In recent weeks, there has been talk that part of Apple’s 23% decline may be due to the fact that capital gains taxes are likely to go up in 2013. The logic goes that since many Apple shareholders are sitting on large capital gains, they are selling to lock in a lower tax rate. If that logic were true one would expect to see similar selling in other top performing stocks, but on average other top long term holds have not seen the same decline that Apple has.
In October I posted a list of the top performing stocks since October 2007–stocks which should have large embedded capital gains liabilities. The chart below compares their performance since the election. It turns out that on average these stocks have continued to do better than the S&P 500 since November 6. This basket has outperformed the S&P by 2.8% since then.
One thing that I think people aren’t currently appreciating about the Fiscal Cliff is that congress is mostly debating how they plan to shrink the deficit, not really if they’re going to shrink the deficit. So, whether there’s a compromise or not, the US economy is going to be facing a similar picture in 2013: deficit reduction. (Of course, if we don’t “go over the cliff” this deficit reduction might happen slower than in a compromise, and certainly a lack of compromise wont be good for market psychology, but from a technical spending point of view the outcomes are actually rather similar.)
In order to take a look at how the US economy has fared in past periods of deficit reduction, below is some important data linking GDP growth to deficit contraction. The chart shows the data for every year that there has been a contraction in the deficit as a percentage of GDP since 1929.
Over that time frame there have been 42 years that the government has spent less money relative to GDP than it did in the previous year, and the good news is that in the vast majority of those years, there has still been positive GDP growth. Real GDP only contracted in 7 of those years and Nominal GDP only contracted in 3 (two of which were in the depression). The reason that nominal GDP has fared better is that there is actually a strong history of inflation in years of deficit reduction–something to definitely watch for in 2013.
|Source: Federal Reserve
If the deficit shrinks by the full fiscal cliff amount of ~$500B next year, that would mean that the deficit would shrink by ~3% of GDP. Below is some data to put that into context relative to other years in which the deficit contracted by a large amount in a single year. Many of the data points are clustered around the post WWII period (when we ran our largest deficits captured by the data), but low real GDP growth and high inflation are characteristic of most of these years.
Much of the recent discussion about the fiscal cliff has focused on the role of the wealthy and their obligation to shoulder the public debt load. With the debt at $16T and the relative concentration of wealth in the US, the wealthy might not ultimately have much of a choice. The top quintile of wealth is going to have to shoulder almost all of the load.
America is a wealthy country, so technically there is enough money to extinguish the whole debt if we needed to, but it would likely take extending the scope of taxation beyond income and into wealth. The savings rate in the US (“leftover” income) is already very low, so there isn’t a whole lot of room to tax income more without severely impacting consumption. There is, however, plenty of wealth, but it happens to be highly concentrated because low income households don’t save much. The top 20% of households hold 85% of the country’s net savings.
Below is a chart of what the richest Americans’ wealth looks like in relation to the Federal debt. The Forbes 400 could only cover ~10% of the total. The top 1% could cover the whole amount, but it would require a one time tax of 71% of their net worth (which includes assets like real estate, which would be tricky to implement).
If Uncle Sam wanted to keep a hypothetical debt extinguishment tax to 30% of an individual household’s net worth, it would have to extend the tax across the top 20% of households, which would include households with an average net worth of ~$700k (that works out to ~210k for that household).
|Source: Federal Reserve, Avondale Estimates of Net Worth Based on 2007 Wealth Concentration Statistics.
Importantly this analysis only includes today’s debt. It does not take into account the unfunded liabilities from social security and medicare. It’s a little scary to think that the majority of American households have almost no savings and will be absolutely dependent on these programs as elderly. These two programs combined are estimated to have an NPV liability of ~$50T, which theoretically wipes out the net worth of the whole top 20%. Before anyone goes into crisis mode though, all that really means is that something will have to change over time.
US Bank management thoughts on consumer credit impact of the fiscal cliff, from 3Q Earnings call:
P. W. Parker – Chief Credit Officer and Executive Vice President
Well, if the worst case happened on the fiscal cliff, I think it’s fair to say we’d probably reenter a recession. And that would be then you’d see unemployment go up, and that would have an impact on consumer portfolio. I’m hopeful that they come to some kind of resolution, and I think the fiscal cliff was designed in such a way that it’s so severe. I think it’s unlikely that there won’t be some political solution that cuts the middle ground and mitigates that risk.
Last week I posted a chart comparing “fiscal cliff” on google trends to “green shoots” and “moral hazard.” Since then, I thought of two other good terms for comparison: “BRIC” and “PIIGS.” Below is a chart comparing these. Somewhat surprisingly, fiscal cliff has overtaken references to PIIGS and BRIC in news reference volume.