The "Fiscal Cliff" is stealing the headlines as 2012 comes to an end. That's a side show in our view. It's virtually certain today's Congress will retain almost all of George Bush's tax code, rather than return to Bill Clinton's. It's also a sure thing that any spending cuts will be spread over ten years, and that none will occur right away. The political conflict is simple show business. Higher tax rates on affluent Americans might briefly impact the country's growth. But with a complete arsenal of loopholes still in place it won't take long for them to rearrange their affairs to avoid paying the government any more cash than they are now.
The genuine economic variables are more complex. Parts of the economy gathered momentum over the second half of 2012. Housing and construction were especially robust. That trend appears likely to continue. Employment figures improved, too. Productivity bounced back after a temporary swoon. Exports were solid. Corporate profit margins remained at elevated heights. And the U.S. economic engine continued to be fueled by record setting federal deficits and even more amped up financial engineering by the Federal Reserve. Consumer confidence improved. Households in general continued to deleverage, freeing up discretionary income. Corporations accumulated cash. China rebounded. Japan promised to accelerate growth. Europe stabilized. A reasonable foundation was being created despite the political uncertainty.
Plenty of headwinds rose up, as well. Most of those are natural developments that occur at this stage of the business cycle. This time around, though, they present greater than normal danger because the initial recovery was so subdued. The Obama Stimulus in 2009 failed to prime the pump. Instead, the country's deficits and debt continued to escalate while GDP growth stagnated at 2% on average. That was 1% below the customary U.S. trend line. It should have been 1% above, considering the immense stimulus provided. Under normal circumstances an adjustment process would take place to pay down the debts incurred and end the stimulus, returning the country to a normal everyday situation. Unfortunately, the economy still is "fragile" by the President's own admission. A huge shortfall between where we are and where we should be still exists. But the debt and deficits are forcing an adjustment process, nonetheless. It just will take place from a weak position, instead of a strong one.
The upcoming year may be more challenging than some people expect. The "Fiscal Cliff" negotiations are bound to cause some drag in the form of higher taxes. Restoring the Social Security tax alone could lower personal income by $100 billion. High earner taxes might pull away another $150 billion. And the waiting around is likely to cause significant delays in receiving tax refunds, deferring disposable income further. ObamaCare taxes will add $25 billion. Health care costs in general are likely to rise as the law unfolds, moreover, pressuring inflation. Most economists predict no inflation in 2013. That forecast could prove optimistic. The "Quantitative Easing 4" program now being conducted by the Federal Reserve is driving up inflation in foreign countries. Those nations are buying Bernanke Bucks to prevent their own currencies from rising in value. That guerrilla trade war could escalate, leading to a larger bubble. Higher interest rates, higher inflation, higher unemployment, and lower corporate profits all could arise in 2013 as the adjustment process unfolds.
The stock market could react to those unanticipated developments. Volatility already is climbing, even on positive days. New issues are performing erratically. If the Federal Reserve sticks to its guns and withdraws its bond buying program when inflation hits 2.5%, investors could beat a retreat. Alternatively, the stock market could roar ahead if the central bank keeps fueling the system as inflation picks up. Our guess is that the economy will slog ahead and fight through the policy obstacles. A setback is possible as the new taxes and rules and regulations are absorbed. But there's no reason why the long term outlook should be anything other than bright.
Our advice is to remain invested in a diversified portfolio of high potential growth stocks.
January 2, 2013 Update - Congress passes the "Job Protection and Recession Prevention Act" last night. The legislation looks terrific considering the parameters the lawmakers had to work with. Our basic view towards 2013 is unchanged. A poorly written law could have made matters worse. Fortunately, that does not appear to be the case. Income tax rates remain at low levels. The hike on high earners begins at $400,000, twice the level expected. Capital gain and dividend taxes remain low by historical measures. Small business depreciation remains accelerated. The estate tax threshold stays at $5 million. While social security and health care taxes will rise the overall impact is unlikely to be severe. Everybody likes to complain about Congress but this time it looks like it came up with a good compromise under difficult circumstances.