Dark Cloud Looms Over Economy as Fiscal Cliff Approaches

 

By Rom Badilla, CFA

August 8, 2012

As stocks rise fueled by positive corporate earnings and waning concerns over the European debt crisis, little attention has been given by the markets on the impending Fiscal Cliff. Given the magnitude of spending cuts coupled with lackluster support by the American consumer, the fiscal cliff may weigh heavily on growth that may sink the economy into another recession.

According to Goldman Sachs’ economics research analyst, Alec Phillips, these spending cuts if left unaddressed, would weigh on real GDP growth in 2013 by almost 4 percent. Goldman Sachs presented the following in their latest report, US Daily: Breaking Down the Fiscal Cliff:

“Over the last few weeks, the political debate on various aspects of the fiscal cliff has begun in earnest, with competing votes in the House and Senate on deferring various aspects of the fiscal restraint scheduled to take effect after year end. So far, Congress has taken the following actions:

  • The House has voted to defer most of the spending reduction scheduled for FY2013 under the “sequester” to future years (the Senate has not acted).
  • The Senate has voted to extend the 2001/2003 tax cuts on income below $250,000 (it rejected legislation to extend all of the 2001/2003 tax cuts).
  • The House has voted to extend the 2001/2003 tax cuts on all levels of income (it rejected a bill to extend the tax cuts only on income below $250,000).
  • The Senate Finance Committee has passed legislation to extend expiring corporate tax provisions as well as relief from the alternative minimum tax (AMT) for two years.
  • The House and Senate have both passed legislation requiring the Obama Administration to detail the spending cuts that would be made under the sequester. The President has not yet signed the bill.”

Due to the uncertainty and apparent lack of urgency by politicians, there are several potential outcomes at the end of the year. Goldman Sachs presented the following chart depicting two alternative paths: a more benign effect on growth if policy changes were delayed (Solid Line) and the Fiscal Cliff which is the scenario that may result if policymakers continue to do nothing (Dashed Line).

Goldman’s analysis included several assumptions on the timing and magnitude of the economic effects from the Fiscal Cliff since there is a fair amount of uncertainty on the details of the implementation of the spending cuts.

Having said this, the perception and ultimately the response by consumers are equally important as the speed of the tax changes in order to how to determine the economic impact. This in turn should add to the ever growing pile of uncertainty, left by policymakers on both sides, for the economy with the elections only three months away.

“Consumers might be willing to “look through” a short-term tax increase if they have a high degree of confidence that a retroactive extension of most or all of the expired policies would replace the lost income. For example, it is possible that one political party could make significant enough gains in the November election that it prefers to extend the expiring fiscal policies on its own terms in early 2013, rather than negotiating a bipartisan compromise in the “lame duck” session of Congress in late 2012. In such a scenario, consumers might be willing to look through the temporary reduction in disposable income since the eventual outcome would be fairly clear and would not hinge on a political agreement between the parties.

On the other hand, if the policy changes that make up the “fiscal cliff” were to take full effect because of a political failure—i.e., if lawmakers were unable to compromise even on policies they both generally support and there was no clear path to resolution—consumers would have much less certainty regarding the eventual outcome and we would expect a lapse to be viewed as more permanent, which could prompt a greater response in consumer behavior.”

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3 Comments

  1. [...] coupled with the outlook components, it appears that the general public continues to discount its potential effect on economic growth and how it could derail the rebound. While bulls are making new highs in prices fueled by Fed [...]

  2. [...] stocks coupled with the outlook components, it appears that the consumers continue to discount its potential effect on economic growth and how it could derail the rebound. While bulls are making new highs in prices fueled by Fed [...]

  3. [...] Whether its Equities or High Yield bonds, risk assets will fall if leaders fail to reach an agreement on the issues surrounding the Fiscal Cliff. The equity fund managers have positioned their portfolios to reflect this view. If pressures begin to mount due to further escalation of an impasse, you can bet that risk assets will have little support. At that point, I wouldn’t be surprised to see equities tumble and yields on lower rated corporate bonds to rise since falling off the Fiscal Cliff will most likely lead to an end of the current recovery and into a new recession. [...]

 
 

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