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Will Santa drop any loot into your 401(k) or IRA this year?

Typically, investors can count on a "Santa Claus rally" in the stock market between Thanksgiving and New Year's, as an upbeat mood about the coming year prompts investors to indulge in stocks along with all the holiday fare.

But this year, questions abound about whether a fragile economy could fall back into recession. The European debt crisis looks increasingly out of control, while the latest chapter in Capitol Hill dysfunction raises the chance of higher taxes for all taxpayers and a smaller safety net for the unemployed.

"Supercommittee failure means that there is a greater risk that the payroll tax cut expires, though there is still a chance this could be attached to a year-end spending bill," said Goldman Sachs economist Alec Phillips. In addition, he notes the risk that "spending cuts in 2013 will be more severe than they would have been under the supercommittee agreement."

Payroll tax relief, which was enacted to put more spending money into consumers' pockets, will expire at the end of the year if Congress takes no action, and so far, Congress has shown no inclination to work cooperatively on tax or deficit-cutting measures. If the payroll tax cut disappears due to political paralysis, the government will collect about $110 billion more a year, but that money will no longer be in paychecks as potential spending money.

That's a concern to investors, because the economy needs consumer spending to grow. In addition, extended unemployment benefits, which provide people with about $50 billion a year to spend, would not be available either.

JPMorgan Chase economists have estimated that if the stimulus expires, the economy will go from a 3 percent annual growth rate this quarter to a 1.5 percent growth rate in the second quarter of next year as households encounter a "sharp hit" to their after-tax income. The economists expect "consumer spending to stagnate."

Investors were shaken in August, when Standard & Poor's responded to government inaction on the nation's debt by knocking the U.S. credit rating down a half a notch, but the agencies have suggested recently that no further downgrades are planned.

That should be a relief to investors, because downgrades can inflict higher borrowing costs on countries, making it difficult to operate. But instead of U.S. Treasury yields rising, as they would based on fear of a downgrade, the 10-year bond dipped below 2 percent this week based on a different concern: Moody's economist John Lonski said investors are worried that automatic cuts in government spending and further federal deficit trimming will slow the economy. Investors move money to safety in bonds, and consequently, yields fall.

Besides the $110 billion payroll tax cuts and $50 billion in unemployment help that could disappear, there are trillions in additional measures that will arise over the next year that could interfere with consumer spending and be a drag on the economy. If the "Bush tax cuts," enacted in 2001 and 2003, expire according to schedule at the end of 2012, consumers will have about $4 trillion less to spend over the next 10 years.

"In the coming weeks, investors are likely to remain on tenterhooks as news flow on the supercommittee intensifies, leading to further volatility across fixed income markets and risk assets," Barclays said Tuesday in a report on "a politically dysfunctional world." And rancor is expected to persist throughout 2012 as the deadline approaches for the Bush tax cut expirations and factions in Congress argue about whether to help just the middle class or allow cuts for the rich too.

For middle-income people, the tax cuts that could expire include a $1,000 child tax credit for parents. But it will decline to $500 without congressional action. Low-income taxpayers also now have a 10 percent tax bracket, but that will escalate to 15 percent if the deadline for an extension runs out. For middle-income and affluent people, the current tax structure will allow about 33 million people to escape the higher alternative minimum tax, if Congress keeps it going. For the rich, the expiration of an estate tax break will mean paying taxes on assets over $1 million, compared with protecting $5 million now.

Meanwhile, as investors worry that a wrong move on taxes and spending could hurt consumers and undermine the economy, trouble in European banks is starting to affect distant areas. Fearful banks are holding on to capital instead of lending, and strategist Ed Yardeni notes that's interfering with lending in emerging markets.

"Globalization works both ways for the global economy and corporate earnings," he said. "During good times, prosperity spreads around the world."

Now, he says, the risk is that bad times in Europe may "result in a global credit crunch."

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(c)2011 the Chicago Tribune

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