The tax hikes and spending cuts scheduled to kick in at year’s end could wreck the economy. So why isn’t Wall Street sweating? MoneyShow’s Jim Jubak, also of Jubak’s Picks, explains.

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 US economy and stock market. Everyone knows the odds of avoiding the plunge are extremely low. And everyone can put a date on the plunge.

Is the only question when to jump out of the car? The US 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 growth of the US GDP 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 US could expect further credit-rating downgrades from 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.

Crashing on Autopilot
Here’s how the Congressional Budget Office summed up the approaching fiscal cliff in January.

  • What the CBO calls "tax provisions," and that most of us think of as the Bush tax cuts, are set to automatically expire at the end of this year. 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 are to go into effect 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 the year, sending the withholding rate back to 6.2% from the current 4.2%.

The total, if all the automatic cuts and tax increases happen, would remove about $500 billion, or 4% of GDP, from the US economy. The effect, the CBO estimates, would be to 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 would stay above 8% in 2013 and wouldn’t decline to 7% until the end of 2015.

The bad news is that the CBO forecast falls at the optimistic end of forecasts. Some economists calculate that tax increases and spending cuts of that magnitude 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, and you get a negative number.

In other words, these tax and spending cuts could push us into recession again (the negative view) or give us an economy growing at just 1.1% (the positive view). That wouldn’t be a recession, technically, but it would feel like one.

What, Markets Worry?
Are the financial markets worried about this? We’re certainly starting to hear a lot of 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 S&P 500—was a result of worries about near-term US economic growth, near-term US job growth, and near- to midterm recession in Europe.

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 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 to worry about January, and way too early to worry about an economic slowdown that would only gradually build up speed in 2013.

But a bigger part of the reason is the US election. There’s a justifiable belief that nothing will get done before we know the results of November’s presidential vote. And there’s a strong belief that politicians will then, in an end-of-the-year panic, do something to prevent the US from driving over the cliff.

What exactly that 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, we don’t know who will wind up in control of Congress.

Will the Democrats keep control of the Senate? Will they take control of the House? Will Republicans gain control of the Senate and keep control of the House, giving them control of both chambers 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 too uncertain and volatile for money to start flowing one way or the other.

There’s no point in disrupting existing portfolio constructions with elections so far away, the results so uncertain, and the results of the results so unclear.

NEXT: Betting on "Kick the Can"

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Betting on "Kick the Can"
I think the reluctance to act now is also based on a not-so-outlandish analysis that the effects of the elections on US 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 Rep. Paul Ryan’s budget blueprint, or a Democratic victory that resulted in the enactment of President Barack Obama’s plan to repeal the Bush tax cuts for the very rich, but 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.

In other words, the most likely effect of the election will be a US replay of the strategy that Europe has perfected during the Eurozone debt crisis: kicking the problem down the road. It wouldn’t get kicked very far, mind you. But you really can’t expect Wall Street to get too worked up about a budget that wouldn’t 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 US credit rating again? Sure, but that’s not likely to be a problem until the summer of 2013.

Might a failure to honestly address the US budget deficit start to hit US interest rates in the second half of 2013? Sure, but that is a problem for the second half of 2013.

In the longer term, I think there are substantial differences between the approaches in the Ryan and Obama budgets—and at some point the markets will reflect that. But not yet.

What Matters Most to Wall Street
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 of the price of dividend stocks. (That would come as quite a shock to all those investors who have bid up the prices of dividend stocks.)

A stock that pays $10 in dividends per share each year 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 see dividend stocks start to slide faster than the market as a whole, that’s an indication that Wall Street has started to take to heart the possibility that Congress won’t act. 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 US 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. And Wall Street’s decision is not to worry about the long run until it’s impossible to ignore it any longer. But certainly not before 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, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.