Policy makers will eventually succeed in smoothing out the fiscal cliff and debt ceiling (whose limit will be hit in February or March) and economic growth will be sustained near current levels of 1.5-2%, but expect large volatility along the way.
- The economic headwind from deleveraging consumers is easing
- Home prices are picking up and residential investment is contributing to growth
- Higher home prices are also supporting consumer spending through wealth effects
- The drag from state and local governments will fade as other sectors pick up
There is pent-up demand for capital spending in the business sector as well, although this will first require a more certain business climate.
However, on the path towards compromise, policy gridlock could lead to unintended consequences and ratings agency ire. Moody’s has already stated it will cut the U.S. to ‘Aa1’ in the absence of specific policies that produce a stabilization and then downward trend in the federal debt to GDP ratio over the medium term. What no one seems to factor in is that, cliff or no cliff, taxes are up on the wealthy and those in the $250K to $1MM bracket are already budgeting to spend less, especially in states like California where the state income tax is up about 4% and sales tax will be higher too. There is still a lot of fear and doubt, but there also seems to be fresh signs of capitulation as people see their after-tax incomes decline. Securities seem to be priced for subdued global growth.
Base case is 2-2½% of fiscal tightening in 2013.
- Across party lines, there is little appetite to roll-over the 2011-12 payroll tax concession, accounting for 0.8% of GDP
- Higher taxes on the investment income for the wealthy are likely to pay for Obamacare – another 0.2%
- Also, pencil in half of the Budget Control Act’s spending cuts or 0.3% of GDP to occur
- All of this is in addition to the already agreed spending and revenue changes from last summer of 1.0%
- The waters become murky concerning the Bush tax cuts where campaign promises and ideology make it more difficult to compromise
- Obama’s campaign centered on forcing the rich to pay more, but it is not in his interest to hold the middle class hostage by insisting that all the Bush tax cuts expire
o Republicans staunchly opposed any tax increases and vowed to roll-over the entirety of Bush tax cuts, but they do not want to be responsible for causing the middle class to be squeezed more
All this suggests a compromise is likely. In addition, the last Alternative Minimum Tax (AMT) patch expired at the end of 2011. It needs to be retroactively fixed before the end of 2012, or the numbers of people hit with AMT taxes will jump from approximately 4 million to 30 million. Without the patch, AMT payments, owed by April 2013, would reduce U.S. GDP by an additional 2% that is not factored into anyone’s fiscal cliff calculations.
The most likely scenario is that President Obama allows for all the Bush tax cuts to roll-over in exchange for higher tax revenue by closing various tax loopholes, reforming the tax code so that the rich have less deductions, and exemptions and higher taxes on investment income. This would allow both sides to claim victory and fulfill core campaign promises. Yet, the other measures mentioned above still suggest fiscal tightening of 2-2¼% of GDP. This is good news for those who expected Armageddon. The bad news is that US growth will likely remain below trend under most scenarios. Markets are picking up on this fact, with the S&P 500 declining 5% since the election.
Although avoidance of the fiscal cliff is hoped for and expected, it is far from guaranteed. Expect volatility in November as the market continues to react to election outcomes and political jockeying, the fiscal cliff becomes the new topic du jour, and both Greek debt and Middle East tensions regain headline status. The global economic slowdown will continue to restrain US exports next year and a resurgence of the euro-zone crisis could shake US financial markets. Nevertheless, domestic demand growth should strengthen, particularly if the housing recovery continues to gather momentum.
Michael Ashley Schulman, CFA