The clock is ticking

Time is running out. As this note goes to press, the cliff negotiations have

devolved into two unpalatable options: (1) extend just the middle income tax cuts

and extended unemployment benefits and allow about two-thirds of the cliff to

happen, or (2) go over the cliff in the entirety. In our view, given the short time

frame and legislative hurdles, the latter appears much more likely.

Here we look at what we believe are likely scenarios and potential impact of each

on the economy and markets. We reiterate our key calls as follows:

􀂄 Going over the cliff is not a benign “slope” as some suggest. Rather, it

accelerates the already-building damage to the economy and markets. The

latest evidence is the plunge in consumer confidence. Indeed, this could mark

the beginning of the rotation in the uncertainty shock from businesses to

consumers.

􀂄 Once the cliff deadline has passed, something has to convince politicians that

what they are doing is not worth the price. Due to reporting lags, the damage

to the economy will only become clear over time. Hence the catalyst for

action will likely need to be market weakness and severe public criticism.

􀂄 Today the stock market has increasingly become the disciplining force in

spurring action in Washington. “Stock market vigilantes” have replaced “bond

market vigilantes.”

􀂄 Going over the cliff has many secondary, largely ignored, negative impacts,

including tax changes that could damage the housing recovery, as well as

negatively impact education and alternative energy, among many others.

Over the coming weeks we expect politicians to agree to a series of partial

patches, with some parts of the cliff delayed and others allowed to expire. The

result would be a series of awkward decision points with attendant pressure on

consumer, business and investor confidence. But we continue to believe the cliff

will be mostly resolved before the end of the first quarter. In our view, the biggest

risk to this expectation is a protracted battle over raising the debt ceiling, which

will be reached by late February or early March, after extraordinary measures.

Cliff or slope?

Optimists on the cliff outcome argue that it is a fiscal “slope,” not a cliff. We

believe this view is correct in a limited sense, but wrong in a more fundamental

sense:

􀂄 The good news is that many of the cuts do not kick in on January 2. Some

tax increases may not be immediately reflected in pay checks. Some

spending programs will wind down slowly as they first use up existing cash

balances. Moreover, even if the economy contracts for a month or two, a

recession usually involves six months or more of decline and if cliff items are

resolved retroactively, the economy could experience a mini-rebound.

􀂄 The bad news is that in the real world expectations matter and just the

possibility of going over the cliff has already damaged the economy. Capital

spending cooled this year and recent consumer confidence readings have

dropped sharply. Holiday shopping has already disappointed and downside

risks to spending increase the longer the cliff casts its shadow. More on

confidence below.

􀂄 The ugly news is that going over the cliff reduces the urgency of getting a

deal done. Once the deadline is violated, what induces the two sides to stop

fighting and start compromising? Doesn’t going over the cliff suggest that

each side believes the short term damage from going over the cliff is not as

bad as the long term “damage” of a “bad” compromise? As we have seen in

the past, often very strong outside pressure is likely needed to induce

decisions in Washington. Historically, “bond market vigilantes” have been the

disciplining force in ensuring responsible monetary and fiscal policy; today,

“stock market vigilantes” are playing that role.

What’s next

While the most optimistic scenarios have been eliminated, a wide range of messy

potential outcomes remain:

􀂄 At this point, the failure to reach a deal means a “clean” grand bargain, where

the two sides quickly compromise on most of the cliff items, is highly unlikely.

􀂄 There could be a mini-deal, where they extend middle income tax cuts and

extended unemployment benefits and allow the other two-thirds of the cliff to

expire. The hurdles for such a deal are high: they require that Senate leaders

agree, that all 100 Senators agree to expedited legislation, a majority of both

the Senate and the House vote for the legislation and the President signs it.

􀂄 As such, the most likely outcome, in our humble opinion, is that all the cliff

items expire—a fiscal austerity equivalent to about 4 ½% of GDP. Then in the

coming weeks there are a series of partial patches with some parts of the cliff

retroactively extended and others simply allowed to expire. The result would

be a series of awkward decision points with attendant pressure on consumer,

business and investor confidence.

While we expect to fall off the cliff, we believe the cliff is resolved before the end

of Q1. The impact on the economy will depend on the following factors:

􀂄 How long do we remain over the cliff? Each week without some resolution

means more delayed spending, increased tax withholding and, most

importantly, a deeper shock to confidence.

􀂄 How many brinkmanship moments? The cliff is big and complicated. A clean

grand bargain is unlikely, in our view. More likely are a series of smaller deals

that patch up the cliff and prolong the uncertainty shock.

􀂄 How big is the austerity and does it hit gradually or quickly? One of the most

dangerous things about the cliff is that there is no phase in period — it all

happens in the first year.

􀂄 How serious is the damage to confidence for consumers, businesses and

investors? So far the scars look relatively mild.

􀂄 How big a credit downgrade is there and is faith in Treasuries as the core of

the global capital markets damaged? Up to now, the US has maintained its

“safe haven” and reserve currency status. If that were damaged, the shock

would be much bigger.

Our base case remains the same as it has been for over a year: GDP growth

drops to 1% in Q1 and, once the cliff is resolved, growth gradually returns to

trend. We expect the shock to gradually shift out of capital spending into the

consumer. Households have been slow to recognize and react to the cliff and we

expect tax increases to push the growth in real disposable income from 2% to

zero next year. On a positive note, we do not expect a recession. We believe the

private sector has recovered significantly from the 2008-09 crisis and growth

would be above 3% absent the cliff. Hence, in our view, a recession is only likely

either if more than a month is spent entirely over the cliff or if the brinkmanship

battle extends into the second quarter.