The Independent Market Observer

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

Posted by Brad McMillan, CFA®, CFP®

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

and tagged Fiscal Cliff, Outlook 2013

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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.

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