The Fiscal Cliff Is Looming

On October 9th, 2012, posted in: Economic News, Newsletter by

Everyone knows the fiscal cliff is looming. Remember the movie, Thelma and Louise? They are about to drive off the cliff, in one last climatic scene of independence and stupidity. You don’t have to go and watch the movie because our very own federal government is heading toward the fiscal cliff. It should be spectacular if Congress does not turn the wheel.

Try as they might, if a new budget agreement can’t be reached by the end of this year or early next year, federal spending gets automatically trimmed – sequestered – by $70 billion through September 30, 2013. Half of it comes from the defense budget. But don’t despair. Government spending is estimated to be about $2.7 trillion from January to September 2013. So, we’re only talking about 2.6% of total spending – or 0.6% of GDP.

The cuts will hurt defense contractors and other recipients of government business and aid. But when the goal is to cut government spending, this could show Washington is starting to get its fiscal house in order. This would probably have a positive effect on GDP. Spending was cut about this much at the end of the first Iraq War in 1991 and the economy grew.

The bigger issue is the tax side of this problem. This includes (1) the end of the 2% payroll tax break of the past two years – $120 billion in extra revenue per year. (2) A new extra 3.8% tax on dividends, capital gains, and interest income and a 0.9% Medicare tax on high earners – $25 billion/yr. (3) lower thresholds for the Alternative Minimum Tax – $100 billion-plus. (4) A return to the 2000 tax rates on income, dividends, and capital gains, including a top official rate of 39.6% on ordinary income and dividends and 20% on capital gains – $150 billion-plus.

The odds of a recession have risen to 25%. But, if all of these tax hikes are allowed to happen,  the odds go up considerably.

With an ear to Washington, it is likely the 2% payroll tax cut won’t be extended again. That, by itself, is not cause for much concern. Personal income is up $460 billion in the past year, so workers have enough income growth to absorb a reversal of the payroll tax cut and still increase their purchasing power. The economic expansion would survive.

The real issue is what impact higher marginal tax rates on ordinary income, dividends, and capital gains will have on investment and work effort. The unsettling impact on consumers and investors will likely cause a retrenching of confidence and investment. This is an era of economic cycles, dominated by shifts in monetary velocity and the risk of a panic. A major and sudden shift in tax burdens would likely cause a recession even if the supply-side effects on incentives are relatively small.

These tax hikes not only will damage the supply-side of the economy, but will subtract hundreds of billions of dollars of income from the private sector. Both sides of the political aisle understand this, which is why there is probably going to be a last minute agreement regardless of who wins the election.

There is no chance an agreement will be reached before the election. Chances of that happening are extremely low. But don’t expect a quick agreement afterwards either. Both parties have an incentive for brinksmanship to drive the best possible bargain for their supporters. Instead, this will probably be pushed to the last days of the lame duck session.

The fiscal cliff will be a mirage in the end. Tax rates will not be increased anywhere near high enough to cause a recession. So it is likely the US will continue to grow right through 2013. The Plow Horse will continue to keep its head down. The stock market “gets” this outcome and it is why the market will continue to move up, despite the threat of the fiscal cliff.

Let the credits roll.

NEWS IN REVIEW

Last Friday’s unemployment report drew political fire from all corners, including Jack Welch Past President of GE. The report showed a nominal increase in the number of new jobs, but created a significant decline in the overall unemployment rate, down to 7.8%.

·   The BLS (Bureau of Labor Statistics) announced 114,000 new nonfarm jobs were created in September, with the health care sector accounting for the biggest increase, nearly 44,000 jobs.  At the same time, the figures for July and August were revised upward by a total of 86,000.  There was a disappointing 10,000 decline in manufacturing jobs. The government unemployment rate dropped from 5.3% to 4.8% in September.

  • The BLS calculated the nation’s unemployment rate at 7.8% down from 8.1% the previous month.  This is the lowest rate since January 2009, when President Obama took office. The improvement unfortunately is attributed to a big jump in part-time employment, hardly a positive return on investment for the US.

Moody’s Analytics, “…job growth is weighed down by the weak global situation, the impending U. S. fiscal cliff, and uncertainty about federal regulations and policies.” Trying to buttress the WH from criticism and claims of manipulation, WH spokesman attributed the large decline to two statistics that come from different surveys, saying they are not always consistent with each other on a month-to-month basis.  Further improvement isn’t likely in the coming months.

We did see signs of economic improvement. These include:

1. The Institute for Supply Management (ISM) showed gains in both manufacturing and service. ISM manufacturing rose to 51.5 and non manufacturing rose to 55.1. Anything above 50 means the economy is expanding.

2. A jump in consumer credit by $12.2 billion in August. This was much higher than projected. A deep dive shows student loans and auto loans were major factors in the increase.

3. Construction spending jumped up sharply compared to last year. Residential construction is at its highest level since January 2009.

Bottom Line: while the economy continues to plod forward, it is at a remarkably slow pace. It may take two to three years before GDP reaches +3% and unemployment falls under 6%. Given this economic reality coupled with the uncertainty of the fiscal cliff and the huge deficits, it is certainly reasonable to question if the stock market isn’t overvalued and likely to have a major correction.

GDP growth for 2Q 2012 was revised downward to just +1.3% from the earlier estimate of +1.7%, and from the +2.0 number revised for the first quarter.  The drop was attributed to further declines in durable goods consumption and fixed investment.

In August, personal income grew by 0.1%, primarily because wage income growth was weak.  Initial jobless claims remained  high at 359,000 for September.

The good news was various measures of inflation declined, due to lower energy prices.  However, the latest bump may change all of that. Most think inflation isn’t a problem for the economy today. In fact, articles are starting to pop up on deflation.

New-home sales were at 28%, up from a year ago and the median sales price for new homes was $256,900 for August. This is up 17% from a year ago and the highest level since December 2004.

Bottom Line:  Depending upon the election, economic recovery may start to accelerate in mid-2013, but regardless, it will take a couple of years to reach +3% GDP growth and 6% unemployment. This is what it will take to curb the national debt and bring the deficit under control if government is going to avoid raising taxes.

WHAT’S HAPPENING IN THE MARKETS

Stocks were up starting  4Q 2012.  The Dow [ +11.40%] the S & P 500 [+16.17%], and the NASDAQ Composite [+20.38%] all gained.  Some are calling this the “Romney Rally,” because of his presidential debate performance.  Mr. Romney is seen by many, as more favorable to business than Mr. Obama. Past performance is no guarantee of future results. Indexes are not available for direct investment.

Look for increasing market instability in the coming weeks as political factors play out.  As stated before, ticking down on both the presidential election in November and the impending “fiscal cliff” at year’s end will drive investors emotions.  Combine those two events with any possible variation in 3Q earnings reports, due out soon. Enough to make markets schitzo.

U. S. Treasury bonds increased for the week (both 10 year and 30 year), raising questions as to whether the Fed’s various activities – QE3 and Operation Twist are working.  The Treasury “spread” (the difference between the rate on 30-year bonds and 90-day T-bills) was almost identical to the beginning of 2012.  So tell me again why the Fed has dumped hundreds of billions of dollars in financing and investing into the economy? Does it really matter?

Mortgage rates continued to dip lower, but has not had any discernible impact on housing. Borrowing rates are unlikely to impact the economy in the next couple of years.  It is the unemployment situation, the market for existing-home sales and consumer confidence that is going to impact the US economy.  Housing is a function of consumer confidence. Confidence drives sales. No one is going to buy or sell if they are afraid. It is status quo until then.

The US Dollar fell in value as the Euro (€) gained ground in early October.  The Euro seems to ebb and flow based on the continent’s economic circumstances.  There has been limited bad news of late. But every knows there is no easy way out for Europe. Their economic and social issues are systemic and long lasting. It is going to be chaotic in Europe for the next couple of years.

California shortages due to refinery problems drove the price of gas in California above $5 a gallon. Oil and gas prices were relatively stable for the week.

YOUR FINANCIAL FACTS FOR THE OCTOBER

According to a recent article in Businessweek, the S & P 500 held cash reserves of $1.01 trillion in the first three months of 2012. Recovery is tied to the velocity of money. This money is going no where.

The 2012 Government Fiscal year ended September 30.  Estimates are the federal government deficit will be $1.1 trillion. The last year time the federal government had a surplus was 2001. The surplus was $128 billion.

HERE IS A USEFUL FINANCIAL WEB SITE

www.FinAid.org – this free site provides a wide range of information and calculators related to funding a child’s college education; helpful in determining the “expected family contribution” (EFC).

 

This information is compiled by Guy Baker from an assortment of news feeds including First Trust, Yahoo Finance, Bloomburg and others. This information is intended to be informational only. This newsletter contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist.  All investing involves risk, including the potential for loss of principal. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

 

 

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