In discussing the fiscal cliff issue, the one big takeaway not to forget is that it is all about austerity----extreme austerity if we go over the cliff and a lesser amount of austerity if we settle it before year-end. More than likely, this is the start of a new era of fiscal austerity in the U.S. In no way do we see this as a solution to the myriad of problems besetting the U.S. economy and stock market. These problems include the continuing excessive level of household debt that is the main culprit holding back economic growth, a loss of economic momentum in the last few months, declining earnings estimates and guidance, the European recession and the growth slowdowns in the BRIC nations and emerging markets. As we explained in last week's comment, it was the huge buildup in household debt resulting in a major credit crisis and great recession that caused most of the budget deficit, rather than the other way around.
Going over the cliff would result in roughly $500 billion of increased taxes and $100 billion in spending cuts in 2013, a total that amounts to about 4% of GDP, and would surely throw the economy into recession within a fairly short period of time. This is a totally undesirable outcome that both sides want to avoid, although even then, a settlement is not a sure bet. Our main point, however, is that even a resolution of the problem would have to involve some combination of tax increases and spending cuts that would add fiscal restraint to an already fragile economy, thereby causing the very recession that everyone is seeking to avoid. The result would be an actual increase in the deficit.
The current consensus is also convinced that additional fiscal restraint will not hurt the economy at this point since it is in a recovery mode and, in any event, is backstopped by an easing Fed. We have our doubts. Even before hurricane Sandy, the economy was slogging along at a barely 2% growth rate, and was showing signs of losing momentum in recent months. Based on numbers prior to the hurricane, the so-called consumer recovery was not solidly based as real disposable income actually declined 0.2% from June through September. Consumers were able to increase spending only by dropping their savings rate from 4.4% to 3.3% over that period. In fact, during the three-month period when consumers were increasing spending by $84 billion, savings dropped $130 billion.
The outlook for capital expenditures is also bleak. New orders for durable goods ex-transportation and defense, a leading indicator of future capital spending, declined 9.1% since year-end and 7.7% since May alone. Industrial production has been flat since February. With consumer spending and capital spending accounting for the vast majority of the economy, overall growth is likely to falter in the period ahead, even before considering the additional fiscal restraint likely to result from the fiscal cliff negotiations.
It is also no help that the ECB, today, has once again lowered its economic forecast for the eurozone. They are now looking for a 2012 decline in economic growth of 0.5%, compared to their September forecast of minus 0.3%. For 2013 the ECB lowered its outlook to minus 0.3% from a previous plus 0.5%. The central bank has been lowering its growth forecasts throughout the past year, and there is no reason to think that this will be the last downward revision. As for China, their continuing heavy reliance on exports to a shrinking global economy does not instill any confidence that their economy is turning around.
In sum, we believe that the recent stock market rally is based on the faulty assumptions that a settlement of the fiscal cliff issue and a recovering economy will propel the market to new heights in 2013. In our view, it is more likely that the additional fiscal restraint that is coming will begin a new era of fiscal austerity in the U.S., and that it will not be without pain.