The Fiscal Cliff – Quarterly Update

The term “fiscal cliff” was coined by the Federal Reserve chairman Ben Bernanke, and refers to the $550 billion in tax hikes and spending cuts that will take place automatically on January 1, 2013, unless the President and Congress take action to prevent it. (Source: Kiplinger’s Personal Finance, October 2012)

Failure to modify the tax hikes and spending cuts would almost certainly induce a recession. The Tax Policy Center estimates that the fiscal cliff would hit 90% of U.S. taxpayers and cost an average of $3,500 in extra taxes per household. (Source: USA Today, October 5, 2012, 5B Investing Protect Your Money)

The fiscal cliff itself isn’t giving money managers nearly as much reason to worry as the uncertainty surrounding it is. “Uncertainty is worse than knowing,” said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management. (Source: Investment News, July 16, 2012, page 34) The most uncertainty surrounds dividends, which have been increasingly popular, given the record low yields in fixed income, Mr. Grohowski said. Right now, the dividend tax rate is at 15%, but depending on what Congress decides, it could go as high as 43% for that bracket. “That’s a pretty big spread of uncertainty,” Mr. Grohowski said.

Unless Democrats and Republicans can agree to extend at least some of the Bush-era tax cuts or postpone some of the spending cuts mandated by the Budget Control Act passed last year, the economy will suffer. “The macroeconomics behind the fiscal cliff issue is horrendous,” said Allen Sinai, chief global economist with consultant Decision Economics, Inc. “It’s unthinkable that this might actually happen.” (Source: Investment News, July 16, 2012, page 34)

Many advisors believe Congress will take steps to moderate some, if not all, of the tax changes before the end of the year. However, even if they don’t, they could still pass laws next year retroactive to the beginning of 2013. Unfortunately, with all the uncertainty still looming today, markets are likely to be swayed by the headlines rather than fundamentals.

The mere threat of $600 billion in tax hikes and spending cuts is already delaying business spending. Big economic forces, both domestic and abroad, are combining to dampen growth. As the economy has cooled, so have the economists’ forecasts. The average estimate of the 79 economists surveyed by Bloomberg is for gross domestic product to rise 2.1% in 2013, down from the consensus of 2.5% in May. The fiscal cliff poses the biggest threat. The combination of deep spending cuts and tax increases set to hit in January could strip as many as four percentage points off 2013 GDP growth. On top of that, the global economy is weakening, particularly in China and Europe, two of the biggest export markets for the U.S. China’s industrial output is growing at its slowest pace since May 2009. Although Europe’s leaders appear to be making progress in taming their debt crisis, much of the continent is already in recession. (Source: Bloomberg, September 17-23, 2012, page 13)

Global trade is stalling, dimming prospects that exports will buoy the U.S. economy in the coming months. The World Trade Organization just projected the global volume of trade in goods would expand only 2.5% this year, down from 5% last year and nearly 14% growth in 2010. The trade slowdown could worsen as momentum slips across the global economy.

Europe was the epicenter of the weakness radiating from the global economy. Weak exports have exacerbated a slowdown in China’s domestic economy, which economists project will grow about 7.5% this year, which would be the weakest annual expansion since 1990. (Source: WSJ, October 1, 2012, A1 Trade Slows)