Fiscal Cliff Explained
We had the pleasure of chatting last week with Nick Bohnsack, who is the equity sector strategist at Strategas. As the sector strategist, his specialty is suggesting which sectors (such as health care, industrials, tech….) look better than others. But, like all the analysts at Strategas, he is a man of many hats, so he can speak for all of his brethren at our favorite research shop. So, we use the occasion of his visit as an excuse to share with you what Strategas is currently thinking about the economy and fiscal cliff.
Prior to the election, the #1 question the Monarchians were most often asked had been “how will the election turn out?” Now that the election is over, people want to know, “will we be cascading over the fiscal cliff?” Good questions! Thanks to the benefit of hindsight, we can easily answer question #1. Question #2, though, that’s tougher.
What is the fiscal cliff? This refers to the expiration of myriad tax cuts and other fiscal stimuli on 12/31/12, and Congress’ complete inability to come together in the past couple years to enact any permanent tax legislation. The term “cliff” ominously implies that the economy will plummet off of a cliff IF the tax cuts are all allowed to expire. Thus tax rates would rise across the board (personal income, payroll, AMT, dividend income, capital gains), and cuts in government spending would automatically take place. The following chart from Strategas breaks down all the expirations:
We all share a ton of skepticism that “lame duck” Congresspeople will be able to reach across the aisle and come to a compromise before the end of 2012. We’ve seen this movie too many times during the current Administration, which has failed to bridge the most polarized Congress ever.
But every stakeholder in the process also knows that the cost of inaction is very high, and every Senator and Representative know they will be the “owner” of the fiscal cliff if it were to come to fruition (even Patty Murray). Nobody wants that, regardless of the level of conviction in their ideology. That doesn’t mean we’ll for sure get a grand bargain, but we’ll almost certainly get some sort of resolution, whether temporary or permanent.
Whereas most market observers are viewing the fiscal cliff outcomes as binary, meaning that either everything or nothing will be extended, Strategas believes that the result will be in the middle somewhere. In order for there to be ANY compromise, there must be some spending cuts AND some tax revenue increases. Both would serve to trim the budget deficit, but also would serve to trim the economy. Thus, Strategas’ baseline forecast is for a shallow recession, driven by cuts in consumer spending (thanks to the sudden realization that income taxes and payroll taxes have just increased), and a stall in business spending (“capex”). The table below delineates their assumptions. In particular, note that the 3rd line (Real GDP growth) turns negative in the first quarter of 2013 (-0.5%).
The misnomer about the fiscal cliff, however, is that once we’ve gone over the cliff, it’s really tough to get back up to the top again. This is a very poor analogy of the current state of the U.S. economy (Greece, perhaps). Our economy has been “deleveraging” for 5 years now, meaning that businesses, banks, and consumers have been busy paying down debt. We have been “under-spending” as a result. Businesses and consumers alike have held off on large spending decisions. This has 2 ramifications. First, there isn’t much room for economic output to drop. Second, there’s a lot of pent-up demand for the next upturn in the economy.
This is why Strategas sees the potential for the next recovery to ensue as early as late next year, led by housing, the energy exploration boom, and pent-up capital spending finally getting unleashed. Remember all the shapes that we all imagined for the economy’s recovery in 2009 and 2010? Would it be a V? U? L (no recovery)? W (double dip)? Their expectation is now something more like vampire teeth….
Even after their post-election drubbing, stocks are still +10% this year. With an economy at “stall-speed,” earnings growth slowing, and a lot of headline risk from the fiscal cliff, the market’s strength this year has caught a LOT of people by surprise. It’s still an open question as to why so strong? Some people would say that a lot of enthusiasm about resolving the fiscal cliff has been built into stock prices, and investors are looking ahead to the next big upturn. We would disagree, at least anecdotally, noting the vast lack of trust that Washington will do anything positive. Instead, we believe stocks are being held up by two huge factors: 1) the Fed (and ECB) seem willing to do ANYthing to support financial markets, and 2) savers and investors who are starved for income have found stocks as a source of income (and income that grows!). These two should factors won’t be going away anytime soon, even if dividend tax rates rise.
Until the next upturn, expect volatility to continue, but the reward for holding on should make up for it.