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A Forecast For 2013: Stocks Up, The Economy Down

2013 could turn out to be a very good year for the stock market, but still be a bad year for the economy. Here’s why.

The fiscal cliff deal struck at the beginning of this month will raise taxes; and higher taxes will negatively impact the economy. However, higher taxes will also reduce the size of the government’s budget deficit. That means that government borrowing will suck less money out of the economy. The Fed, on the other hand, has already begun to pump a great deal more money into the economy. In fact, it now looks like the Fed will print more money through its expanded third round of Quantitative Easing than the government will borrow to finance its budget deficit. With the government borrowing less and the Fed printing more, there is likely to be a growing pool of excess liquidity. It is also likely that at least part of that excess liquidity will make its way into the stock market and push stock prices higher – regardless of what’s happening in the real economy.

Let’s take a closer look at the details.

It is estimated that the fiscal cliff deal will raise taxes this year by approximately $250 billion, an amount roughly equivalent to 1. 6% of GDP. That is likely to cause the economy to be $250 billion or 1. 6% smaller than it otherwise would have been. Remember, every economy is made up of just four parts: personal consumption expenditure, business investment, net trade and government spending. The $250 billion tax hike most likely will reduce personal consumption (and therefore GDP) by roughly the same amount, i. e. $250 billion. The economy is already very weak going into 2013. The fiscal cliff deal will make it $250 billion weaker.

It was not at all certain that the US economy could have grown by 2% in 2013 even before this deal. Now, higher taxes will deduct roughly 1. 6% of GDP. Therefore, it is quite possible that the economy will slide back into recession due to this fiscal tightening. Moreover, during the next couple of months, the Democrats and Republicans in Congress will continue to battle one another over raising the ceiling on how much debt the government can issue. Technically, the “debt ceiling” has already been reached. The Republicans have said that they will not vote for a higher debt ceiling until a deal is reached to cut government spending. If their demands are met and government spending is cut, that will further reduce the size of the economy and increase the chances of recession this year. Either way, with or without government spending cuts, the real economy will face severe headwinds in 2013. That could very well mean that the unemployment rate will soon begin to rise again.

Luckily for equity investors, stock prices are not determined solely by the fundamentals of the real economy. They are also affected by liquidity or, in other words, by how much money is sloshing around the economy. This year, thanks to the Fed, it appears that there will be an enormous amount of liquidity sloshing around. The Fed is now printing $85 billion of new money every month. That will add up to just over $1 trillion if QE 3 goes on all year. That will be more than the entire budget deficit, which should be somewhere in the range of $800 billion to $900 billion this year. With the Fed printing even more money than the government is borrowing, there will be plenty of excess liquidity available to push stock prices higher – and perhaps significantly higher!

Moreover, the ample liquidity is likely to spill over into other asset classes as well. As long as the Fed continues printing money at the present rate, gold and silver prices should move higher, property prices should rise and even bond prices should remain high (which will keep yields low). Rising asset prices will make those who own assets feel richer and encourage them to spend more. And, increased spending will support economic expansion…. so long as the Fed keeps printing.

In other words, lacking any fresh ideas, the Fed is once again attempting to drive the economy through asset price inflation. With US median income being driven lower due to globalization and with fiscal austerity now set to shrink the economy thanks to Congress, the Fed has once again begun to resort to bubble blowing to stave off economic collapse.

The global economic raft is being aggressively inflated with the injection of new money. As long as this continues, asset prices will rise. This won’t go on forever, however. We have seen this all before. When the Fed signals its intentions to stop (or slow down) its printing press, investors should quickly take their profits because, at that time, asset prices are likely to quickly deflate. Until then, ENJOY THE RIDE!