Financial Professionals


The Economic Impact from the Fiscal Cliff

Over the past six months the strength in the U.S economy has clearly shifted away from manufacturing toward the consumer. Confirmation of this shift has been reflected in the disappointing reports from durable goods, ISM manufacturing, and regional manufacturing indices. Conversely, recovering auto/housing figures, strong consumer confidence readings, and retails sales confirm the shift. The collective data has led to our “services over goods” investment thesis.
Ahead of the U.S. presidential election much speculation centered around whether the goods side of the economy was in the midst of a slowdown on fears of the pending fiscal cliff. I believed all along, and communicated it here, that yes, the pending fiscal cliff was the culprit.  For those that fought hard against the premise, post-election, with the status quo in D.C. certified, you can no longer ignore the evidence.
Last week’s Sandy-effected Philadelphia Fed -10.7 reading incorporated continued anemic capital expenditure intention for the next six months, which has nothing to do with Sandy. Corporations with 2008 fresh on their minds have reacted much quicker, immobilizing spending than consumers ahead of the cliff.
An obvious question would be are corporations smarter than consumers in tightening so quickly? That answer will be known in the coming weeks but what is certain is that the “services over goods” investment thesis will be victim number one should D.C. fail to avert the cliff. In essence, we would lose the “services over goods” investment thesis and place the overall economy at risk for recession.
What I expect will happen is a two-step process:
1.  Avoid the cliff.
2.  Craft a script to debate entitlements, spending cuts, and revenue in 2013.
Using the evidence of history as a guide, there is time before Congress leaves for the Christmas break to avoid the cliff. In 2011 the agreement to extend the payroll tax cut was reached as D.C. headed home for the holidays, two days before Christmas. The year prior after the midterm elections, an agreement to extend the Bush tax cuts was not reached until one week prior to Christmas.
Congress returns from their Thanksgiving holiday on November 26. As they departed last Friday, they communicated some optimism. Let’s hope they convince us differently and get a deal done. I expect they will.
Within the compromise details, I will look for three things:
1.  Is enough clarity provided so that capital spending will unfreeze in 2013? It is wrong to suspect that corporations don’t want to spend. In the commentary of multiple manufacturing CEOs during earnings conference calls, the eagerness to invest was highlighted. Potentially, this could resurrect the flailing industrial and material sectors.
2.  Unearned income tax rates will be...? I expect both capital gains and dividend rates to rise from the current 15% to at least 20%. Add on the 3.8% tax for the March 2010 health care law, and that takes both rates to 23.8%. I would be surprised if they went above 23.8%. Specifically, the dividend rate which as suggested, is taxed as ordinary income, would be 43.4% for the highest earners. That 43.4% would be a market headwind.
3.  How the services side will be impacted by a rise in personal tax rates. The 2% payroll tax cut will expire; don’t expect relief on that. Additionally, I expect upper income earners will see their tax rate rise to pre-2001 levels. What might be yet to be determined is the threshold for “upper income” – $250,000? $500,000? $1,000,000?   
Senate Majority Leader Harry Reid, Senate Minority Leader Mitch McConnell, House Speaker John Boehner, and House Minority Leader Nancy Pelosi all stepped to the podium Friday with optimistic messages. Sounded great. Well, go ahead “convince us differently.” Get a deal done that disappoints all sides; isn’t that the best deal anyway?

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Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.