There are a lot of reasons to be bullish on domestic equities in 2012 following the lackluster returns of 2011. Earnings multiples this low have typically portended high forward returns, a high spread of earnings yields over investment grade bond yields favors equities on a relative basis, and even the solid start to the year points to future gains. The tremendous economic uncertainty caused by the disperse range of outcomes possible in Europe and U.S. government policy has made investors attribute high discount rates to what look like otherwise robust earnings streams. While the Greek drama highlights the market ambiguity, looming fiscal uncertainty in the United States could be an even larger and more direct market headwind over the next year.
Payroll Tax Cut
By the end of this month, lawmakers must agree on an extension of the payroll tax cut or face cutting at least a full percentage point off the growth rate in gross domestic product. Federal taxes to fund Social Security are imposed equally on employers and employees, consisting of a tax of 6.2% of wages up to an annual wage maximum in the low six figures. For the year 2011, the employee's contribution has been temporarily reduced to 4.2%, while the employer's portion remained at 6.2%. Currently, 160 million American workers are aided by the benefit of a payroll tax deduction that has lowered the payroll tax rate from 6.2% to 4.2%. If this tax cut expires in February, the take-home pay of most consumers in the United States, a group that makes up approximately 2/3 of the composition of national income, will see a 2% reduction.
Budget Control Act of 2011
Through all the political wrangling of the debt ceiling debate that helped trigger the market selloff that began in August of 2011, the ultimate effect of this act is still far from certain. What we do know is that only $20-25 billion of discretionary federal spending is to be cut in 2012, which will only lower gross domestic product by about 0.1% - 0.2%.
The bill did directly identify $917 billion of cuts over a ten-year period. The portion of those cuts attributable to 2013 is likely to cut around a half a percentage point off of the growth rate on the nation's $15 trillion gross domestic product. What we do not know fully is the impact of sequestration, across the board cuts that would be implemented automatically if budget cutting minimums were not hit. With a new Congress set to be elected in 2012, the cuts for 2013 and subsequent years could be eliminated or deepened. Like much of what this Congress and Administration has jointly achieved, the only certainty is uncertainty, which is bad for business investment (15% of gross domestic product) and financial markets in general.
Bush Tax Cuts
The Bush Tax Cuts, passed as a part of the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 by then President George W. Bush, significantly lowered the marginal tax rate for most U.S. taxpayers. These tax cuts also made changes to taxes on capital gains and taxes on qualified dividends, pre-contribution limits on retirement plans, and estate and gift tax rules. These tax cuts were extended by President Obama for two additional years as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. JP Morgan estimates that the expiration of these tax cuts at the end of 2012 will reduce 2013 gross domestic product by a full percentage point.
The efficacy of the Bush Tax Cuts is one of the most debated elements of fiscal policy in history, given the tradeoff between household stimulus and the resultant build-up in government debt due to reduced tax collections. The argument over these tax cuts will be only a microcosm of the looming debate over fiscal austerity necessary to stabilize the federal budget deficit and growing national debt versus near-term fiscal stimulus to aid a still battered economy and high unemployment.
Collectively, the run-off of the Obama stimulus and eventual lessening of unemployment benefits, the expiration of the payroll tax cuts and the Bush tax cuts, looming reductions in government spending due to the Budget Control Act, and reductions in state and local government spending in order to balance municipal budgets could reverse any modest gross domestic product growth in 2013. The government will need to take a balanced approach between near-term cuts and longer-term austerity or risk pushing the economy back into recession.
In the near-term the best course of action for the domestic economy and its financial markets is continued fiscal and monetary accommodation, with the emergence of a credible plan to tackle long-term entitlement spending. Investors will be forced to monitor political developments, and remain cognizant of the meaningful impacts on economic growth of these collective decisions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
