12/21/12 - Outlook 2013: The Economy Returns to Normalcy - The Fiscal Cliff (Part 4)

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Dec 21, 2012 4:54:36 AM

and tagged Fiscal Cliff, Outlook 2013

Leave a comment

All of the preceding analysis is based on the assumption that the fiscal cliff is averted and that a deal, which phases in any tax increases and spending cuts over time, rather than imposing them all on January 1, is cut.

Economic impact

Should such a deal not be cut, the impact could be severe. Although there will not be an immediate change in the economy of the type implied by the word cliff, the effects will begin immediately as payroll withholding rates are adjusted, which will reduce take-home pay across the board, with the greatest proportionate impact on the lower-income tiers.

The statutory impact of the tax increases and spending cuts will be about 4 percent of GDP, with about two-thirds of that coming from tax increases. The aggregate impact will be greater than that, however, as the relationship is not one-to-one. In fact, economic studies suggest that tax increases have a negative effect on economic growth in the 2–3x range, while spending cuts have a 1–2 multiplier. Overall, the fiscal cliff could, over time, decrease growth by 6 percent or more. Starting from a base growth rate of around 2 percent, this would result in a significant recession.

An analysis by the Congressional Budget Office (CBO) suggests that the fiscal cliff-induced contraction could increase the unemployment rate to 9.1 percent. I suspect that the damage would actually be worse. The CBO also suggests that the economy would contract for two quarters before starting to grow again, but, again, I suspect that is optimistic.

Financial market impact

Fixed income markets might well benefit from the fiscal cliff, as the deficit will decrease dramatically, and the financial security of Treasuries could actually be improved, which, along with any flight to safety, could result in lower interest rates overall. Equity markets, on the other hand, would face probable revenue declines and increased risk aversion, which could result in a one-two punch to market values, as both earnings and valuations would decline simultaneously.

Both markets could suffer from the fiscal cliff, but equities are likely to get hit much harder. The next phase, though, where the U.S. runs into the debt ceiling again—expected early in 2013—could hit fixed income harder. If no agreement is reached on the fiscal cliff, the likelihood of an agreement on the debt ceiling will decrease. If no agreement is reached there, the U.S. could conceivably go into voluntary default, which could hammer fixed income.

The fiscal cliff and pending debt ceiling are the primary risk factors for financial markets, and, at this point, given the wide range of possible outcomes, there is no real way to estimate the consequences. Should we need to do so, we will issue updated guidance when we have more information.

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®