Fiscal Cliff Raises Possibility of Further Downside in the U.S. Markets

Elliott Gue |

NYSE Wall StreetFor the past few months, I’ve grown increasingly concerned about a second-half slowdown in the U.S. economy, cata­lyzed by uncertainty over major tax increases and spending cuts that are slated for early 2013.

This $560 billion hit to the U.S. econ­omy will remain a threat regardless of who wins the White House (see “The Fiscal Cliff”). That’s because none of these tax increases or spending cuts rep­resent proposals made by the Obama or Romney campaigns. Instead, the entire $560 billion austerity package is the re­sult of measures already passed by Con­gress and signed into law.

To avert the precipitous fiscal plum­met on January 1, 2013, the current­ly deadlocked legislative and executive branches would have to agree to re­peal or delay implementation of exist­ing laws.

The risks for the U.S. economy are grave including more than $400 bil­lion—2.75 percent of gross domestic product (GDP)—in tax increases and more than $100 billion in automatic spending cuts.

The Congressional Budget Office (CBO) estimates that these tax hikes and spending cuts would shrink the U.S. economy at a 1.3 percent annual­ized pace in the first half of 2013, re­stricting it to growth of just 0.5 per­cent for the full year.

The problem with the CBO’s report is that it’s almost comically optimis­tic. The non-partisan research group estimates that U.S. economic growth in 2013 would be 4.4 percent if all of the scheduled fiscal contraction is repealed and 0.5 percent if current laws stand. That means the CBO estimates the impact of these measures to be about 3.9 percent of GDP.

However, the U.S. economy has not managed growth of 4.4 percent since 1999, at the height of the technolo­gy bubble. The CBO assumes that the US economy will return to what could be considered “normal” historical patterns in 2013, but I see that as highly unlikely. U.S. consumers continue to pay down debt and banks face signifi­cant new regulations that will hamper credit growth. Meanwhile, oil pric­es remain a headwind, even though they’re off their recent highs. The U.S. economy certainly won’t get a lift from strong economic growth in the European Union, given the region’s still-unsolved sovereign credit crisis.

A legacy of the 2007-09 financial crisis is a slower U.S. economic growth rate of 2 percent to 3 percent, at best. If we assume a slower baseline rate of economic growth in 2013, the reces­sion caused by the fiscal cliff looks far more severe than the CBO projects.

History suggests that tax increases have a more immediate and deleteri­ous long-term impact on economic growth. Based on the CBO’s esti­mates, close to three-quarters of the scheduled 2013 fiscal contraction will stem from “revenue policies,” Wash­ington, D.C. lingo for tax increases. That means that the biggest hit to the U.S. economy would be felt in the first two quarters of the year. With the U.S. economy just barely limping along, the first two quarters of 2013 will feel like a moderate to severe re­cession, not the mild downturn the CBO suggests.

The Momentum Factor

When the economy improves and businesses boost hiring, consumer in­come rises and gives the economy and stock market a shot in the arm—think of it as a self-reinforcing feed­back loop. But the same is true on the downside. If the U.S. economy shrinks at a worse than 2 percent annualized pace in the first half of 2013, the dam­age is likely to persist into the second half of the year.

These tax hikes and spending cuts are hardly a state secret—the words “fiscal cliff” have entered investors vernacular. Businesses also are aware of these risks and most of them won’t wait until January 1, 2013 to react. They’ll try to predict the degree to which fiscal policy will affect their re­spective industries and change spend­ing patterns accordingly.

Regardless of the outcome of the November elections, some or all of the scheduled fiscal austerity is likely to be either postponed or canceled. How­ever, for this to happen, the current administration and divided Congress need to hammer out a compromise in a lame duck session after the elections, a tall order in light of today’s partisan rancor. Of course, the newly elected Congress could alter the law retro­actively in early 2013 but under that scenario, uncertainty would linger un­til at least the end of January.

Given the other headwinds facing the U.S. economy such as still-high en­ergy prices and Europe’s credit mess, I’m expecting a second wave to the current economic slowdown. One in­dicator I’m watching carefully is initial jobless claims, which have been trend­ing back to 2012 lows. If businesses cut spending, it should translate into a weakening labor market.

I still think the U.S. economy will avert outright recession. Also, it’s a hopeful sign that the euro debt conta­gion is prompting EU leaders to take tangible steps to mitigate the crisis. In particular, Germany’s opposition to such measures as euro-area bond is­sues shows signs of weakening.

I’m also encouraged to see Italian 10-year yields still well under 6 per­cent, a sign that the market has confidence in efforts undertaken by Italy’s technocratic government to bring the nation’s budget into balance.

Nonetheless, the risks of a downturn are rising this summer.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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