Fiscal-Cliff Concerns Hurt Economy

Companies hold back for fear of higher taxes, budget cuts in new year.

Companies are starting to delay hiring and spending out of concern that Congress won’t reach a compromise in time to avoid automatic tax increases and budget cuts that would pull billions of dollars of purchasing power out of the economy.

Faced with a so-called fiscal cliff of more than $600 billion in higher taxes and reductions in defense and other government programs in 2013, U.S. companies are pulling back, though the deadline for congressional action is more than six months away.

The best strategy for companies to follow when confronted with such uncertainty ahead of Dec. 31 is to “stay lean and keep your inventories taut,” Sandy Cutler, chief executive officer of industrial equipment-maker Eaton Corp. in Cleveland, told a conference May 31.

Economists are predicting this trend will pick up through the year. “A lot of people see the fiscal cliff as a 2013 story, but you don’t board up the windows when the hurricane is there, you board up the windows in anticipation,” said Michael Hanson, senior U.S. economist at Bank of America Corp. in New York.

Hanson sees U.S. growth decelerating to 1.3 percent in the third quarter and 1 percent in the fourth quarter as the European debt crisis and worries over the U.S. budget increasingly weigh on the economy. Gross domestic product advanced at a 1.9 percent annual pace in the first quarter.

 

Recession Concern

Things would get worse next year if Congress allows all of the scheduled spending reductions and tax increases to take effect. In that case, a recession is likely, the non-partisan Congressional Budget Office warned in a report last month.

The scheduled budget cuts haven’t had much of an effect on financial markets, with investors preoccupied by the intensifying crisis in Europe. Sixty-one percent of the 234 fund managers surveyed by Bank of America last month saw the euro region’s debt troubles as the biggest concern in the world economy, more than three times as many who said that about the U.S. fiscal cliff.

In a sign of investors’ equanimity, U.S. stocks have been the best-performing major equity market in 2012, with the Standard & Poor’s 500 Index up by more than 6 percent so far this year.

Such sentiment could shift if Congress doesn’t act in the next few months to avoid the year-end budget precipice, said Peter Fisher, senior managing director in New York at BlackRock Inc., the world’s largest money manager.

“The markets don’t want to wait until Dec. 31,” Fisher, a former Federal Reserve and Treasury official, told Bloomberg Television on May 30. “Congress is going to have to wake up in October when the markets start pricing in the uncertainty of a recession in 2013.”

Lawmakers, for their part, said they don’t anticipate much from Congress until after the November election. The two parties are just too divided.

Preferred Systems Solutions is among government contractors coping with delayed procurements and agency cost-cutting, said Scott Goss, president and chief executive officer of the Vienna, Virginia-based engineering and information technology provider. One intelligence agency asked Goss to lower his charges on an existing 10-year contract.

 

Feeling ‘Squeeze’

“I’m feeling more of a pinch and squeeze than I ever have before,” Goss said. “As soon as they start these massive cuts, they’re going to impact the economy.”

Defense contractors are “most fearful” of across-the- board reductions that could spur as many as 350,000 job losses if Congress doesn’t act, said Cord Sterling, vice president of the Aerospace Industries Association of America.

In the absence of guidance from President Barack Obama’s administration about how the cuts would be carried out, companies “have to assume those go into place,” he said.

The prospect of cuts already is having a “chilling effect” on the industry and Lockheed Martin Corp. and other companies may stop hiring and training, Robert Stevens, chief executive officer of the world’s largest defense company, said in March on Capitol Hill. Last month he said that laws requiring advance notice of firings may prompt grim warnings in September and October.

Other companies have changed their hiring plans. RTI International Metals Inc. began building a plant in Virginia in 2007, intending to hire more than 200 workers and devote half of the facility’s capacity to defense programs, said Dawne Hickton, chief executive officer of the Pittsburgh-based titanium manufacturer.

Defense cuts and the uncertainty surrounding the fate of the new Joint Strike Fighter changed the company’s plans, causing it to scale back the size of the plant and curtail hiring.

“We’ve probably got about 50 people” at the facility, which opened at the end of last year, Hickton said.

The fiscal cliff is a catch-all phrase for a confluence of budget measures coming to a head at the end of year. Chief among them is the expiration of tax cuts for income, dividends and capital gains championed by former President George W. Bush. A 2- percentage-point cut in payroll taxes is also set to end.

If Congress does nothing, 82.9 percent of U.S. households would face tax increases averaging $3,701, according to the Tax Policy Center, a nonpartisan research group in Washington. More than 98 percent of households earning more than $50,000 a year would pay higher taxes.

 

Defense Cuts

On the spending side, some $65 billion in automatic cuts are set to take effect in 2013 as part of last year’s deal to raise the debt limit. Half of the reductions will come from defense spending.

Besides the tax cuts, expanded unemployment benefits and a provision that prevents steep cuts in Medicare reimbursement to doctors are scheduled to expire on Dec. 31.

All told, the steps on their own would reduce the federal budget deficit by $607 billion, or 4 percent of the gross domestic product, in the fiscal year starting Oct. 1, the CBO said. The shortfall this fiscal year is projected to be $1.2 trillion.

Federal Reserve Chairman Ben S. Bernanke warned lawmakers on June 7 that such a “severe” tightening of fiscal policy would “pose a significant threat to the recovery” if it were allowed to proceed. He also has indicated that the Fed would be hard-pressed to offset the full effect of such moves on the economy.

Given the stakes involved, economists surveyed by Bloomberg News last month said they expect lawmakers to avert an economic decline by delaying or rescinding many of the spending cuts and tax increases slated to take effect in 2013.

Even if Congress doesn’t take steps to do that by the end of 2012, the U.S. won’t immediately lapse into recession, according to Chad Stone, chief economist at the Center on Budget and Policy Priorities. The Washington group advocates policies that benefit lower- and middle-income Americans.

“The economy will indeed start down a slope that could ultimately lead to a recession in 2013,” he wrote in a June 4 report. “That’s a far cry from the economy falling off a cliff and plunging immediately into a recession.”

Still, companies are hunkering down to prepare for the potential fallout.

 

Cash Flow

Kimmie Candy Co. this month put on hold plans to add five or six workers to its 23-person payroll because of slowing sales growth and the political uncertainty in Washington, said Joseph Dutra, president of the Reno, Nevada-based company.

“For a small business like mine, cash flow is the biggest concern,” said Dutra, whose company makes Choco Rocks and Sunburst candies. “If you don’t know where the economy is going and where the government is going on taxes, you don’t want to take too many risks.”

Other companies are reacting in similar ways, according to Jim McCaughan, chief executive officer of Des Moines, Iowa-based Principal Global Investors LLC, which works with some 30,000 employers on their retirement benefit plans.

“What they’ve said to us actually in the last couple of months is we are slowing hiring because of the fiscal cliff and that’s really their reasoning more than the European uncertainty,” he told a conference on June 6. “It’s more that Washington isn’t doing anything about the tax rises that are scheduled to come.”

U.S. employers expanded their payrolls by 69,000 workers last month, the smallest increase in a year and significantly down from an increase of 275,000 in January.

The impasse over the budget is taking a toll on the economy and will reduce growth this year by about a half percentage point, according to CBO Director Doug Elmendorf.

“We think it’s an issue now and will be increasingly an issue in the second half of the year,” he told reporters last week.

His agency has been affected, too. Officials are unsure about whether to replace workers who leave because it’s impossible to plan on next year’s budget.

“That must play out on a much, much larger scale with more significant enterprises than ours,” Elmendorf said.

 

 

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