What Fiscal Cliff May Mean To You - Risk To The Economy And Stocks Are High If All Tax Hike And Spending Cuts Take Effect

Without congressional action, up to $600 billion of expiring tax cuts, new taxes, and automatic spending cuts are set to take effect at the end of 2012 or beginning of 2013. If they hit all at once, the impact could amount to as much as 4%-5% of GDP, according to our research, the equivalent of falling off a “fiscal cliff.” Some experts anticipate the economy would experience a significant slowdown and there would be major consequences for financial markets.

What are the odds that Congress will fail to act? And what could the range of possible congressional actions mean for the economy, and the financial markets? Could we experience a repeat of last year’s debt ceiling drama and credit rating downgrades?

We gathered four Fidelity experts to answer these questions and more.

Capitol scenarios

Federal Reserve Chairman Ben Bernanke and a number of observers have used the term “fiscal cliff” to describe several big fiscal events set to occur in the U.S. at the end of this year and in early 2013. Among them:

• The expiration of the Bush-era tax cuts at the end of 2012, including current lower tax rates on capital gains, dividends, income, and estates, as well as number of other measures.
• The expiration of fiscal stimulus measures, such as the payroll tax cut and extended unemployment benefits.
• Spending cuts scheduled to be triggered automatically in January 2013 as a result of the failure of the deficit reduction super committee last year.

Depending on estimates, the impact of all these actions taken together would be a fiscal shock on the order of $300 billion to $600 billion in just one year. Such policies would reduce the budget deficit and begin to address the nation’s increasingly worrisome debt situation. However, economists generally agree that allowing the fiscal cliff to take effect in full, at the same time, could have a substantially negative impact on the economy in 2013. But that isn’t necessarily going to happen. I see four possible scenarios.

Scenario 1: punt

A likely scenario is that Congress and the president agree to punt the issue into 2013. If this occurs, the tax cuts will not expire, tax increases won’t take effect, and the spending cuts will be delayed until after the presidential inauguration and new Congress arrives in 2013.

Scenario 2: modest compromise

Congress and the White House reach compromises on some tax and spending provisions, with the election having a significant impact on what those compromises might be.

Scenario 3: over the cliff

A less-likely scenario, I think, is that Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures. The economy goes over the cliff.

Scenario 4: grand bargain

In my view, the chance of a grand bargain taking place after the election and before the end of the year is a long shot. In this scenario, Congress and the White House would reach a deal addressing tax, spending, and fiscal issues for the medium to long term.

In addition to the fiscal cliff, the U.S. will again approach the debt ceiling early next year. While the sequence of events puts the debate over the fiscal cliff before the debt deadline, the two issues are likely to be intertwined.

The outcome of the 2012 elections matters, but the resolution of these issues is tough regardless of whether Democrats or Republicans are in control. That’s because they reflect longstanding philosophical differences between the parties about the proper role and size of the government, and how to grow the economy.

Debt ceiling dynamics

The debt ceiling is once again going to be a line in the sand. While it may be reached shortly after the elections, Treasury has a number of tools to postpone an actual showdown this year. The Treasury has signaled the debt ceiling wouldn’t be hit until early 2013, but there may be potential market disruptions before then. More importantly, we’re going to have to first address the proposed tax increases and spending cuts by December 31.

Normally, the debt ceiling is simply a blame game between Congress and the incumbent president about spending cuts and tax increases. It usually comes down to the wire, but there’s resolution. Last year, however, was different. New members of Congress wanted spending cuts; others openly talked about the prospect of defaulting on debt.

The market ramifications were quite disruptive. Long-term interest rates rose on fears of default while the cost for investors to insure against a default increased as well. We also saw dislocations in the stock markets. Then Standard & Poor’s unexpectedly downgraded U.S. debt from its premier Triple A status - something that Moody’s has said is a possibility as we approach the fiscal cliff.

Perhaps I’m an optimist, but I believe between now and early 2013 certain back-channel discussions probably will take place to address tax reform, spending cuts, and revenue increases. Perhaps, in early fall, we might see proposals coming from Washington that may actually prove to be positive steps forward rather than the worst-case scenario.

Best for bonds

If the government does nothing and the spending cuts and tax increases take effect, we get a big fiscal contraction. As painful as that is, I think it’s a very good scenario for the bond market. That's because the fiscal contraction likely means slower growth and lower inflation, which means lower bond yields. Furthermore, this scenario would likely lead to considerable policy uncertainty as market participants would expect some sort of policy U-turn in the near future; that uncertainty could lead to a flight to quality, further supporting Treasuries.

The worst scenario for bonds would be the grand bargain between the White House and Congress because that presumably would result in less abrupt fiscal adjustments, with a softer impact on the economy. In that scenario, you could get a sell-off in bonds, but it might be healthy, as it would unwind some of the risk premium already priced into Treasuries.

The other two scenarios - punting decisions into 2013 or muddling into a compromise - will have a far more nuanced impact. If there is a sense that Washington is kicking the can down the road, then we could see downgrades by the rating agencies, which in turn could lead to forced selling by certain investors. But that isn’t a foregone conclusion. Last year, for example bonds actually did quite well after S&P cut the U.S. debt rating.

Remember that there’s a difference between getting a downgrade by investors, which could lead to higher yields, versus a downgrade by a rating agency. The downgrade from investors comes when they decide that there’s no credible way to get the ratio of debt–to-GDP on a sustainable path in the long run; we haven't had that yet. What we’ve had is a downgrade by one rating agency, which was a shock to consumer and investor confidence. So, it led to a sell-off in stocks and other risk assets and a flight to quality, namely bonds, whose downgrade ironically had sparked the whole selloff.

Whether that happens again depends on how the markets read these events, especially in the case where a negotiated outcome is muddled.

Stock market fallout 

In the worse-case scenario - if we fall off the fiscal cliff - the impact will be quite large. The more fiscal austerity that kicks in, the bigger the effect it has on economic growth. Depending on how you measure it, the automatic spending cuts and tax hikes would cut as much as 4%-5% of GDP. If you consider that the economy is growing around 2% a year, that would be enough to throw us back into recession.

According to our research, corporate earnings could decline by double digits, perhaps as much as 20% or more. If this happened, it would have a tremendously negative impact on the stock market and other riskier asset categories.

Keep in mind, any time you move from a very large deficit back to a path of sustainability, it is going to require the government to eventually shore up its balance sheet. The key here going forward is the balance -  trying to get a gradual reduction in government spending that allows for the private sector to fully resume its role as the primary growth engine of the economy.

The most likely political scenarios would push off most of the fiscal pain beyond the beginning of 2013. That would obviously be a lot more manageable from an economic standpoint, but it’s important to keep in mind how they go about it. If it looks like we’re just kicking the can down the road and have no plan of ever addressing the problem, it will be very negative from a confidence standpoint. We need to at least have an appearance of progress toward grappling with it early on in 2013.

We have to remember, the debt problem has been a dark cloud over investor psychology, and business and consumer sentiment, for a while now. So the closer we can get to a medium term, long-term resolution, the more we have the opportunity to remove that dark cloud.

What I’m looking for are some main attributes of a deal. First, is it truly sustainable over the long term? Are we addressing things like entitlements, which are really the 800 pound gorilla? Second, is it something that can get us a more efficient tax system? Does it include some tax reform that could actually make our economy more productive, broaden the base, and simplify the tax code? Third, we also have to be careful that we’re not balancing the books at the expense of undoing positive infrastructure, research, and other things that governments historically have funded and are important for the long term trajectory of the U.S. economy.

I think anything that moves us toward a resolution that has some of those attributes can turn the sentiment around, and possibly even improve the long-term outlook for the U.S. economy.