Who’s Afraid of the Fiscal Cliff?

Warnings about the fiscal cliff have saturated the US public debate. But consumers are still spending, even though they face huge potential tax hikes, while companies are being very cautious—even though they have relatively little to lose.

These trends provide some guidance on how the US economy may benefit if an agreement is reached—or how it may suffer if the economy goes over the cliff.

Fiscal uncertainty is not a new feature on the US economic landscape. In 1986, as the debate over President Reagan’s proposed tax reform dragged on for nine months, corporate spending declined. After the tax reform legislation was enacted in October 1986, business capital spending rebounded.

President Clinton faced a similar situation in 1993. Just after he was elected, Clinton proposed major deficit reduction legislation instead of an expected tax cut for the middle class. Talk of broad tax hikes led individuals and companies to defer investment and spending, and economic growth slowed.

The current debate has also added confusion and uncertainty. But the situation today is different because the behavioral response of consumers and companies isn’t aligned with the risks they face.

For example, individuals face the biggest risk because, without an agreement, a $536 billion tax hike will kick in from January, adding 5% to the average household tax bill. Yet consumer confidence remains buoyant, according to November surveys (Display). New vehicle sales soared to 15.5 million units in November—the highest rate since 2008. Sales were firm even if we exclude a boost related to replacements of cars that were damaged or destroyed by Hurricane Sandy.

While consumer spending in other areas is less robust, the willingness to purchase big-ticket items like cars shows that consumers are not yet spooked by the fiscal cliff. We think US consumers are focusing more on modest improvements in labor and housing markets. They may also have been reassured by President Obama’s pledge to avoid raising taxes on middle income taxpayers.

Meanwhile, business confidence has plunged, even though corporate tax rates won’t change at year-end. Companies seem to be rethinking spending and investment plans. Many have adopted active risk-management strategies since the financial crisis to guard against adverse outcomes, especially those that are hard to predict. According to a new US Economic Policy Uncertainty Index, created by Professors Scott Baker and Nicholas Bloom of Stanford University and Professor Steven Davis of the University of Chicago, policy uncertainty is slightly higher than it was during the Lehman Brothers crisis (Display).

We still think that the fiscal cliff is likely to be avoided. But companies are clearly afraid of it anyway and it will take some time for managements to regain confidence. Yet this also means that a fiscal deal may prompt a revival of corporate spending and investment, which could produce a positive surprise in US economic growth next year. Conversely, if policymakers fail to avoid the fiscal cliff, rising taxes would force consumers to tighten their belts, which could undermine the economic growth outlook.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Joseph G. Carson is US Economist and Head of Global Economic Research at AllianceBernstein.

Joseph G. Carson

Joseph G. Carson joined AB in 2001. He oversees the Gobal Economic Research group, which provides economic analysis for the firm, and has primary responsibility for economic and interest-rate analysis of the US. Previously, he was chief economist of the Americas for UBS Warburg . Over the years, he has also served as the chief US economist at Deutsche Bank, as chief economist at Chemical Bank and Dean Witter, and as senior economist at Merrill Lynch. Carson began his professional career in 1977 as a staff economist in the US Department of Commerce and represented the department at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. Early in his career, he also held a variety of roles at General Motors. Carson was named to the Institutional Investor All-Star Team for Fixed Income while at Deutsche Bank, He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Location: New York

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4 thoughts on “A Municipal Bond Cliffhanger

  1. I personally believe you are way off base here. Are you looking out for the clients or the brokerage firm and it”s reps. I have been dealing in Muni bonds for about 40 years and there has always been a segment of the political jerks trying to do away with the nature of the tax free status. Sure, they have come in the back door and made the tax free income effect the taxability of other income based on amounts of income a person has, but to change the tax free status would take an act of Congress. Now, with what we have as a congress at this time that could happen, but before it is approved I am sure some of them would realize the effect on their own pocketbooks…higher infrastructure rebuilding costs, same for schools, hospitals and any public paid project for the good of the people in the area(there are standards here) Your doom and gloom approach would be a definite high cost to the consumer or investor who would be using short term investing and multiple purchases over the intermediate to long term, making some sales people and firms happy to receive multiple commissions and concessions. Not so good for the client. I have never seen where the knee jerkers win over the patient believers. Have a good day.

    • Personally, I hope you are correct—that Congress sees the benefit of tax exemption for municipal issuers and maintains the current tax status of municipal bond interest. However, that is far from certain. In fact, the President has proposed limiting the benefit of tax-exempt interest in his budget, which would effectively tax municipal bond interest for some investors. Interest rates are incredibly low and any change to the tax status of municipal interest would probably impact the longest-maturity bonds the most. As such, for those concerned about changes to the tax code and the potential impact on municipal debt, their focus should be on their longest holdings, and not their entire municipal portfolio. In this way, our advice is anything but a knee-jerk reaction to uncertainty, but rather a prescription to get the biggest benefit for the least number of transactions.

  2. Good information here. Here in California we have high taxes and our clients are concerned about the effect of Prop 30. Thanks for your comments.

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