Our economic forecast for 2013 comes down to one simple phrase: “It all hinges on Washington.”
“The president and Congress must decide whether tax rates rise or fall, whether fiscal stimulus or austerity rules the day, and whether the long-term budget deficit issues or entitlements will be addressed,” says Robert Leggett, senior investment strategist at FirstMerit Wealth Management Services.
The Federal Reserve has promised to hold short-term rates low until the unemployment rate falls to 6.5 percent, unless it determines inflation is likely to exceed 2.5 percent, he says. Will the Fed’s newest $85 billion monthly quantitative easing — bond buying — program continue to suppress longer maturity bond yields in 2013? To paraphrase the European Central Bank’s Mario Draghi: ‘Believe us, it’ll be enough’ to keep the U.S. Treasury 10-year bond yield from rising much in 2013.
Smart Business spoke with Leggett about what to expect in 2013.
How do you expect Washington to address the fiscal cliff?
The Washington glass seems ‘half full,’ so fiscal cliff compromises should be reached. Taxes will be raised on the ‘rich,’ however that is defined. Tax increases on everyone else will be limited by extending middle class tax cuts, ‘patching’ the Alternative Minimum Tax and gradually ending the FICA (Federal Insurance Contributions Act) 2 percent payroll tax holiday.
Alas, anyone who has a taxable investment account will pay more taxes through higher capital gains rates and higher tax rates on common stock dividends. Entitlement reform will likely be kicked down the road, but credit rating agencies should be assuaged by an agreement to create a congressional commission, lessening the risk of a January ratings downgrade. Likewise, there should be just enough spending cuts to allow a compromise on raising the debt ceiling.
What are some risks with the current situation, and how likely are they to occur?
The downside risk hinges on Washington, where policy errors could take us over the cliff, leaving the economy crushed at the gorge’s bottom by another severe recession.
Sounds horrifying, doesn’t it? But this worst-case scenario is very unlikely. Even if taxes are raised, the increase shouldn’t be too stiff, and history shows the spending impact will be minor. Modestly higher capital gains rates also have a limited impact. Changes to corporate taxes and deductions will be a mix of pluses and minuses, as always. The regulatory burden only goes in one direction — heavier — but who does that surprise?
Despite volatile gasoline prices, the consumer price index inflation rate dropped to roughly 2 percent, and that trend should continue. Energy prices shouldn’t rise significantly, as increased supply meets very slow demand growth. With consumers, housing activity and prices are on the upswing, and residential construction has been additive to GDP for the past six consecutive quarters. Combined with the doubling of the S&P 500 since 2009 and decline in consumer debt outstanding, household net worth has improved sharply. Continued modest but steady 2013 job growth should lower unemployment rates.
So, what should happen next year?
Basically, the economy can do one of three things: improve, stay the same or get worse. The presence of feedback loops often determines which occurs. 2012 began with a positive feedback loop — rising production of goods and services meant more hours worked, and incomes grew, resulting in greater demand for goods and services, leading to rising production of goods and services. Unfortunately, fears arose for both businesses and consumers. Uncertainty weakens the links of a positive feedback loop and can eventually forge a negative chain. Fortunately, much of the uncertainty should be alleviated by even a partial resolution of the fiscal cliff and budget deficit issues.
All in all, expect a slow start to 2013, with hangover from partisan battles and going over the fiscal cliff, or perhaps fiscal slope, to some extent. However, as uncertainties are alleviated, GDP growth should reaccelerate to 2.5 percent or more in the second half.
The opinions and information contained in this message have been derived from sources believed to be accurate and reliable, but FirstMerit Bank N.A. makes no representation as to their timeliness or completeness. This message does not constitute individual investment, legal or tax advice. All opinions are reflective of judgments made on the original date of publication and do not constitute a guarantee of present or future financial market conditions.
Robert Leggett is a Senior investment strategist at FirstMerit Wealth Management Services. Reach him at Robert.Leggett@FirstMerit.com.
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