With the CBO projecting a recession and the Fed poised to act, equities could be at risk.
The Congressional Budget Office recently laid out two economic forecasts based on two different fiscal policy paths. Neither forecast looks appealing.
In the first one, the Bush tax cuts expire while government spending is cut by about $100 billion according to current law. This is effectively the removal of fiscal stimulus and raises the likelihood of recession in 2013. This path requires no Congressional action. In other words, unless Congress acts, we are headed off a fiscal cliff. We can see the effects of a fiscal cliff in Europe, where they call it austerity. Eurozone gross domestic product contracted in the second quarter and the continent has likely entered another recession.
The second path requires the extension of tax cuts and postponement of spending cuts. This would cause another $1 trillion deficit and even under this scenario, the economy would expand in 2013 at a meager 1.7%.
There are two approaches to stimulating economic growth: through either the supply side or the demand side. Cutting taxes is a supply side measure, because at a lower tax rate, we keep more of our earnings, giving us an incentive to work harder, thus increasing the supply of labor. Under the Obama plan, taxes on the highest wage earnings will rise and approach 50% of earnings all in. The idea of losing half of your paycheck to taxes might lead some to spend more time on leisure activities and less on work.
A boost in government spending is a demand-side measure, as government spending has a multiplier effect that trickles through the economy. Economists have long believed that supply-side measures were the only ways to permanently boost the economy. To them, supply-side measures work in the long run while demand-side measures would work only in the short run. To this, John Maynard Keynes, a champion of demand-side measures, replied that, "In the long run, we are all dead." However, it is hard to imagine that even Keynes would have advocated the kind of structural deficits we are now running.
Such confusion on the fiscal side puts more pressure on the Federal Reserve to act on the monetary side. Indeed, Fed minutes released this week seemed to indicate that more bond buying is on the horizon: "Additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery."
To be sure, Morningstar is not predicting a recession, but rather sluggish growth. As our economist Bob Johnson has pointed out, leading indicators are still positive.
The Outlook for Stocks
There seems to be a growing aversion to taking on equity risk, as highlighted by the strong flows into bond funds and out of stock funds over the past four years. Given this bifurcation in asset flows as well as the market's reasonable valuation at 14 times price/forward earnings, the contrarian in me wants to bet on equities. However, if we do hit another economic rough patch, which looks increasingly likely, earnings will come under pressure and stocks may, in fact, turn out to be overvalued.