Alongside the Eurozone sovereign debt crisis and a potential Chinese hard landing, the big issue currently on investors' lips surrounds the scale, and impact, of the US "fiscal cliff".
With the first of the presidential debates now underway, Keith Wade, Chief Economist at Schroders gives his view on the potential for political chicanery, and implications for financial markets, in the last few months before the US reaches its fiscal cliff.
"The US will reach its fiscal cliff on January 1st, 2013 - this is the point when fiscal tightening comes into force as a result of the expiration of several pieces of existing legislation. For example, the Bush tax cuts and automatic spending cuts ("sequestrations") which were imposed previously as a result of the failure of last year's super-committee to reach a satisfactory conclusion on the US's deficit reduction.
"Unless changes to current law are enacted, fiscal tightening worth around $610bn (4% of nominal GDP) will occur in early January. Of this, around $150bn will come from spending, including both defence and entitlement, with the remainder coming from revenue. Within this, the single most significant aspect of tightening will come from the elapsing of the Bush tax cuts, worth around $220bn. We expect the US to reach a compromise before January 1st involving a fiscal consolidation, worth around 1-1.5% of GDP, which would dampen growth but is unlikely to be sufficient to push the economy back into recession.
"While the fiscal cliff has been much discussed, we believe that the markets may currently be a little sanguine about the impact of the consolidation, leaving scope for volatility as political uncertainty increases. Avoiding the full fiscal cliff of 4%, which would almost certainly be enough to drive the US economy back into recession, will require both compromise and haste from politicians. With no discussions occurring pre-election (November 6th), the re-convening of the "lame-duck" congress on 13th November will be the first opportunity to thrash out a deal, just six weeks before the cliff is due to hit. The situation is further complicated by the disruption caused by the holiday season, with both Thanksgiving (22nd November) and Christmas falling in this window. Finally, with the current congress one of the least productive in history due to the ideological chasm separating the two parties, the omens for compromise and bipartisanship are poor.
"The likeliest outcome to date is that President Obama will retain the White House, the Democrats will maintain a slender Senate majority (but not near the 60 seats needed for a supermajority) and the House of Representatives will stay Republican. We believe a Republican sweep of White House, Senate and House would increase the chances of hitting the full cliff. With control of the legislative and executive branches in January, the incentive for Republicans to negotiate during the "lame-duck" congress may be reduced, allowing them to pursue their own agenda in the New Year, causing no resolution before the full cliff hits. Although we would likely see some of the cliff repealed early in the new administration (particularly tax increases and defence cuts), and retroactive repayments of increased taxes, this scenario would have a negative impact on activity and confidence.
Conclusion
"We expect that the uncertainty surrounding the size, and composition, of US fiscal consolidation could dampen the appetite for risk assets, particularly equities, as we head towards the end of 2012. With little sign of a resolution, it would come as quite a surprise if businesses were not delaying investment and hiring decisions, and households their discretionary spending decisions, until the resultant impact on tax codes and order books are known. Furthermore, any changes to the relative balance of income and capital gains taxes could have profound implications for portfolio construction and investment philosophies. Finally, if we see political chicanery reminiscent of the August 2011 debt-ceiling debacle, both ratings agencies and investors will question the ability of US politicians to make difficult choices, with negative implications for both the equity and bond markets."
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