In Newport, R.I. there is a three-and-half-mile foot trail that hugs the New England shoreline known as the Cliff Walk. Its collection of Gilded-Age mansions and sweeping views of Easton’s Bay and the Atlantic Ocean are breathtaking. But its craggy bluffs and scenic seascape are nothing like the cliff walk the US economy is headed for if politicians can’t reach a compromise. Rather, it’s a treacherous road filled with fear, drama and the potential for significant pain. With the elections behind us, the fiscal cliff—a combination of expiring tax breaks and automatic spending cuts slated to take effect Jan. 1, 2013—is now, arguably, the biggest driver of volatility in the market.
A look at the headlines shows that focus on the fiscal cliff is mounting in the wake of last week’s elections, even though chances of it occurring in its entirety remain unlikely. The election outcome was a continuation of the status quo in Washington: a Republican-controlled House of Representatives, a Democratic-controlled Senate and a Democrat in the White House. Not surprisingly, that set off panic on Wall Street as chances increased that the US government will go off the fiscal cliff of automatic tax increases and spending cuts next year. Adding to the concern was an announcement last week from Fitch Ratings that the US risks plunging into a recession that will damage economic growth worldwide if policy makers fail to act.
Clearly, there is a lot at stake. The Congressional Budget Office released a report last week projecting how the economy will be positively impacted if the fiscal cliff or components of it could be avoided. It also reiterated the risk of falling off the cliff: the unemployment rate would rise to 9.1% by the fourth quarter of 2013. It’s no surprise that both the Dow Jones Industrial Average and the S&P 500 lost more than 2% this week.
However, there are still reasons to be positive on the economy and the stock market:
Stock-Market Resilience Stocks sold off in the summer of 2011 as politicians failed to come to a compromise on the debt-ceiling crisis. In fact, the S&P 500 dropped to 1099 on Oct. 3—an 18.4% loss. The government’s inability to reach an agreement on how to handle the deficit was confidence-shattering for investors. However, the stock market climbed back to 1257, a 14.4% gain, by the end of the 2011. By the end of February 2012, the stock market had recouped its losses and had even moved higher, with the S&P 500 finishing at 1365. While we’re likely to see heightened volatility and more market drops in the near term, this period could represent an attractive buying opportunity for investors with longer time horizons.
Unwavering Consumer Confidence While stocks endured their worst week since June—the S&P 500 lost 2.43% and the Dow lost 2.12%—it was the best week since July 2007 for consumer confidence. Consumers are clearly not as worried about the fiscal cliff as business leaders and the media are. With confidence among US consumers at a five-year high, this could translate into greater spending. Given that consumer spending comprises more than two-thirds of GDP, this could, in turn, boost economic growth.
Slower Growth of the Deficit The federal deficit is not declining but the growth of the deficit is slowing. Last month, the Treasury Department reported that the federal government will incur a budget deficit of $1.1 trillion for fiscal year 2012, which is $207 billion less than the operating deficit for 2011. And the deficit this year will be about three-quarters of the size it was three years ago, as a percentage of GDP. This, combined with very low borrowing costs for the federal government, may reduce the urgency to make all the cuts in one fell swoop in the event the US falls off the fiscal cliff.
Washington’s Willingness to Compromise The environment seems more conciliatory today than it was in the summer of 2011, with rhetoric from both parties seeming more conducive to compromise than in the past. In addition, it was reported several months ago that a small bipartisan group of senators is quietly working on a solution to the fiscal cliff by reviving the deficit-reduction plan recommended by the Simpson-Bowles commission, which would reduce government spending more gradually. Any indications of bipartisan cooperation, as well as an easing into spending cuts, could inspire confidence on the Street.
No Government Shutdown Congress has already made going over the fiscal cliff on Jan. 1 less disastrous by agreeing on a deal to fund the government through March. In other words, there will be no threats of a government shutdown on Dec. 31, which would have created widespread panic among investors.
So while this cliff walk is no cake walk, there may be more pessimism about the fiscal cliff priced into the stock market than warranted. At Allianz Global Investors, our base case remains a last-minute compromise, which would result in a fiscal tightening of roughly 1.5% of GDP for 2013. We continue to believe the greater concern is financial repression. For investors, low growth and low interest rates are putting a squeeze on real returns—far more treacherous terrain than any fiscal cliff.
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