U.S. Economy
If Congress fails to achieve a deal that minimizes the full 4% impact to GDP, the economy is likely to experience at least one quarter of negative GDP in 2013, if not an outright recession. Should Congress reach a compromise that lowers the drag on GDP to less than 2%, the economy may only flirt with a recession in the first half of 2013.
While the stock market may rally if a deal emerges prior to the fiscal cliff deadline, there could be an unpleasant hangover when investors realize growth will slow and earnings will decline anyway. There could, however, be a small silver lining if a deal is struck. Many companies and small business owners have delayed investment decisions until they have better clarity on tax rates and confidence that Congress is capable of responsibly handling the fiscal cliff. After last year’s debt ceiling debacle, Congress has certainly earned a level of skepticism. According to the U.S. Department of Commerce, in the third quarter, business investment in equipment and software was flat. It was the first quarter without growth since the fourth quarter of 2009. Although the details of any deal may be unpopular, knowing the specifics with some certainty will allow business leaders to plan accordingly and will likely result in a modest rebound in business investment. This could help offset a small portion of the coming fiscal tightening.
The bottom line is that the economy in 2013 will look a lot like 2012, only slower. This suggests job growth, which has averaged around 150,000 each month in 2012, will be less, so the unemployment rate will not fall significantly. The Federal Reserve has targeted the unemployment rate as a policy driver and has pledged to keep QE3 in place as long as the unemployment rate remains elevated. The Fed will have no reason to end QE3 before the end of 2013. Weak growth in 2013 will also mean the underemployment rate (U-6), won’t fall much from October’s 14.6% rate. Over the last year, average weekly earnings have increased 1.5%, while earnings for production and nonsupervisory workers are ahead a paltry 0.8%. The Consumer Price Index is up 2.2% from a year ago, and according to the Department of Labor, real earnings are down 0.7% from October 2011. The purchasing power of workers has declined in the past year, and paychecks are not stretching as far to meet monthly bills.
Despite extraordinary monetary accommodation, aggregate demand has remained tepid, which is why GDP growth has been barely above stall speed. The primary reason the economy has been unable to achieve a self-sustaining recovery trajectory is weak job and income growth, which diminishes consumer demand. Higher Social Security and income taxes in 2013 will lower disposable income, leaving less money for consumers to spend. Aggregate demand will also be negatively impacted as the federal government reduces the rate of increase in government spending. Congress is expected to terminate the extended unemployment benefits and other income transfer programs when they discuss how to lower next year’s budget deficit. Since 2008, fiscal policy has helped to support and sustain aggregate demand with $1 trillion deficits annually. In 2013 and beyond, fiscal policy will shift from a tailwind to a headwind, and there is very little the Federal Reserve can do about it. The Fed will keep rates low, continue QE3 and hope the stock market does not swoon.
Last summer the stock market held up, despite numerous economic reports reflecting the slowdown the economy experienced in the third quarter. Institutional selling remained muted though since money managers interpreted the slowing as more reason for the Federal Reserve to launch round three of quantitative easing. The expectation was that QE3 would lift stock prices just as QE1 and QE2 had. Despite punk economic news, it made no sense to sell during the summer since QE3 and a higher stock market were right around the corner. Ironically, the stock market peaked on September 14, the day after the Fed announced QE3.
The same pattern may develop around the fiscal cliff. Although the ride may be a bit bumpy, most investors expect Congress to reach a compromise that avoids the fiscal cliff. Any deal is expected to result in a big stock market rally, so selling now makes little sense for institutional money managers. This raises the possibility of a market high within days of an agreement, since after the deal is announced, investors will only have the prospect of slower economic growth and more pressure on corporate earnings to look forward to. As we discussed last month, the Shiller Price/Earnings (P/E) Ratio uses trailing 10-year earnings, rather than current estimates for earnings as most analysts do. Over the last 130 years, U.S. stocks have traded about 17 times trailing earnings. Most analysts estimate S&P 500 earnings for 2013 will be around $100 and, with the S&P 500 trading near 1,400, they conclude the S&P’s P/E is roughly 14. However, the Shiller P/E Ratio pegs the S&P’s P/E at 22, which is almost 30% above its historical mean, and 57% above the conventional P/E of 14. Nobel Laureate James Tobin created the Q Ratio as a method of estimating the fair value of the stock market. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. The mean average of the Q Ratio has been 0.70 since 1900, and as of June 30, 2012 was at 1.10, or 44% above its historical mean. The stock market does not decline just because valuations are above average or high. Stock market declines occur because investors are given a reason to sell. There is a grab bag of reasons that may give investors a reason to sell in 2013, with the fiscal cliff being just one of them.