Weekly Market Commentary - The Budget Bombshell

In one week, President Obama is due to submit his 2013 budget, which covers the fiscal year beginning on October 1, 2012. The Congressional Budget Act of 1974 requires the President to submit a budget request to Congress on the first Monday in February, but the Administration has scheduled the release instead for one week later on February 13. In addition, Congress must pass a budget resolution by April 15 of every year. However, the President missed the deadline last year and while the House passed a budget resolution last year, the Senate did not. This year is likely to be no different, with no budget being passed. But this does not mean the 2013 budget does not have potentially market moving consequences. The 2013 budget is already going to have the biggest impact of any budget in decades even if no action is taken in Washington. The fiscal headwind comprised of both tax increases and spending cuts under current policy totals over $500 billion, or 3.5% of GDP.

The 2013 budget changes, primarily consisting of tax increases, are already in the law and would need to be changed to mitigate or restructure them to be less of an economic drag; if not a return to recession may be looming in 2013.

While the United States economy is not likely to see the big declines in government spending that came after WWI and WWII, the United States has never experienced a deficit cut by more than 2% of GDP that did not end in a sharp decline in GDP. The last time the budget deficit was cut by a similar amount to the 3.5% on tap for 2013, it was 1969. In 1969, the deficit narrowed by 3.1% during the year, and GDP ended up shrinking -1.9% in the fourth quarter (and by -0.6% in the following quarter) as the U.S. entered a recession. Despite the recession, the efforts to narrow the deficit in 1969 had one pleasant outcome: they balanced the budget. Unfortunately, the budget changes on tap for 2013 will still leave the federal budget far from balanced.

The further apart the parties in Washington appear to be, even on extending the unemployment and payroll tax cuts that expire this month, may make investors increasingly nervous. This may result in the return of market volatility in February after stocks got off to a strong start to the year.

While the President’s budget is unlikely to get much attention in Congress, the markets may begin to price in a major budget deal taking place in early 2013 for several reasons:

  • the economic impact of the many scheduled tax increases and spending cuts,
  • the debt ceiling will be hit again in early 2013 and require legislative action to approve an increase,
  • the rating agencies have warned that they will be watching in 2013 for the United States to take actions to return to a path of fiscal sustainability, and
  • the President and a newly elected Congress will have maximum political capital to make it happen in early 2013.

But the risk that a budget deal does not eventually happen should keep markets from moving steadily higher in 2012, as they have done year-to-date, without a reality check. With Congress now back in session and the President’s budget due on February 13, just a week away, the markets may begin to refocus on the risks to the economy posed by inaction in Washington leading to a return of volatility.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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