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VOL. 36 | NO. 35 | Friday, August 31, 2012

Another patch looks likely to avoid ‘cliff’ dive

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Cliff Avoidance 2: Last week, the Congressional Budget Office (CBO) released an update to its budget and economic outlook for the ensuing 10 years.

You could probably count on one hand the number of times that official government organizations actually predict recessions.

However, the CBO does predict one in its latest update. If current law remains in place (i.e. if no new bill is passed by Congress and signed by the president, which in and of itself appears to be a monumental task these days), tax increases and spending cuts galore will hit on Jan. 1.

The spending cuts include Medicare payments for physicians, along with defense reductions and automatic enforcements established by the Budget Control Act of 2011.

Assuming they all go forward, the CBO predicts that GDP will contract by 0.5 percent over the coming 12 months. Furthermore, it estimates that the unemployment rate will rise to 9 percent during the second half of 2013.

Theoretically, higher tax revenues and spending cuts do push the deficit down to $641 billion in fiscal year 2013, with debt held by the public falling to 58 percent by 2022.

While that is somewhat good news from a long-term fiscal health perspective, the speed of the deficit reduction is too much for the economy to bear in the short-run.

The CBO also ran some numbers based on an alternative fiscal scenario.

This scenario assumes that all tax cuts remain in place, with the exception of the 2 percent payroll tax cut. Furthermore, the AMT is indexed for inflation, the Medicare doc fix is enacted and the Budget Control Act of 2011 is modified, removing the automatic spending cuts but maintaining the caps on discretionary spending.

The CBO projects that the alternative scenario would produce GDP growth of 1.7 percent and an unemployment rate of 8.0 percent, neither of which is anything to write home about, but both of which are better than the previous estimate.

The fiscal situation would remain dire, as a fifth straight $1 trillion+ deficit would arrive, while public debt would rise to 90 percent of GDP.

Expect this alternative scenario to gain more traction with the legislative and executive branches, as it might be the perfect Washington election-year medicine, allowing something to get done in temporary patch form without either the legislative or executive branch having to take the blame.

This is obviously not the first time we have addressed this topic, and it will undoubtedly not be the last.

Why does this matter to investors? In our punch/counter-punch market thesis, the low confidence punch that has landed on the already skittish retail investor is only exacerbated by the CBO warnings of this week (investors removed $16 billion out of equity funds in the six weeks prior to Aug. 8).

If European financial crisis fears continue to abate and U.S economic data continues to gradually improve, further P/E multiple expansion could be goosed by an eventual cliff resolution (counter-punch strikes back!).

Until that point, though, the punch remains in force as uncertainty rules the day.

Mark Sorgenfrei Jr. is vice president and investment analyst for Waddell & Associates Inc.