We have two separate themes in the market today. One is that Washington's failure to reach a fiscal cliff deal is causing worries of what might happen as the fiscal cliff begins to unfold and the second is that the economic data we received this morning on what has actually happened is quite good.
Three reports this morning, whether it's personal income and outlays, durable goods or my favorite, the Chicago Fed National Activity Index, all point to a growing economy with rather solid fundamentals. But the market is focused on dysfunctional politics.
But in the meantime, what about that supposed recession? Even if we do go off the fiscal cliff (or slope, as I prefer), it's not as though all of those $600 billion in tax hikes and spending cuts comes out of the economy right at 12:01 a.m. on Jan. 1. No, while going down the slope won't be a good idea and will cause some economic pain, that fiscal contraction will come out of the economy over time, leaving a chance for a January deal to avoid some of the problems. What remains to be seen is what any ultimate deal holds in store and that is essential for forecasting economic growth from this point.
Deal or no deal, what I am most interested in, though, is what will be the effect of the expiration of the 2% payroll tax cut on the economy. Both sides agree, rightfully so I might add, that allowing this temporary measure to expire is a good idea to maintain the solvency of the Social Security trust fund. That said, this would essentially be a 2% pay cut that would show up in consumer disposable incomes and perhaps spending in the coming year.
But in the meantime, the economic data look good, including that of consumers' income and spending. Spending in November rose by the largest amount in three years, as inflation-adjusted consumer spending rose 0.6% and real after-tax income climbed 0.8%. (Part of this may reflect a post-Sandy rebound.) In any case, both monthly increases of spending and incomes were the largest in at least eight months. Consumers were even able to increase their savings rate, which edged up to 3.6% from 3.4%, while they spent more on cars and other durable goods. Spending on durable goods is important, as it signals that consumers are feeling more confident, despite what surveys might say, and are comfortable shelling out funds on often big-ticket items.
Manufacturers responded in turn, as orders for durable goods advanced 0.7%, following a 1.1% gain in October, and was the sixth increase in the past seven months. Most categories, with the notable exception of aircraft, climbed higher. And excluding transportation, orders rose 1.6% after gains of 1.9% and 1.7% in the prior two months. This is solid.
Importantly, businesses increased their capital spending (again, outside of aircraft) by a robust 2.7% in November following a similarly strong 3.2% gain in October. This means businesses are confident in investing in future production.
Even before these reports, the Chicago Fed National Activity Index, which is a composite of 85 different indicators available as of Dec. 20, posted a large increase to +0.10 from the previous month's read of -0.64. The one-month data shows the economy is growing a bit above trend (its long-term potential growth rate, thought to be currently around 2.5% or so). Meanwhile the three-month moving average, a more widely followed measure, also advanced to -0.20 from -0.59, but showing the economy growing just slightly below trend. Both measures are the highest in at least six months.
What we don't know from today's data is, of course, what will happen next. It is quite possible that the advances in both business investment and consumer spending were predicated on the assumption that there would be a budget deal. Since, as of right now, there is no deal and it looks like we will descend the fiscal slope (I really want to move away from the cliff analogy), we may see cutbacks in spending and investment from both consumers and businesses come January. But based on the market's reaction this morning, it looks like investors, while disappointed, are hardly panicked. And that is a good sign, at least so far.