With less than 20 days till the end of the year, investors are primarily focused on one thing: the fiscal cliff. The fiscal cliff refers to the more than $500 billion in tax increases and across-the-board spending cuts scheduled to take effect after January 1, 2013 as described in the Budget Control Act of 2011.
Over the last month since the election, both Congress and the administration have been in negotiations to avert the fiscal cliff. As of this writing, a deal or compromise has not been reached. Thus, uncertainty remains as to whether the U.S. will go over the fiscal cliff.
If January 1st comes around without a deal being reached, $400 billion in tax cuts will expire-among them are the Bush-era tax rate reductions and the 2 percent cut in payroll taxes. On the spending side, the emergency unemployment-compensation program will expire, saving $26 billion. Another $11 billion in savings will come from a 27 percent reduction in Medicare payments to doctors. The largest savings is known as "the sequester" in which $65 billion in cuts will be enacted for most federal programs over the last nine months of 2013.
Several scenarios are possible depending on the outcome of the negotiations. One is that the politicians are unable to reach an agreement, and we go over the fiscal cliff. The effect will be higher taxes and certain federal programs will be cut. The negative impact will likely lead to a recession in early 2013 as estimated by the Congressional Budget Office (cbo.gov/publication/43694). The long-term impact could be positive in that the federal debt becomes more manageable with the ratio of debt to GDP falling over time.
The second scenario is that a deal is reached to extend everything to avoid the cliff. In this case, the economy will likely grow next year, but the federal budget would continue to operate in the red, which is not sustainable in the long run. This could lead to another credit rating downgrade of the U.S. government.
The third scenario is referred to as the "Grand Bargain", which was the premise of last year's negotiations between President Obama and House Speaker Boehner. This deal is based on the recommendations of the Simpson-Bowles Commission (fiscalcommission.gov). The bi-partisan commission was "charged with identifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run". If certain parts of the commissions' recommendations are agreed upon and implemented, a recession in 2013 could be avoided.
As a result of the uncertainty, U.S. companies have begun to increase their dividend payments ahead of schedule to take advantage of lower tax rates this year versus paying it out next year at potentially higher tax rates. Even though there is a good chance that the economy would enter into a recession next year, there are still a few bright spots in the economy that could make the recession mild, if not a brief one.
One is the continuing and sustained recovery in the housing market. The U.S. is now entering a phase in which household formation is creating a strong demand in construction of housing units. This could add as much as two percentage points or more in the overall GDP growth in the next 12 to 18 months.
The second is the recovery of the auto industry. The destruction of property by super storm Sandy in the northeast has contributed to an increase in demand in the auto industry, particularly in the used car market.
Last, companies have strengthened their balance sheets over the last four years since the credit crisis, and have not yet begun to fully re-invest in their businesses and deploy the cash they have built up. As a result, American businesses are positioned well to weather a recession next year as well as invest in their businesses should we avert the fiscal cliff.
Not knowing what the outcome will be, investors should prepare for a worst-case scenario, which is a recession in 2013. At the same time, I am also hopeful for the future.