As everyone knows, barring quick Congressional action, federal income, dividend and capital-gains tax rates will increase on Jan. 1, 2013, and the estate tax will revert to a higher rate while applying to smaller estates. Meanwhile $110 billion in cuts to federal spending on defense and other domestic programs will take place as an initial down payment for $1 trillion in cuts that are required through the next decade under last year's deficit deal.
Investors can't say they haven't been adequately forewarned. Ben Bernanke and the U.S. Federal Reserve have warned about the impending fiscal cliff. The Congressional Budget Office has warned the fiscal cliff will drive the U.S. economy back into recession. They see economic output dropping by 0.5 percentage point in 2013 if Congress fails to act, while other estimates of the impact are as high as 4% of GDP. The IMF and other global agencies are also urging Congress to quickly reach an agreement on a permanent fix, saying a stop-gap solution could be harmful not only to the U.S. but to the global economy as well. The Street of course has been all over this story.
[Related -How to Tell False Hope From Rational Optimism]
But most investors and economists have trouble believing the U.S. Congress could be so criminally negligent as to avoid taking any action on an issue that has been on the radar screen for at least six months before the January 1, 2013 deadline, but that is exactly what they are most likely to do, punting at the 11th-hour to buy more time to wrangle out the details. U.S. House of Representatives Speaker John Boehner probably has the most realistic scenario. He doesn't expect a grand bargain avoiding the fiscal cliff to materialize in a lame duck session of Congress, but also doesn't see the country plunging over the edge of the fiscal cliff, because he thinks Congress and the White House will find a way to punt the looming deadlines on the debt ceiling, the Bush tax cuts and the budget sequester into 2013.
[Related -The US Macro Trend Holds Steady To Date Amid Market Turmoil]
Since the fiscal cliff is now the issue du jour among the media and investors, expect more pressure in the form of falling stock prices the longer Congress dallies on the issue. This means the U.S. stock market could remain "choppy" throughout the rest of November and through December. Since the Fed has already made its move in announcing "unlimited" QE and stock prices already peaked immediately after, there is probably no positive offset to the fiscal cliff debate during this period. Thus the "typical" post election selloff as Democrats return to the White House could linger, as the U.S. stock indices, including the DJIA, the S&P 500 and the NASDAQ, have already broken 200-day MA interim resistance.
Meanwhile Euroland, the U.K. and Japan Slip Back Into Recession
While investors were focused on the U.S. presidential election, Markit's Eurozone PMI fell to 45.7 in October from 46.1 the month previous, marking its 9th month below the 50 expansion/contraction line and a 40-month low. Markit says the latest Eurozone PMI is consistent with the region's economy shrinking at a quarterly rate of around 0.5%. The services PMI now stands at its lowest level since July 2009.
The EU Commission has downgraded its forecasts to a 0.4% contraction in 2012 and just 0.1% growth in 2013 versus a prior expectation of 1.0% growth in 2013. The Commission sees 0.8% growth for Germany in 2012 and 2013, 0.2% and 0.4% growth respectively for France, and -2.3% and -0.5% contractions for Italy, respectively. Adjacent to the Euro block, the U.K. economy is expected to show slightly negative growth this year, and anemic 0.9% growth in 2013. The Euro crisis has now clearly engulfed Germany, the core of Euroland. Germany reported a slide of 1.8% in September industrial output, while new orders fell a more than expected 3.8%, leading many to fear Germany is also falling into recession as the country's export machine sputters. German exports are recently sliding at their fastest pace since late last year. The situation for Spain and the weaker Southern European economies of course remains bleak, with Greece's is in its sixth year of depression, a debt-load rising much faster than expected, and obviously a lost cause.
The EU Commission's forecast could still be too sanguine. All key measures of the eurozone money supply contracted in September and private credit fell at an accelerating pace. The broad M3 gauge, watched by experts as an early warning signal for the economy a year or so ahead, shrank by €30bn and is now down by €143bn since April. The narrow M1 gauge watched for signals of activity six months head, has held up better but also contracted in September, To conventional Keynesian economists, the message is "The ECB needs to stop obsessing about fiscal issues and do real quantitative easing (QE) if it wants to stop the Eurozone going the way of Japan." Yet Japan's quanto easing failed miserably, and U.S. quanto easing's boost to asset prices is rapidly fading. Indeed, U.S. stock prices peaked immediately after the Fed announced "unlimited" QE. The credit and loan contraction is pushing Euroland into a deflationary spiral, and renewed recession.
Bottom line, the Draghi Put has temporarily cut borrowing costs for southern Europe but cannot solve the deeper economic crisis. Yet the ECB's plan for unlimited bond purchases, or Outright Monetary Transactions (OMTs), is still seen by many as necessary to stop a negative spiral dynamic taking hold in the crisis-stricken economies. The great unknown is how long the Draghi balm can keep market vigilantes at bay.
In Asia, Japan is engulfed in the Eurozone/China malaise, and could also see two quarters of negative growth.
U.S. Stocks Still the Least Dirty Shirt in the Closet
Compared to the mess in Euroland and Japan's ongoing malaise, the U.S. economy actually looks bouyant despite the big speedbump of the fiscal cliff. The uncertainty will cause investors and traders to push stocks down enough to light a fire under an intransigent Congress's but sufficient enough for them to at least punt the problem to avoid the worst of the fiscal cliff; thereby avoiding a U.S. recession in 2013.
Fortunately, the energy revolution underway in the U.S. and clear signs of a slowly mending housing market are probably enough to keep the U.S. economy recovering despite inaction by the Congress, the inevitable increased taxes as well as regulation from the re-elected Obama Administration and the drag from sinking Euroland economies.
The USD continues to maintain its relative value vis-a-vis FXE and JPY, meaning USD assets remain relatively attractive for foreign investors seeking refuge from problems in their own markets. Further, Gold has not been responding well versus the S&P 500 to more central bank money printing, possibly because investors do feel that progress in economy recovery and repair is being made at least in the U.S., albeit in fits and starts. While the S&P 500 renewed its April 2012 high, Gold has challenged prior highs twice and failed.