In its most basic form, GDP is equal to:
GDP = Government Expenditures + Total consumption + Total Investment + (-) Exports
As you can see from the above formula, one of the components is government expenditures. What this means is that the more any government spends, the higher GDP is. Of course the government is not the only one that spends, but it is a very big part of the overall component.
Government spending is also important, because a portion of the private sector depends on government expenditures. Military spending, for example, may actually add to GDP in more ways than one. For example, the government gives money to the military complex and they provide the government with products and services. But because the military complex exports many of those products, that might actually add to GDP, more than the actual expenditures of the government.
That little extra in output is called the fiscal multiplier. The fiscal multiplier is different for every country. It also depends on where we are in the economic cycle. Even economists don't agree on how to calculate it and don't agree on what causes it. The only thing we know is that it's in there.
But the fiscal multiplier also works backwards. Meaning, for every dollar in government spending reductions, GDP retracts a little bit more.
The fiscal cliff will take effect on Jan. 2, 2013 when $530 billion in tax increases and spending cuts are triggered automatically. Since Congress and the Obama administration could not reach an accord to reduce the federal budget deficit, a series of automatic tax hikes and decreases in spending will automatically take place to close the gap.
So one big question concerning the market is, how will a tax hike and budget decrease to the tune of 4% of GDP affect the market? The answer is that it will affect it by a lot. And because of that pesky fiscal multiplier we talked about, it is probably safe to say that at least another $200 billion (conservatively) will be sucked out of the economy as a result of these automatic triggers.
If the automatic triggers go ahead as planned, make no mistake, the U.S. economy will fall into recession. The question is, is there anything that can be done to avoid these spending reductions and higher taxes? As far as I am concerned, the answer is no.
The only thing that can be done is to alter the mix. And even though a deal has not been yet struck, I am pretty sure that Congress and the president will eventually come up with a plan in order to avoid these triggers. Especially as far as the payroll tax is concerned, it's not a good idea to raise it at the current time with such high unemployment, knowing all too well that unemployment will rise even more.
My big concern, as far as the market is concerned, is that the scapegoat might be corporate taxes. Take a look at the chart below. Corporate taxes are near all-time high. I have a hunch that this cash cow will be an easy target.
It goes without saying that stocks will be affected if higher taxes are imposed on listed companies.
But there are many other concerns that have nothing to do with the U.S. that might make matters a lot worse and intensify the recessionary forces. Europe is already far too fragile to be able to shelter itself from a U.S. recession. The Europe banking system is already in shambles. Yesterday, France and Belgium agreed to inject another $7 billion (5.5 billion euros) in Dexia, thus entirely putting the bank in state hands. I can testify that we will see much more of this.
On that note, BCA Research recently has something to say about global credit:
The credit impulses in all three major economies - the euro area, the U.S. and China - are now negative, albeit very slightly in the case of China. This is the first time in three years that all three components have been simultaneously negative. And after hovering at a point of inflection the combined credit cycle indicator has lurched down again. For any open exporting economy, such as the euro area, the global credit cycle is much more important than the domestic credit cycle. This is because the sales and profits of large European companies are sourced globally, not just from Europe.
I don't have to tell you how a combination of U.S. spending cuts and or tax hikes, together with a world wide credit crunch, will affect the global economy and equities. The answer is, the effect will be very negative and the tone will not be gentle.
In the mean time, Derek Burleton, deputy chief economist, TD Economics, wrote in a note to clients:
The risks that the U.S. economy will fall off the looming fiscal cliff and fall back into recession is one of the top risks facing Canada's economy as we head into 2013. The need for Canada to continue to grow its exports to a recovering U.S. economy is becoming increasingly important in light of a fatigued consumer sector at home.
So Canada is facing consumer fatigue and they hope to alleviate this fatigue by exporting their way to the U.S.? I don't think so.
Any way you slice it and you dice it, a fiscal restraint environment will most likely drag the U.S. economy in recession. That will also have an adverse effect on Europe, which might intensify the recession in the U.S.
Banks lead in a recovery and usually lead the way down in a recession. This means that Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), Morgan Stanley (NYSE:MS), Bank of America (NYSE:BAC) might all be affected.
Even more so European banks. Deutsche Bank (NYSE:DB), Commerzbank (OTCPK:CRZBF) and Credit Agricole (OTCPK:CRARF) are sure to be affected. Just yesterday, Credit Agricole posted a $3.6 billion loss. And If you ask me, I think we will see much more blood in the European bank space.
The good news is that markets have, to a great extent, discounted much of this. In other words, a big portion (not all) of the current fiscal cliff noise is probably already baked into stock prices. I have no other explanation for the fact that stocks like Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL) have a forward P/E of 9.
Also, I am not worried much about the U.S. bank space. U.S. banks have good capital cushions and they have already written off most of the bad loans of yesteryear. So yes, they might be affected, but unless things get very messy, I do not see much price pressure on U.S. stocks, even in the bank space.
And if you ask me, if the president and Congress come to some kind of a deal that will resolve the mix of measures needed to be taken for the fiscal problem to be resolved in an orderly fashion, I actually think stocks like Microsoft and Apple will probably go up.
However, having said that, we are not there yet. As such, markets will be nervous, until they see a clear sign of how the fiscal cliff issue will be resolved and to what extent these reductions and tax increases will affect the economy.
One thing I am sure of, both the economy and markets will be affected, for in a fiscal restraint environment, there is nowhere to hide. However, as far as the markets are concerned, I think most issues have already been discounted. The fiscal cliff issue is nothing new and markets have had more than enough time to digest all information and conclude what they will do.
Therefore, unless we get a real messy political situation between the Congress and the president, my call is that even if the markets correct, that correction will be manageable and tolerable.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.