U.S. Economy: Why The Looming Fiscal Cliff Matters

Includes: SPY
by: Eric Parnell, CFA

Worries about a potential slowdown in the U.S. economy are being compounded by the threat of the U.S. economy careening off of a fiscal cliff at the end of the year. Supposing the economy begins to reverse course to the downside in the coming months, how much of an additional drain if any will a reduction in fiscal support place on the U.S. economy and the stock market (NYSEARCA:SPY)?

First, it is worthwhile to examine the specifics of the cliff that so many are now concerned about. Basically, at the end of 2012, a variety of government spending programs and tax cuts are set to expire. According to the Wall Street Journal, this includes roughly $100 billion in government spending cuts along with over $400 billion in tax increases on consumers and businesses. Thus, the cliff represents a total dollar amount equaling 3.5% of GDP. In an economy that is still struggling to achieve sustainable growth over three years since the outbreak of the financial crisis, draining half a trillion dollars out of the system represents a critical drag on future growth.

It is worthwhile to explore in more detail the potential implications of the pending fiscal cliff. To accomplish this objective, it is worthwhile to revisit GDP as measured by the Expenditure Approach, which is the sum of the following four components.

C : Consumer Spending

I : Business Spending

G : Government Spending

X-M : Net Exports (Exports minus Imports)

Prior to the financial crisis, U.S. nominal GDP peaked at $14.416 trillion during 2008 Q2. This included the following composition:

C : $10.127 trillion

I : $2.165 trillion

G : $2.870 trillion

X-M : -$746 billion

By 2009 Q2, the economy bottomed with a total U.S. nominal GDP of $13.854 trillion. This represented a -3.9% nominal contraction in the U.S. economy and included the following composition:

C : $9.782 trillion

I : $1.494 trillion

G : $2.917 trillion

X-M : -$338 billion

Thus, The U.S. economy suffered a -$561 billion decline in nominal GDP due to a -$345 billion drop in Consumer Spending and an even more dramatic -$672 billion decline in Business Spending. This was offset, however, by a +$47 billion increase in Government Spending and a dramatic +$408 billion improvement in Net Exports, as the U.S. stopped importing twice as much as we lost in export demand from overseas customers. In short, the increase in Government Spending and a sharp decline in the trade deficit helped keep the decline in GDP from becoming far worse than what it was at the time.

Let us now fast forward to today. In 2012 Q1, the U.S. economy reached a new nominal peak of $15.462 trillion based on the following composition:

C : $11.015 trillion

I : $2.045 trillion

G : $3.024 trillion

X-M : -$621 billion

We have seen the following developments since the previous nominal peak in the U.S. economy nearly four years ago. Consumer Spending has increased by +$888 billion from the previous peak, but Business Spending is still lower by -$120 billion (and this is on a nominal basis). Government Spending is higher by +$154 billion, and the economy is still holding on to a Net Export improvement of +$124 billion, as the U.S. has added more Exports than it has added in Imports over this time period.

So what are the key takeaways from this information as we look ahead for the U.S. economy? First, although corporations remain as profitable as ever on a net margin basis and balance sheets are generally healthy, Business Spending remains restrained and appears likely to be sensitive to the threat of a slowdown or any new crisis phases in the coming months. Consumer Spending has gained solidly from its previous peak, but would likely come under the most pressure in the event of another economic slowdown with many household balance sheets still fairly stretched.

Thus, the onus would likely once again fall on Government Spending and Net Exports to help offset the decline in Consumer Spending and Business Spending. But with a fiscal cliff looming at the end of the year, not only is the "G" component of GDP not likely to be positive, it has the potential to add on the negative side to the tune of as much as -$100 billion. Moreover, the tax cut expirations would only compound the weakness in the "C" and "I" components. And even if an agreement is reached before the end of the year and the fiscal cliff is postponed into the future, it is unlikely that we will see any meaningful positive numbers on the Government Spending side. At best, it will likely be essentially flat barring some new fiscal program.

As for Net Exports, the notion that the U.S. economy is in relatively better shape at this stage of the crisis will likely serve as a negative as it relates to the trade balance. With many Asian economies also slowing and the situation in Europe descending into crisis, the U.S. can hardly count on export demand from overseas sustaining itself ahead of import demand into the U.S. As a result, a decline in Net Exports would be more likely this time around instead of a sharp improvement.

Bringing this all together, whereas we had two positives in Expenditure Approach to U.S. GDP to help offset two major negatives during the 2008-2009 episode, we are facing a situation in 2012 where all four components of U.S. GDP may turn decidedly negative at around the same time. Such an outcome would not bode well for a U.S. economy that is still trying to find the confidence to return to its feet from the previous recession several years ago.

For these reasons, it will remain worthwhile to monitor the fiscal debate closely in the months ahead including the dialog as we enter the height of the Presidential election season, as it will go a long way in determining exactly how much strain the U.S. economy may be facing in the coming quarters.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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