Almost everything happening these days seems to be adding to the uncertainty of the outlook. The consensus had been that once the election was over, investors would have a better sense of what the United States economy would be like in 2013 and how the tax structure might change. Once the ballot boxes had been stored, however, Hurricane Sandy hit the East Coast, causing enormous personal and economic hardship. As power resumed in the region, Washington focused on the so-called fiscal cliff. Both parties showed a willingness to take steps to reduce the impact on the economy of the expenditure cuts and tax increases by January 1, but as yet no specific agreement has been reached. In Europe Greece asked for a two-year extension in meeting its debt to GDP targets, and finance ministers and other officials attended various meetings on structural change, but they still have not come up with a plan for greater fiscal convergence. In China the leadership transition has taken place and more fiscal and monetary stimulus is planned, so at least there is some good news coming out of the world’s second largest economy where recent data shows it is improving.
Against this backdrop it is hard to make serious investment decisions. The WSJ reported that corporations are curtailing capital spending plans but with all that’s going on, that should not be front page headline news. Profits as a percentage of sales are peaking and corporate profits as a percentage of GDP are at a recent record. Companies are functioning at maximum efficiency and unless managers see important sales increases, they have little reason to make capital investment decisions.
The uncertainties surrounding the fiscal cliff are also hardly reassuring to corporate managers. I am still worried that modest corporate revenue increases resulting from slow overall economic growth will make earnings improvement in 2013 difficult.
I also think that the tax rate on dividends and capital gains is sure to go up. I would put both at 20 per cent plus the 3.8 per cent surcharge to help pay for the Affordable Care Act. The expectation that these taxes will increase has caused heavy selling of appreciated holdings by individuals wanting to reap their profits before year-end. I fear that a cap will be placed on charitable contributions has also caused many to give securities with large capital gains to institutions who then sell them in the open market, putting additional pressure on prices. These factors help explain the poor market performance since the election. It is unclear when this will end, but it should create some buying opportunities in recent winners along the way.
The payroll tax cut which was extended last year affects most working people but there is limited support for continuing it in its present form for another year. It is unlikely to end abruptly; a gradual roll-off would be less disruptive. There are a number of other items such as jobless benefits, physician payments, the sequestering of funds for defense and healthcare, and adjustments in the Alternative Minimum tax that are on the table and both parties will attempt to defer some of these. If the whole fiscal cliff of $600 billion–plus were to hit in 2013, the economy would almost certainly slip back into recession or something very close to it and neither political party wants to be responsible for that.
The idea of eliminating tax preferences for certain industries like oil and gas and real estate is surely going to be considered. So will limitations on deductions for charitable contributions, mortgage interest and state and local taxes. There are special interest groups that will be fighting hard to preserve these preferences and deductions, and that is why I think the whole process of dealing with the fiscal cliff will spill into next year.
Another issue is the debt ceiling, and we may be approaching this faster than is widely believed. When the current limit was established there was agreement that the increase from $15.25 trillion to the current level would be matched by spending cuts, but I don’t believe Washington has taken that trade-off seriously. What will probably happen is that the whole debt ceiling issue will be folded into the fiscal cliff negotiation. It cannot be ignored.
Perhaps the most distressing aspect of America’s current financial predicament is that we are weighing the merits of various expenditure cuts and tax increases that will surely slow an economy with a record number of people out of work 27 weeks or more and more people on food stamps than ever before. And because we are so focused on cutting government programs we cannot consider any major program to improve our decaying infrastructure or deal with the fact that we, the largest economy in the world in terms of GDP, are a country whose 15-year-olds rank 22nd in the world in reading, 21st in science and 29th in math. We are considered the leader of the free world, but will that be true several decades from now?
There is not much new to report on Europe. The continent is in a shallow recession now and the leaders of the key countries continue to work towards some form of fiscal integration. The key risk continues to be that social unrest related to the implementation of austerity programs in the various countries impedes the ability of their governments to agree to the formation of a banking union, to provide deposit insurance and to agree to supervision of the budgetary process by the European Commission. With the resolution of many issues in doubt it is not surprising that the markets are wavering. The markets are fairly valued so a major decline is unlikely, but a significant move higher is improbable also.
— Byron Wien is Vice Chairman, Blackstone Advisory Partners LP.
