For weeks, most financial pundits, including myself, have been writing about the perils of the fiscal cliff — the expiration of the Bush-era tax cuts and the implementation of significant spending cuts set to go into effect Jan. 1. The combination of tax increases and spending cuts, worth about $800 billion if implemented, is expected to drive the U.S. economy back into recession early next year. Congress and President Barack Obama continue to grapple with these issues, but no agreement is forthcoming. Regardless of whether we go over the fiscal cliff, avert it altogether or perhaps slide down that slope part way, will the U.S. economy survive and eventually thrive?
As we near the end of 2012, and with only 14 days left for Congress and Obama to come to some kind of agreement, the chances of finding a viable solution to the fiscal cliff are certainly small, at least by the end of the deadline. To me, it seems more likely that, if there is an agreement at all, it will not be a real solution. Rather it will be a short-term “patch” to take the sting off of the worst effects of the fiscal cliff, to be followed, sometime later in 2013, with a more permanent solution.
I’ve written recently of my belief that there is probably no real solution to the problems we are facing available. No matter what Congress and Obama do, we’ll still face extreme challenges. I do believe the U.S. economy can weather this storm and that it will eventually rebound. Here’s why:
First, we are still the strongest economy on the planet. Our economy is the largest and the most diverse. We have the most productive, innovative people in the world. We have the most developed financial system, despite its obvious flaws and weaknesses. We have an educated workforce that reacts favorably to proper incentivization. We have a Federal Reserve that is proactive, and is providing plenty of liquidity to support growth. We have a broad consumer base that has proven time and again to be optimistic, with spending patterns that reflect that optimism.
Second, interest rates are at all-time lows. Low rates, coupled with a willingness on the part of banks and other financial institutions to lend, will support active borrowing, which, in time, will provide the financing necessary to support economic growth. Low interest rates will also continue to allow the government to refinance its debt at a relatively low cost, despite the massive size of the national debt. Low interest rates also help real estate, the mainstay of wealth-building for Americans. Low mortgage rates keep monthly mortgage payments relatively low, allowing buyers to afford higher home prices. Low rates also incentivize investors to purchase income properties and developers to develop.
Third, employment is improving. Technology is allowing, for the first time in decades, for U.S. companies to bring jobs, even manufacturing jobs, back home. Rising standards of living in countries such as China, where historically labor costs have been exceptionally low, rising currency values of these countries against the U.S. dollar, coupled with advances in technology that allow American workers to be more productive, on balance, make shipping jobs offshore less attractive for U.S. companies.
Rising employment is the foundation of economic growth, especially since about 70 percent of gross-domestic product comes from consumer spending. Consumers with good jobs spend more, driving economic growth. Companies are still laying off workers, but they are also cutting other costs and stockpiling cash, waiting for the economy to improve. While this is somewhat of a catch-22 — companies are waiting to hire until the economy improves, but we need more hiring to improve the economy — these companies eventually will see enough demand for their products and services to begin hiring in earnest, driving more consumer spending and thereby driving economy expansion.
In the short run, I do not expect Congress and Obama to agree on anything that will avert the negative impact of the fiscal cliff. Regardless of what they do or don’t do, I believe the economy and the stock market will suffer, at least for the next several weeks to a few months. I think they will eventually agree on something that comes fairly close, and that in the longer term will make a positive impact on the economy. I also believe they will make the changes to taxes retroactive to the beginning of 2013, so taxpayers receive the benefits for the entire calendar year. This will be sort of like a tax bonus, since taxpayers will feel like they are getting a kind of refund. This should have a positive impact on consumer spending, although it won’t come until later in the year.
For investors, the short-term outlook for stocks is negative, and I still recommend sitting on the sidelines, for now. Consumer spending will likely be weaker than expected, given the uncertainty about the fiscal cliff. Corporate earnings, especially for retailers will suffer. This should result in a drop of at least 20 percent for stocks from current levels. I expect to see the Standard & Poor’s 500 fall to as low as 1,200, which would provide a much more attractive valuation for the market, at which point I will be a buyer.
If Congress and Obama pull a rabbit out of their collective hats, and somehow find common ground on a “grand bargain” solution that addresses the need to reduce the budget deficit and national debt without crushing the economy, stocks would rally strongly. Even if they could somehow put aside all differences to come to an agreement, I don’t see any solution that will work, but I guess anything is possible. Given the challenges, my advice is to hope for the best, but plan for the worst.