikely to return to a more sustainable level until probably 2014.

Consumers are also struggling with stagnant wage growth, which for hourly workers is at a record low, and negative in real terms with, income growth barely keeping pace with inflation. One little-noticed development is that personal income growth has decelerated sharply over the past 12 months. Part of the reason for this is the slowdown in government transfer payments—direct payments such as unemployment benefits.

Volatility should remain elevated, due to international and US fiscal policy uncertainties. Because these political and economic uncertainties are already reflected in volatile markets, the impact of the fiscal cliff is unlikely to be a big, sudden hit. Congress is likely to engineer another escape hatch when it finds itself backed into a corner again, and only an extremely small portion of the cuts are scheduled to occur in 2013 anyway.

 

What the “fiscal cliff” means to you? No big changes.

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