The Independent Market Observer

11/20/12 – Back to the Happy Place, for the Moment

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Nov 20, 2012 11:32:34 AM

and tagged Fiscal Cliff

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Yesterday, the stock market cheered the good news on the fiscal cliff negotiations—that everyone was being polite to one another for a change. The market melted back up to the level of, well, last week. Even with yesterday’s bump, though, we are still down about 3.5 percent in the past month, which suggests that investor optimism may be premature. Let’s think for a minute about what the fiscal cliff means, and what “solving the problem” might mean, to see whether this degree of optimism is warranted.

First of all, the fiscal cliff consists of two major components: tax increases and spending cuts. Within those two divisions, there are smaller items. On the subject of tax increases, for example, the impending expiration of the Bush-era tax cuts is getting all the press.

No one is talking about the expiration of the payroll tax cut, but that is going to have the widest effect on taxpayers. When the tax cut goes away on January 1, 2013, 160 million workers will see the amount of their paychecks shrink. The typical American family will lose about $1,000 a year as a result.

This will have a disproportionate effect on the economy, especially for the less affluent. For people living paycheck to paycheck, any reduction in income will lead to an immediate reduction in spending, which will hit the economy directly and immediately. The 2013 tax increase of around $95 billion could reduce GDP growth by about 0.6 percent, which is significant when GDP is only growing 2 percent, at best, right now.

And this, remember, is a relatively minor piece of the overall fiscal cliff; what’s more, it doesn’t even begin to solve the deficit problem. The really scary thing is the fact that the cuts in spending and tax increases have to happen. If they happen fast, we will see the cliff; if they occur slowly, we will see a drag on growth over time. But happen they will.

The question is how. The election seems to have shifted the argument from whether to raise taxes on the rich to how and how much. The New York Times (NYT) has two articles on the front page about taxes: “Tax Talk Raises Bar for Richest” and “For Tax Pledge and Its Author, a Test of Time.” The first article talks about how the $250,000 bar is really a $300,000 bar—or even a $500,000 bar—which is an interesting spin on the definition of rich. I see this as a trial balloon on where the bar will eventually be set, with the president winning the point that the rich will pay more. The Wall Street Journal (WSJ) recognizes this as well, in “President Has Small Edge on ‘Fiscal Cliff’ Leverage” on page A4 today. The second NYT article talks about the no-new-taxes pledge signed by most, but not all, Republicans and how it is starting to potentially erode.

All in all, the tax narrative is changing in the direction of higher taxes for everyone. The spending narrative is also changing, with entitlements in the crosshairs. “Entitlements Split Democrats” (WSJ, p. A4) is a good summary of the bind that the party finds itself in. We have not started having that fight yet—it will come after the tax fight and will be even tougher. Arguably, the election spoke to whether to raise taxes, but no one really raised the entitlements issue, so that will have to be fought out from the beginning.

We appear to be seeing some real progress, at least in postponing the problem, but any real solution will involve sacrifices on everyone’s part, and a market reaction that assumes we will be going back to the normal of, say, 2007 is at least premature. Even though the market is more reasonably priced than it was a month ago, we are not out of the woods yet.

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