As my boss, Ken Fisher, recently wrote in Financial Times, however, that fear’s misplaced:
Ken Fisher, Financial Times
As he explains, the $984 billion in budget cuts over the next 10 years sounds astronomical, but when you scale it properly, the picture improves. Most of these cuts aren’t real spending cuts—they’re cuts to the projected rate of future spending. Yes, federal spending will shrink next year, but it’s projected to grow each year thereafter—just by less than initially planned.
In 2013, total federal spending is projected to be $9 billion less than 2012—spending cuts will be deeper in the year’s first half, but spending increases in the second half will offset much of these. The US’s economy is strong enough to handle a net $9 billion less in federal spending next year—the private sector is healthy, profitable and growing. $9 billion amounts to about 0.06% of US GDP. For comparison, this year, federal spending fell by about 0.2% of GDP, and though this weighed on GDP growth, the economy still grew—private-sector components were more than strong enough to offset the government’s smaller contribution.
As for tax increases, if all the planned hikes take effect, it won’t be great—tax hikes generally hinder economic growth—but it wouldn’t be disastrous. Income tax rates would revert to levels seen in the 1990s, which are still at the low end of the historical range—and the 1990s were an overall great time for stocks. Higher capital gains taxes might make investment a bit less profitable, but history shows capital gains tax increases don’t cause bear markets—because so many other variables impact market returns, sometimes stocks have risen after tax increases, and sometimes they’ve fallen.
With that said, it’s highly unlikely the fiscal cliff plays out as widely feared—Congressional negotiations may seem stalled, but everyone in Congress has a vested interest in delaying or watering down at least some of the components, which would dramatically lessen the impact. Some provisions will stay—the tax increases tied to the Affordable Care Act will stay, and the small temporary reduction to payroll taxes will likely end. But Congress should compromise on an extension of the 2001/2003 tax cuts.
As it stands, both US political parties want to extend at least some of these cuts. The Republicans in the House of Representatives passed a bill to extend them for everyone, while the Democrats in the Senate have passed a measure to extend them for everyone except those earning over $250,000. But several Democratic Senators who won seats in traditionally Republican states in 2008 are up for re-election in 2014, and they won’t want to lose to Republican challengers—their likely fate if they allow these taxes to rise. Hence, these Senators likely support a measure to extend the cuts for everyone—with the full support of Democratic party leadership, which will want to keep the party’s majority in the Senate.
This won’t happen immediately, however, and maybe not until after January 1, 2013. And market volatility may very well return in the interim. But looking longer term, it’s highly unlikely stocks fall off the fiscal cliff.