The Republican Budget Proposal: Reading the Economic And Market Tea Leaves

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Last week, Congressman Paul Ryan unveiled a Republican budget proposal that would spend $5.3 trillion less over the next decade than President Obama’s budget plan.

While proposed budgets from Republicans and Democrats are generally at odds, the differences between the parties’ current proposals are particularly stark and provide evidence for my forecast for the global market this year: Two quarters of sun, followed by a chance of severe thunderstorms in the fourth quarter.

Why the gloomy forecast? On January 1, 2013, thanks to a number of temporary measures that expire simultaneously, the US economy is set to face significant fiscal drag, i.e. a damper on economic growth from higher taxes and lower spending. But given the realities of election year politics and the ideological chasm currently separating Republicans and Democrats, it’s unlikely that Congress will reach any solution to this situation before Election Day in November.

In fact, a compromise may still prove elusive in the seven weeks between the election and January 1. After the presidential election, Washington will have less than two months to reach an agreement on the expiring measures and a myriad of other issues. While the past two years have brought a number of death-defying last minute Congressional compromises, the two parties’ diametrically opposed platforms will be particularly challenging to reconcile come the morning of November 7th.

Just one example of how far apart the parties currently are: Ryan’s budget proposes a dramatic simplification of the tax code and a significant reduction in marginal rates. In contrast, the president’s platform envisions significantly higher levels of government spending and a more progressive tax code.

To be sure, some commentators expect that a compromise will be reached. In a recent opinion piece in The Wall Street Journal, former Fed Vice-Chairman Alan Blinder writes that Congress will more likely come to an agreement “just before the bubbly flows on New Year’s Eve” than send the US economy “falling off of a fiscal cliff.” But he does note that “finding a clever way to kick the can down the road is becoming a bigger and bigger challenge” and I completely agree.

If a compromise isn’t reached later this year, the impact on the United States becomes obvious when you list all the policy changes that will occur simultaneously. Marginal tax rates would go up; dividend and capital gains taxes would rise; the payroll tax holiday would expire; a new 3.8% tax on unearned income would take effect; extended unemployment benefits would expire; and more than $110 billion in automatic spending cuts would take effect.

Best estimates indicate that the total fiscal drag associated with these changes will be $500 to $600 billion, equivalent to roughly 3% to 4% of US gross domestic product. This is a significant amount under any circumstances but is even more frightening in an environment in which US growth has been barely 2.5%.

The good news is that to the extent the economy continues to recover and Europe can avoid more turmoil, this issue is unlikely to derail the equity rally in the near term. However, as the election nears and potential outcomes come into focus around Labor Day, whether the stock market can continue to move higher will potentially hinge on how much investors expect a late-year fiscal compromise.

Source: Bloomberg

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