Is the U.S. set to plunge off a fiscal cliff at the end of 2012? Sure enough and here’s why Wall Street doesn’t care–yet
The fiscal cliff approaches. Everyone in the vehicle knows it is there. Everyone in the vehicle knows that plunging over the fiscal cliff would send shock waves through the U.S. economy and stock market. Everyone knows the odds of avoiding the plunge are extremely low. Everyone can even put a date on the plunge.
Is the only question when to jump out of the car?
The U.S. fiscal cliff sits on the horizon at the end of 2012.
A perfect storm of pending tax increases and spending cuts—all automatic unless politicians in Washington move to stop them—would cut U.S. GDP growth in half in 2013, according to the Congressional Budget Office.
If politicians stop the tax increases and the automatic budget cuts but do nothing to reduce the resulting deficit–which is frankly the most likely outcome if Washington does anything at all—GDP growth would pick up and unemployment would fall in 2013. But deficits would soar and the percentage of debt held by the public would climb to the highest level since the end of World War II. The U.S. could expect further downgrades from ratings companies such as Standard & Poor’s, a weaker dollar, and rising interest rates, which would all cut long-term growth.
A pretty set of alternatives, no? Let’s sketch in a few more of the grisly details before we talk about whether and when investors should cut and run
Here’s how the Congressional Budget Office summed up the approaching fiscal cliff in January 2012. What the CBO calls “tax provisions,” but that most of us think of as the Bush tax cuts, are set to automatically expire at the end of 2012. That would boost individual income taxes by $3.8 trillion from 2013 through 2022. The Alternative Minimum Tax isn’t indexed to inflation so with rising inflation more and more taxpayers face the higher rates of the AMT. Congress has passed a series of one year patches that have essentially increased the income level at which the tax hits. Without that fix—and no fix has yet been passed for 2012—the Congressional Budget Office projects that the number of taxpayers subject to the AMT will go from 4 million in 2011 to 30 million in 2012. The automatic spending cuts put in place as part of the debt ceiling compromise go into effect automatically in January 2013. The spending cuts amount to $103 billion a year. The cuts to Social Security withholding taxes, enacted as part of the Middle Class Tax Relief and Job Creation Act of 2012 in February, expire at the end of 2012 sending the withholding rate back to 6.2% from the current 4.2%.
The total effect, if all the automatic cuts and tax increases happen, would be to remove about $500 billion or 4% of U.S. GDP from the U.S. economy.
That, the CBO estimates, would reduce GDP growth from 2% in 2012 to 1.1% in 2013. Cheeringly, the Congressional Budget Office estimates that economic activity would “remain below the economy’s potential until 2018.” Unemployment stays above 8% in 2013 and doesn’t decline to 7% until the end of 2015, according to this projection.
The bad news is that the CBO forecast falls at the optimistic end of projections. Some economists calculate that tax increases and spending cuts of the magnitude the CBO lays out would cost the economy about 2.8 percentage points of growth. Subtract that from the 2.2% annual growth rate recorded by the economy during the first quarter of 2012 and you get a negative number.
In other words these tax and spending cuts could push us into recession again (the negative view) or into an economy growing at just 1.1% (the positive view.) That wouldn’t be a recession, technically; it would just feel like a recession.
Are the financial market’s worried about this? We’re certainly starting to hear some talk about the “fiscal cliff.” For example, on May 3 the Washington Post published a piece by Mohamed El-Erian, co-chief investment officer of bond-fund giant Pimco, warning about the fiscal cliff and urging Washington to get with the program.
But I don’t think that fear of the fiscal cliff is yet manifest in the stock market. The drop last week—33 points or 2.4% on the Standard & Poor’s 500 stock index—was a result of worries about near-term U.S. economic growth and near-term U.S. job growth and near- to mid-term recession in Europe. But if investors had focused on the fiscal cliff, the damage would have been much more severe. In fact, I’d say, at this point the near-term decline in stocks is likely to be limited by optimism over higher economic growth in the United States in the second half of the year.
Part of the reason for the lack of worry about a fiscal cliff is that it’s still too far away. The stock market is notorious for its inability to think more than about six months ahead. It’s only early May—too early by a month or two to worry about January and way too early to worry about an economic slowdown that would only gradually build up speed as 2013 unfolded.
But a bigger part of the reason is the U.S. election. There’s a justifiable belief that nothing will get done before the results in November’s presidential and Congressional votes. And there’s a strong belief on Wall Street that politicians will then, in an end of the year panic, do something to prevent the U.S. from driving over the cliff.
What exactly that something might be is just about impossible to predict at this point because not only don’t we know who will win what looks like a tight presidential contest, but we don’t know who will wind up in control of Congress. Will the Democrats keep control of the Senate? Will they make inroads into the Republican majority in the House or even, unlikely as it seems now, win control of that body? Will Republicans gain control of the Senate and keep control of the House, giving them control of both parts of Congress?
The eventual combination makes a huge difference if you want to predict how likely Congress will be to act and what it will do. And right now the political landscape is just too uncertain and volatile to start investment cash flowing one way or the other.
There’s no point in disrupting existing portfolio constructions with elections still so far away, the results so uncertain, and the results of the results so unclear.
I think the reluctance to act now is also based on a not-so-outlandish analysis that the short-term effects of the elections on U.S. fiscal reality aren’t like to result in very much real difference—in the short term. In the short-term a Republican victory that led to the enactment of the Representative Paul Ryan (Rep.-WI.) budget blueprint or a Democratic victory that resulted in the enactment of President Obama’s plan to repeal the Bush tax cuts for the very rich but to leave them in place for the middle class would have roughly the same effect on the fiscal cliff. They would both amount to a step back from the edge for 2013 because the short-term effect of both plans would be to keep a good percentage of the expiring tax cuts in place. In other words, the most likely effect of the election would be a U.S. replay of the strategy that Europe has perfected during the euro crisis: the problem would get kicked down the road.
It wouldn’t get kicked down the road very far, mind you, but you really can’t expect Wall Street to get too worked up about a budget that wouldn’t even go into effect until October 1, 2013.
Might the credit rating companies look at the budget that Congress begins to pass in February (or later or, as has happened recently, not at all) and decide to cut the U.S. credit rating again? Sure, but that’s not likely to be a problem until summer 2013. Might a failure to honestly begin to address the U.S. budget deficit start to hit U.S. interest rates in the second half of 2013? Sure, but that is a problem for the second half of 2013. Might the likely real-world version of the Ryan plan with its big tax cuts and politically dead on arrival rhetorical gesture at eliminating tax deductions to balance the budget result in some toxic mix of inflation and recession in 2014 instead of 2013? Sure, but, you don’t seriously expect Wall Street to worry about 2014 in 2012? (Although Mitt Romney has told Ryan, according to The Weekly Standard, that he would work to enact the Ryan budget in his first 100 days in office.)
In the longer term I think there are huge differences between the approaches in the Ryan and Obama budgets—and at some point—when one of them is in really likely to pass–the markets will reflect that. Just not now.
Actually, the first bit of end of the year brinkmanship that I expect the financial markets to react to isn’t anything nearly as cosmic as the coming fiscal cliff. It’s much nearer and dearer to Wall Street’s heart.
The current 15% tax rate on dividends is set to expire at the end of 2012. Along with a provision in the Obama administration’s health care package that puts a 3.8% surtax on all forms of investment income, the expiration of the current rates would send the total tax on dividends to 43.4% from 15%. If Wall Street gets to the point where it thinks that change is likely, you’ll see a steady erosion in the price of dividend stocks. (Which would be quite a shock to all those investors who have bid up the prices of dividend stocks.) A stock that pays $10.00 in dividends a share currently gives an investor $8.50 in income. An increase in taxes to 43.4% would take that post-tax yield down to $5.66. To keep the yield steady under the new tax rate, a $100 stock, paying a dividend of $10 and providing an after-tax dividend of $8.50 would have to fall in price to $66.59 a share.
If you start to see dividend stocks begin to slide faster than the market as a whole, that’s an indication that Wall Street has started to take the possibility that Congress won’t act to heart.
In fact, if you see dividend stocks start to slide that would be a good indication that Wall Street has started to think seriously about the possibility that the U.S. economy might actually plunge off that fiscal cliff.
Until then, Wall Street’s bet is that Congress will kick the can down the road again. Wall Street’s decision is not to worry about the long run until it’s not possible to ignore it any longer. And may be not then.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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Personally, I think the outlook on the dividend tax is being hyped. Taking the straight forward pricing analysis that you used is oversimplified. The first thing that comes to my mind is what dividend stocks were like BEFORE the Bush tax cuts. Back then, I remember the big hype about how the dividend paying stocks would get a huge boost, and dividends would increase – neither of which occurred. Instead, growth stocks boomed.
People bought dividend stocks back then for the same reasons they declare today.
And the stocks still grow, MCD as an example.
All else being equal, the dividend is still income; better still in an IRA. In the end, people bought into this income when they paid much higher taxes. After a while reality will settle in, and gthe hype will be shown for what it is, and any depression in price will be mostly recovered.
Just for the record, the average deficit under Bush was VERY manageable, well under $500 billion a year.
Obama has racked up trillion dollar deficits every year in office, and has put the US in more debt than every President from George Washington to Ronald Reagan COMBINED.
Obama put us in this fiscal mess with his ridiculous stimulus programs that have done nothing but made the problem worse.
Our government needs to shrink to match the tax base, not the other way around.
Altec, this is an investment site. I think you meant to leave this comment on Fox News.
Agreed. Please post your grossly uninformed distortions elsewhere.
Perhaps Altec’s comments should have been left
someplace else, however they were not
“grossly uninformed distortions.”
Altec appears more informed about the macro-economic effects of fiscal imprudence than many posting here. Investing in Switzerland is different from investing in Zimbabwe.
Unfortunately, the USA has adopted fiscal policies from Zimbabwe.
I believe the stock market will decline for the next 4 months due to the price of commodities like iron ore and oil.
If there is an economy where wealth is extracted from the shareholders and the working man, by excessive management perks, how long will it take for the working man who gets paid with W2 income to revolt against the “capitalist system”?
Why are dividends and capital gains worth lower taxes than W2 income?
n46130, I’m no expert but I think there’s a four-letter word that might help explain the lower rate on capital gains–risk.
IMO, we need to let the tax cuts expire and use the money to fund job programs and give wind under the wings of labor. I would rather see long lasting pay raises than termporary, deficit financed tax cuts a.k.a. business demand stimulus a.k.a. special interest enriching bills. A pay raise and useful infrastructure is long term prosperity. Temporary tax cuts and welfare is the road to serfdom.
Personally, I think the US needs to do something serious about the debt, sooner than later. I realize this will have serious effects on the GDP, but those effects will happen eventually, and the sooner they happen, the better, in my opinion. The US currency cannot survive our continued fiscal irresponsibility. So long as the power elite chooses all the candidates for public office, we cannot expect sane action from government. We will have to settle for incompetent stumbling. When the stumbling is in the right direction, I applaud the effect, and pray it continues.
The problem with Altec’s grossly misinformed view is that it simply is not true that Obama’s deficits are larger that all these other presidents combined. The numbers he uses puts Bush’s trillion dollar Medicare plan on Obama’s books. Also it puts the cost of two wars on Obama’s books.
With this said we do need to address deficits responsibly. Taxes are going to need to be raised as well as cuts. However, when rich companies lobby the government I would bet the young people and the middle class will be on the choping block. Altec, go ahead watch fox news, but please watch other forms of news to challenge your thinking. Not everything on fox is bad but you can you can’t live in that bubble forever.
Like others have said, this is an investing site. The bottom line is every monetary system requires a circulating medium of exchange. Ours requires constant expansion of the money supply. We need MxV to move higher so what do we propose to accomplish that?
Tax cuts for the rich lead to more accumulation and lower V. Welfare-based business demand stimulus lead to more accumulation and lower V. We all don’t like expanding M to infinity. So what are we to do? Less politics and more solutions.
I’m not sure how calling half-trillion dollar budget deficits during boom economic times “very manageable” is anything other than a grossly uninformed distortion. Because if you balloon the national debt, as Bush did, during the good times, what are you going to do when the bad times hit? When tax revenue plummets and reliance on social programs increases? I guess we’re finding out what you do: ignore the lessons of the Great Depression, blame the people trying to mop up the mess, and spout self-serving nonsense about macroeconomics that would make any 9th grade Econ student embarrassed for you.
I’ll ask again, for the umpteenth time: if you think Keynesian stimulus is counterproductive folly that only mushy-headed liberals would believe in, why would you take investment advice from someone like Jim? Have you not read what he’s written on the subject?
The only thing I’ll grant you is that at this stage of the crisis, and after thirty years of Republican administrations abusing the national credit card, there may not be enough room left on it to sustain the massive stimulus necessary to actually improve things significantly. Going forward we’ll likely just have to do the best we can at stimulating the economy while running only a modest or no deficit. It will greatly slow our recovery, but there may indeed be nothing for it. In any case, pointing fingers at Obama for all of this is pretty absurd, unless you credit him with the power to travel back in time and mind control Republican presidents.
I’d rather invest in a country with a stable currency and no deficit than one where $1.5 Trillion-dollar deficits are commonplace and healthcare costs consume 40 percent of dividends.