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

05/08/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

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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