Time for Mitt to take the gloves off

The US Presidential election is between two candidates, one of whom believes that it is not worth worrying about the 47% of voters who do not earn enough to pay income tax, and the other who tells small businessmen that it was the government that enabled their business to be successful. Such a clear ideological difference should mean that the result matters greatly to Wall Street and financial markets.

Yet, 2012 has seen little impact on markets from US politics – the headlines this year have been about the Eurozone debt crisis, the Federal Reserve’s policy and the Chinese economy. The election should be close given the poor performance of the US economy (though not its stock market) under Obama, but the lack of strong Republican candidates has left them with the rather uncharismatic Romney as their best choice. His gaffes in recent weeks leave him currently trailing Obama in most of the key swing states as the contest enters the final straight.

There are three election debates to come, which could turn things around, but it seems unlikely that the experienced and eloquent Obama would lose out so badly to the more formal Romney in head-to-head debate.  A Romney win from here would be a big surprise but would in all likelihood also come with Republican majorities in both Congress and the Senate This is typically a combination that Wall Street would cheer. However an Obama win would be combined with a continued Republican majority in Congress and the only question for markets would be what happens to the Senate. Currently the Democrats have a 51-47 majority with 2 Independents – with 33 Senate seats being contested in November. Of those 7 (6 of which are currently held by Democrats) are believed to be races that are too close to call.

This all matters because of the “fiscal cliff”. This is (i) a number of previously agreed tax cut measures which expire on December 31, and (ii) the penalty clause US politicians set for themselves if they were unable to agree on long term measures to reduce the budget deficit, which make roughly equal cuts in defence and welfare spending. The idea of the penalty clause was that each side would be forced to make compromises on a longer term deal in an attempt to avoid large cuts in the area that most concerned them (defence for the Republicans and welfare for the Democrats) – sadly it didn’t work. The combination of all these measures would be to tighten fiscal policy by about 4% of GDP in 2013 and would send the US economy into recession.

No one seriously believes that such a massive tightening of policy would be allowed to happen, but to avoid it , the “lame-duck” sessions that occur from the election until Christmas with the old membership of both Congress and Senate, will have to agree to some compromises. It is perhaps understandable that, before the elections, neither side were prepared to make any compromises, but the hostility shown by many in the Republican Party towards Obama since he became President has taken the working relationship in Washington between the two parties to a very low ebb. It is not clear that this would change if Obama were to be re-elected and still faced a hostile Republican party in the two Houses. It is possible that an angry and upset Republican Party would not make any compromises and let the US economy fall into recession.

Markets are currently pricing in an Obama victory, and then some sort of compromise over the fiscal cliff that doesn’t drive the US economy into recession. A Republican victory would lead to a rally on Wall Street, but a bad-tempered defeat for them where emotions ran high would be a very negative development for America and the world.

Bernanke sets the printing presses to “GO” and walks away

The recent decision of the Federal Reserve to go ahead with a policy of QE3 by which they buy $40bn of mortgage and agency securities every month until further notice was dramatic and shocking in many regards:

  • Timing – Historically the Fed has sought to avoid making major policy moves in their last meeting before an election for fear of being seen to be acting politically. In 2008, there was a global crisis which required action – this is not the case in 2012.
  • Politics – Romney and many in the Republican Party have already made clear their opposition to Bernanke personally and to the policies of Quantitative Easing already adopted. Were Romney to be elected, he might choose to ignore the fact that Bernanke has been appointed until 2014 and seek to get him replaced. The Fed’s action can be interpreted as a major political snub at a critical juncture.
  • Economic justification – Both QE1 and QE2 were introduced at a time of clear weakness in the US  economy and significant financial market concerns about the possibility of deflation. So far this year, the US economy has been growing at about a 2% rate, unemployment has been declining gently and inflation expectations have been rising.
  • Size – At $40bn per month, the policy amounts to an annualised rate of QE of  half a trillion dollars. However, the reinvestment of principals and coupons and the continued working of Operation Twist (which followed QE2) mean that for the rest of this year the Federal Reserve will in fact be purchasing securities at an annualised rate of over a trillion dollars. These are astonishing amounts of money.
  • Transmission mechanism – In the press conference following the decision, Bernanke was asked about how he expected this policy to have real world effects. He repeated his  belief that by raising equity prices, companies would find it cheaper to invest. In addition, he said that because this time the Fed was buying mortgage securities, this would reduce mortgage costs in the economy, thus boosting house prices, so helping consumers to feel wealthier, which would encourage them to spend more. This trickle-down effect of previous QE policies from injecting money into financial markets moving into the real economy is widely believed not to have worked. It appears to benefit those in financial institutions whilst having little real economic impact.
  • Duration – By making QE3 open-ended and further insisting that the Federal Reserve would not begin to tighten policy until recovery was very firmly established, even at the risk of some higher inflation in the short term, Bernanke has made it very clear that continuous easing is now the default policy setting, probably for several years. Previous QE announcements were for set amounts of money over set periods of time – this is very different – money will continue to be printed until the economy recovers.

So the unlimited money printing of the Federal Reserve now sits alongside the unlimited buying of peripheral bonds by the ECB announced the week before  and the unlimited selling of its currency by the Swiss National Bank that has been in operation for a year. Central Banks – so long famed for their moderation and control in all things relating to money have set the printing presses to “GO” and walked away.

One conclusion that could be taken from this is that the Central Banks, who we hope are a little better informed about these things than the rest of us, are terrified, and that the state of the global economy and financial system is in fact far worse than anyone is prepared to admit.

The clearest market implications of this shocking move are to expect a weaker dollar (with so many more dollars now being printed) and a higher gold price. QE1 and QE2 were positive for equity prices, but the biggest beneficiaries were precious metals (gold and silver), oil and agricultural commodities. It is by no means clear that QE3 will do anything to boost real growth in the economy, and so the boost to equities may be more short-lived and less significant than previous rounds. Most interesting has been the recent moves in government bond markets where yields have risen as long-term expected inflation worries have begun to return.

Coming soon – a real electoral debate about the US fiscal deficit and a weak 2013

Recent general election campaigns in fiscally-challenged countries such as the UK, Spain and France have been noticeable for their politicians’ reluctance to spell out specific measures that they would introduce to bring down the enormous fiscal deficits in these countries. The electoral success of the right-of-centre parties in the UK and Spain was however immediately followed by significant programmes of cutbacks to government spending as well as some tax increases.

It is now clear that the US Presidential election will be between Obama and Romney (who would have believed five years ago that a US election would be between an African-American and a Mormon). With Obama having presided over trillion dollar deficits throughout his term in office, how best to manage these deficits and the ensuing government debt will be the key battleground of the election campaign. The two candidates will argue from the two opposing economic and political traditions. Obama, the Keynesian, a believer in public spending acting as a stimulus to the economy to offset private sector deleveraging against Romney, the orthodox conservative, a believer in small government and balanced budgets. Obama wants to tax the richest 1% more and maintain government benefits to the poorest in society whilst Romney wishes to cut taxes, particularly for the wealth-creators, and cut all areas of government spending except for defence (in practice this means welfare  and health spending). It is only in America that Obama’s tax plans for the top 1% would be called “class warfare” and many would agree with that assessment.

Both men are highly intelligent, clear thinkers, who can produce very articulate presentations of their respective cases and let the American people then make an informed decision as to in which direction they want their country to go for the next four years. It could be democracy’s finest hour (or three months) although the history of recent elections tends to suggest that other rather more superficial issues will also get much attention.

The end of this year though is critical for US public finances, as both sides have put off all the difficult decisions regarding the budget until after the November election. If nothing changes between now and next January 1st then 2013 will see the expiry of the Bush tax cuts, which heavily benefit those whose income is high and generated from corporate dividends, and the Obama payroll tax cuts which benefit those in work. In addition, spending cuts affecting both defence and welfare in roughly equal measure are due to come into effect. If all these measures are allowed to come into being at one time the aggregate effect is likely to be to drive the US economy straight into recession. However no one expects all these measures actually to occur though – if Obama wins he will seek to reduce the welfare cuts and extend the payroll tax cuts and if Romney wins her will seek to reduce the defence cuts and extend the Bush tax cuts.

Financial markets do not appear to have these measures in focus just yet, or be paying attention to the fact that whoever wins there will be significant fiscal consolidation in 2013. They should be because Europe’s recent history demonstrates clearly that this consolidation, also known as austerity, necessarily involves reducing people’s disposable incomes, either because taxes are rising or because government spending is falling, and that this has to have an initial, deflationary effect on private sector demand. 2013 is very likely to be a pretty bad year for the US (and thus probably also for the world) economy. Markets tend to look 6 to 9 months ahead, so the next few weeks should see them begin to discount this weakness – this should be good for government bonds but less good for equities.