America’s cliffhanger

The US fiscal cliff agreement, which passed through Congress on the first day of the year, showed most US politicians in a bad light.  Only at the very last minute before significant tax increases and spending cuts would have taken effect, did all participants agree to (i) a deferral of these measures for two months, (ii) a 4.6% tax increase on all incomes over $450,000, and (iii) a 2% payroll tax increase on all incomes up to $107,000.  Obama got the tax increase for the top 1% of earners that he had campaigned for, which will raise about $60bn a year, and the Republicans demanded no further extension of the payroll tax cut, which will raise about $125bn a year.  Together these measures will reduce US consumer incomes by a little over 1% of GDP in 2013.

This was just about the minimum possible level of agreement, and the fact that it took until 1st January to get to that point does not bode well for the chances of securing a more substantial and longer term agreement on government finances ahead of the next fiscal cliff deadline which is now 1st March.  However, several important conclusions can be drawn from recent events:

  1. All US politicians do now understand that the fiscal cliff deadline would have sent the US economy into recession if no agreement had been forthcoming, and that a failure to extend the US debt ceiling would lead to a technical default on US Treasuries with very negative consequences for markets.  Neither side wish to be seen as responsible for either of these events therefore future agreements will likely be made in time.
  2. Markets believe that agreements will always be made in time and so much less inclined to panic ahead of the fiscal deadlines.  Without markets exhibiting any such fear, the politicians have less reason to give ground in the negotiations until the very last minute.
  3. Obama has continued the style of his first term of not being prepared to engage directly with the Republican leaders in negotiations, preferring instead to call them to the White House in order to lecture them, and then leaving negotiations to others in his cabinet.  This is not helping to build goodwill and gather support, making substantive future agreements more difficult to achieve.
  4. Neither Republicans nor Democrats are actually very concerned about the levels of public debt ($16tr, more than 100% of GDP) and the budget deficit ($1tr a year) per se.  The Republicans are essentially opposed to any tax increases, which would tend to harm their supporters, and the Democrats are essentially opposed to any spending cuts, which would tend to harm their supporters.  There is some scope for tit-for-tat concessions here, but getting beyond the minimum acceptable levels to avoid market crises will be very difficult.
  5. This lack of strong commitment to deficit reduction makes it likely that there will be no meaningful austerity in the US until there are difficulties in selling the Treasury Bonds necessary to finance the deficits.  Given the weakness of the European economy following its efforts at austerity, this should support the US economy in the short term.
  6. The policy of the Federal Reserve is currently one of Quantitative Easing of $1 trillion per annum until further notice.  The Fed is providing the markets with enough new money to finance the budget deficit.  Ultimately, such a policy will lead to inflation and a collapse of confidence in the dollar.

The investment implications of the above are that US financial markets continue to be supported, in the short term, by a lack of austerity and continued printing of money, but that in the longer term, these same policies will lead to inflation and a credit crisis. With this outlook, investors should broadly remain invested in company shares, wary of bonds with fixed coupons and insured with gold.

The time is ripe for politicians to act

Next month’s US Presidential election has been a very firm check on any significant economic policy action by politicians not just in America but also in Europe and China.  It has been left to those in charge of the Central Banks to make all the policy running this year.  In response to the weakening economic data and political stalemates over the last six months, both Bernanke and Draghi have taken it upon themselves to take significant policy action and encourage their politicians to do the right thing.

This year, being an election year, it proved impossible to get any bipartisan agreement in the US on anything to do with the budget deficit – the Republicans insisted on no tax rises of any kind, and the Democrats were not prepared to contemplate any spending cuts.  Instead, they created an outcome of Mutually Assured Destruction, in which in the absence of any other agreement before the end of this year, substantial tax increases and spending cuts will automatically take effect from the start of next year.  If fully enacted, these policies would undoubtedly push the US economy into recession in 2013. It is only after the election in early November that the politicians will begin to get to grips with this issue.  The world economy needs a compromise to be effected between the two parties, assuming, as currently appears likely, that one party does not hold all three of the Presidency, the Senate and the Congress.

Markets are currently expecting that such a compromise does in fact occur.  The best time for any politician to make a politically difficult decision is immediately after an election, when any future electoral consequences are as far away as they will ever be.  Mr Bernanke has indicated that he holds an insurance policy in the event of no agreement and he will become much more aggressive with his QE programme, further to concentrate the minds of the Republicans.

In the Eurozone, the politicians have clearly adopted stalling tactics with regard to making a decision on whether to give further help to Greece, and have delayed receiving the Troika report from an initial late August date until mid November, just after the US elections.  The much smaller Cyprus bailout has also been delayed to be sorted out at the same time as Greece.  The Spanish bailout has also been delayed, first by the Spanish Prime Minister, who has regional elections on October 21st and who does not want to be seen asking for money before then. Also by Germany and some EU officials who are concerned about the knock-on effects in markets of a Spanish bailout request, most particularly for Italy.  Dealing with all of these together in November appears to be the preferred strategy, and as in the US markets are expecting there will be a satisfactory resolution (at least for now).  The longer term issues of enforced austerity weakening growth prospects and the lack of competitiveness in the Southern European economies will no doubt create further crises in due course.

China too is going through leadership change, with the new Politbureau team being unveiled just two days after the US elections.  Here too there has been evidence of policy drift this year with the slowing Chinese economy met by silence from the politicians, though the Central Bank have been easing policy a little during the year.  It is not known what the economic priorities of the new leadership team will be, but markets would appreciate an idea of the direction of policies that will be followed.

The last two months of the year thus provide the opportunity for politicians around the world to resolve several uncertainties about economic policy that have been allowed to build up ahead of the electoral time frame.  Some clear leadership in the next few weeks should boost market confidence, but political indecisiveness would be very damaging to markets. The time is therefore ripe for politicians to act.