Uncertainty Around Fiscal Cliff Makes the Going Tough for Stock Markets

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Fiscal Cliff

What Was the Fiscal Cliff?

The fiscal cliff refers to a combination of expiring tax cuts and across-the-board government spending cuts that was scheduled to become effective December 31, 2020. The idea behind the fiscal cliff was that if the federal government allowed these two events to proceed as planned, they would have a detrimental effect on an already shaky economy, perhaps sending it back into an official recession as it cut household incomes, increased unemployment rates, and undermined consumer and investor confidence. At the same time, it was predicted that going over the fiscal cliff would significantly reduce the federal budget deficit.

Fiscal Cliff

The Fiscal Cliff Explained

Who actually first uttered the words “fiscal cliff” is not clear. Some believe that it was first used by Goldman Sachs economist, Alec Phillips. Others credit Federal Reserve Chairman Ben Bernanke for taking the phrase mainstream in his remarks in front of Congress. Still, others credit Safir Ahmed, a reporter for the St. Louis Post-Dispatch, who, in 1989, wrote a story detailing the state’s education funding and used the term “fiscal cliff.”

If Congress and President Obama did not act to avert this perfect storm of legislative changes, America would have, in the media’s terms, “fall over the cliff.” Among other things, it would have led to a tax increase the size of which has not been seen by Americans in 60 years.

How Big Are We Talking?

The Tax Policy Center reported that middle-income families will pay an average of $2,000 more in taxes in 2020. Many itemized deductions were subject to phase-out, and popular tax credits like the earned income credit, child tax credit, and American opportunity credits were to be reduced. 401(k) and other retirement accounts were to be subject to higher taxes.

Your marginal tax rate is the tax you pay on each additional dollar of income you earn. As your income rises, your marginal tax rate (better known as your tax bracket) rises. For 2020, the tax brackets were 10%, 15%, 25%, 28%, 33% and 35%. If Washington did not act, those rates would have gone up to 15%, 28%, 31%, 36% and 39.6%, respectively.

In addition, the Congressional Budget Office estimated that 3.4 million or more people would lose their jobs. The October 2020 unemployment rate of 7.9% represented significant improvement over the October 2009 rate of 10%. The Congressional Budget Office believed that up to 3.4 million jobs would be lost post fiscal cliff due to a slowing economy with layoffs stemming from cuts in the defense budget and other things. This could have resulted in an increasing unemployment rate up to 9.1% or more.

What Are the Bush Era Tax Cuts?

At the heart of the fiscal cliff were the Bush Era Tax cuts passed by Congress under President George W. Bush in 2001 and 2003. These included a lower tax rate and a reduction in dividend and capital gains taxes as the largest components. These were set to expire at the end of 2020 and represented the largest part of the fiscal cliff.

The potential expiration of the Bush-era tax cuts also affected tax rates on investments. The long-term capital gains tax rate was to increase from 15 to 20%, and qualified dividend rates to increase to the individual’s marginal tax rate up from a fixed 15% under the current plan. This not only would have affected Wall Street investors, but also retirees and retail investors, who were withdrawing funds from qualified retirement plans and brokerage accounts.

The current estate and gift tax exemption of $5.12 million was also scheduled to drop to $1 million. At the time, the tax on estates valued over $5.12 million was 35%. After the fiscal cliff, a 55% tax rate on estates over $1 million would have applied.

Social Security Payroll Tax Rates Would Have Increased

In 2020, Congress approved a temporary reduction in the Social Security payroll tax. This 2% reduction took the tax from 6.2% down to 4.2% on the first $110,000 in earnings. This temporary rate was set to expire at the end of 2020, which would cost an individual making $50,000 per year an additional $20 per week in taxes. However, that may not have been the end of the impact of the fiscal cliff on Social Security. Social Security has a lot of moving parts, and lawmakers from both sides of the aisle believed that making changes to Social Security, in addition to the lapse of the payroll tax cut, could raise much-needed revenue.

Was There a Bright Side to This?

There were principally two bullish arguments regarding the fiscal cliff. First, that the Congress won’t allow it to happen, and second, that maybe it wouldn’t be so bad if it did happen.

Taking a very different track, there was also an argument that the cliff itself would be a long-term positive. Few argue that the U.S. has to tackle its deficits at some point, and this sort of “bitter medicine” would be a harsh, but definitive, step in that direction. Although the short-term impact could be severe (recession in 2020), the bullish argument would hold that the long-term gains (lower deficits, lower debt, better growth prospects, etc.,) would be worth the short-term pains.

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According to the Congressional Budget Office, by 2022, the budget deficit would fall to $200 billion from its current level of $1.1 trillion. That would all be welcome news, but in order to get there, the nation would face almost certain financial turmoil.

How Did We Fix It?

Lawmakers met at the White House over this issue. Both sides called the meeting productive, but neither side indicated that a deal was imminent. Democrats wanted to see more revenue (tax increases), especially from the nation’s wealthy, as part of any deal. Republicans favored more spending cuts, especially to entitlements like Medicare. While both sides subscribed to different philosophies concerning taxation, each had indicated that they were willing to compromise on many of the more critical issues leading to Jan. 1.

Three hours before the midnight deadline on January 1, the Senate agreed on a deal to avert the fiscal cliff. The key elements of the deal included an increase in the payroll tax by two percentage points to 6.2% for income up to $113,700, and a reversal of the Bush tax cuts for individuals making more than $400,000 and couples making over $450,000 (which entailed the top rate reverting from 35% to 39.5%).

4 Questions to Understand the Fiscal Cliff

What investors need to know.

Judging by media coverage, the so-called “fiscal cliff” is the only thing driving the U.S. stock market these days. Unfortunately, a lot of the coverage is either alarmist, erroneous, or focused solely on the daily (or even hourly) micro-developments in the story. Here are four simple questions with answers I hope will help long-term investors frame the issues properly.

1. What is the fiscal cliff?
The “fiscal cliff” is, to use another metaphor, a perfect storm of tax increases and government spending reductions that are set to begin on Jan. 1, 2020. These changes stem from a number of sources, including:

  • The 2020 Budget Control Act, which put an end to last year’s debt ceiling crisis. One of the provisions called for automatic across-the-board cuts in defense and discretionary spending if Congress failed to enact spending cuts voluntarily.
  • Expiration of the George W. Bush tax acts, which were extended once by President Barack Obama in 2020.
  • Expiration of the 2% Social Security payroll tax cut and federal unemployment benefits, both of which were extended by President Obama in 2020.

Without any countervailing action from lawmakers, the policy path we are now on would significantly reduce the budget deficit in 2020 — but at great cost to the economy.

2. Why is it called a “cliff”?
The Congressional Budget Office estimates that if no action is taken to avoid the fiscal tightening from the combination of lower government spending and higher taxes, the U.S. economy will shrink by 0.5% next year on an inflation-adjusted basis. In many areas of ordinary life, a half-percent decline in some metric or quantity isn’t terribly consequential; often, it will go completely unnoticed. If you have $2 in change in your pocket, you’re unlikely to be concerned by the loss of a penny. A student who scores 100 on her first test won’t panic if the next test comes back marked 99.5.

When it comes to the U.S. economy, however, the decline equates to recession and all the unpleasant things that go along with it. Let’s get specific: According to the CBO, under that scenario, the unemployment rate would rise from its current level of 7.9% to 9.1% by the fourth quarter of next year. The last time the unemployment rate was at that level was in July 2020. The U.S. economy could effectively lose the benefit of nearly two and a half years’ worth of improvement.

3. It’s not really a cliff, though, is it?
Well, no. Federal Reserve Chairman Ben Bernanke coined the expression “fiscal cliff” in a Q&A session during his Semiannual Monetary Policy Report to Congress on Feb. 29, 2020. Bernanke chose it voluntarily to focus lawmakers on the risks associated with premature fiscal tightening, and it has become popular as shorthand for the damage that lawmakers’ inaction could wreak on the economy. However, the metaphor is misleading in that it suggests an immediate, sharp, and irreversible drop-off in economic activity on Jan. 1. Think Wile E. Coyote running off the edge of a cliff and plunging into a canyon while chasing the Road Runner.

In reality, that’s not what would happen here. For example, the CBO estimates I cited above assume that lawmakers do nothing whatsoever throughout 2020 to alter the current policy path. Instead of a coyote going off a cliff, think of a car without steering starting down a long slope toward a wall. The sooner the driver applies the brakes, the less damage the car takes when it car reaches the wall.

4. So if Congress and the White House act in time, we can avert any negative impact on the economy altogether?
Not so fast! There is plenty of anecdotal evidence that the fiscal cliff is already having an impact on companies’ behavior, whether they be Dow Jones Industrial Average (DJINDICES:^DJI) or S&P 500 (SNPINDEX:^GSPC) components or smaller businesses across the country.

With the release of its Beige Book business survey last Wednesday, the Fed said that seven of its 12 districts reported “either slowing or outright contraction in manufacturing,” with some respondents “[expressing] concern about the outlook for 2020, in part, due to the uncertainty regarding the outcome of the fiscal cliff.”

Meanwhile, investment bank Goldman Sachs published what it calls its S&P 500 Beige Book at the beginning of November, according to which the fiscal cliff was one of the top three concerns cited by companies in their third-quarter earnings conference calls. Blue-chip names that referred specifically to fiscal-cliff-linked uncertainty as an impediment to planning include McDonald’s (NYSE:MCD) , General Electric (NYSE:GE) , and JPMorgan Chase (NYSE:JPM) .

Will Fiscal Cliff Uncertainty Defeat Market’s Favorable Seasonality?

It’s no secret that the stock market makes most of its gains in the winter months, and if it’s going to have problems they usually take place in the summer months.

The pattern is so consistent that academic studies prove that over the long-term betting on the pattern even with a strategy as simplistic as the venerable old ‘Sell in May and Go Away’ dictum, outperforms the benchmark S&P 500 by a wide margin, while taking only 50% of market risk.

However, it doesn’t happen every single year. So by far the majority of investors remain skeptics, and in spite of their performance history believe there must be a way to be right 100% of the time.

Last year (2020) the market followed the seasonal pattern in classic fashion. The rally in the winter months of 2020-1011 topped out May 1, followed by a double-digit summer correction. The summer correction ended in October, and a typical winter months rally began.

This year followed a similar pattern – until June. A strong winter rally topped out in late April into a summer correction. But the correction ended at the June low, with a rally that carried the market up to a level fractionally higher than the seasonal May exit. At that point, exiting May 1 had not paid off.

But then the market pulled back again to a level lower than the May 1 peak.

The question for seasonal investors now, fractionally ahead of the market if they followed the spring exit and recent re-entry signal of my Seasonal Timing Strategy, is whether the rally that began in November was the beginning of a typical favorable season rally into next spring.

It’s been a nervous attempt to rally so far as uncertainties over the fiscal cliff negotiations continue.

That uncertainty is not being helped by the way several months of positive economic reports that indicated the U.S. economic recovery is back on track, have been replaced by some reports for October and November that are less supportive of that conclusion.

As I wrote last week, durable goods orders were flat in October after an encouraging increase in September, new home sales fell 0.3% in October, and consumer spending declined in October for the first time in five months.

On Friday this week it was reported that the University of Michigan-Thomson Reuters Consumer Sentiment Index fell sharply in early December, from 82.7 in November to 74.5 so far this month, much worse than the consensus forecast of 82.0

The Labor Department also reported on Friday that 146,000 new jobs were created in November, much better than the consensus forecast of 95,000. But previous reports for September and October were revised down by 49,000 jobs total.

But don’t count seasonality for the winter months out yet.

The wait and see attitude of business and consumers regarding the fiscal cliff, which has been creating the recent weakness in economic reports, would likely take a decided turn for the better again if a reasonable compromise is reached to avoid the cliff, or at least kick it down the road again.

And nothing in the typically slow negotiation process so far has disabused me of expecting that outcome.

By the way if that happens, although it would a positive for a few months, down the road the remnants could provide the catalyst for the seasonal pattern to continue next summer.

So I continue to be watchfully optimistic that a typical ‘favorable season’ rally will continue to come out of the rubble of the current uncertainties.

But it is still not a time for over-confidence, or to adopt a buy and hold approach.

Until there is more clarity regarding the cliff, I favor conservative holdings like the SPDR DJIA etf, symbol DIA, and the Utilities Sector, via etf’s like the Select SPDR Utilities, symbol XLU, while holding an ample supply of cash ready to pounce on more aggressive opportunities.

The fiscal cliff and the economy
Pointless, painful uncertainty

by G.I. | WASHINGTON

Everyone agrees uncertainty is bad for the economy. But doing something with this observation is seriously hampered by the fact that uncertainty is almost impossible to define and measure.

Many academics count things that proxy for uncertainty, such as mentions of the word in news articles. That’s one of the components in the uncertainty index developed by Scott R. Baker, Nicholas Bloom, and Steven J. Davis whose work we wrote about it here; it links heightened policy uncertainty to weaker growth. It’s also used by Jonathan Brogaard and Andrew Detzel here; they find increased policy uncertainty leads to lower stock prices and private investment.

Establishing causality is tricky. A weak economy or a traumatic event like a financial crisis or terrorist attacks will both raise uncertainty and provoke a policy response, but it’s the economic event, not the policy, that raises uncertainty and hurts growth.

I have my own back-of-the-envelope exercise. I count mentions of the word “uncertainty” in the Federal Reserve’s “beige book.” As my nearby chart shows, uncertainty has shot up in the last month. (Some months are blank because no beige book was released then.)

The beige book is a narrative based on conversations between analysts at the Fed and business contacts throughout the country. While this means it’s not well suited to quantitative analysis such as mine, it does allow you to isolate the source of the uncertainty.

Usually, it’s the economic or sales outlook. Often, it’s an event beyond America’s control: the European crisis, higher petrol prices, Japan’s tsunami, and so on. Some months, though, the source is clearly exogenous policy decisions. In April of 2020, the federal budget was cited in three of that month’s 15 references to uncertainty. Recall that that month the government was on the verge of shutting down over Republican pressure for cuts to discretionary spending. One reference was to the future of Fannie Mae and Freddie Mac.

Uncertainty rose again in July; four of 14 references were related to fiscal policy, almost certainly because of the fight over whether to raise the debt ceiling (explicitly cited twice). The downgrade to America’s credit rating that following the debt ceiling negotiations and the intensification of Europe’s crisis sent stock markets tumbling, which explains the spike in uncertainty in September.

Uncertainty appears more often in this month’s beige book than any month since September. Five of 30 references cite fiscal policy, apparently a reference to the fiscal cliff. A sampling:

The Chicago District noted uncertainty over the effects of U.S. fiscal policy actions was reducing their customers’ demand for credit… The Boston, Cleveland, Atlanta, Chicago, and Dallas Districts said employment levels were flat to up slightly, with most contacts citing U.S. fiscal policy uncertainty or weak demand for their conservative approach to hiring… [M]any contacts had become more cautious about future spending decisions, pointing to the heightened uncertainty surrounding the federal fiscal environment and the upcoming November elections.

Conservatives and businesses often blame uncertainty about new regulations such as health care for the economy’s weakness. That argument doesn’t get much support from the beige books. This doesn’t mean they’re wrong. Many individual regulations may in aggregate produce significant uncertainty that doesn’t show up in this exercise. However, such background anxiety can’t really explain the periodic spikes in uncertainty and associated economic slowdowns. (Monetary policy, another frequently-cited source of uncertainty, is never mentioned as such in beige books I examined; on the other hand, consider the source.)

So this admittedly crude exercise seems to demonstrate that in terms of economic impact, fiscal policy trumps all other exogenous sources of policy uncertainty. Why does this matter? Because it’s so pointless. It’s not surprising or even necessarily bad that tighter fiscal policy leads to weaker growth. That may be the price of sustainable public finances. But the disincentives to hire and invest brought on by the debt ceiling battle and now the fiscal cliff aren’t the result of fiscal policy per se, but by the reckless and confrontational way that America makes it. Little wonder Ben Bernanke, the Fed chairman, spent so much of the last two days begging Congress to act on the cliff. Such action is not a substitute for more quantitative easing; but the stimulative impact would so much greater, with far fewer side effects.

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