Carl Stick, manager of the Rathbone Income fund, considers whether the fiscal cliff will derail the weak US economic recovery.
Fiscal imbalances in the US remain a huge worry. Arguably, markets are putting their heads in the sand, as equities recover versus more expensive asset classes. We, however, are more circumspect.
Data this year has not been too bad, but the fiscal cliff looks like the tip of a bigger problem. The US still has major long-term debt issues and, in the short term, it is not generating enough tax revenue. Without the political will to cut taxes or welfare, how will it finance its expenditure?
At every level, it could be political suicide to make any difficult decisions between now and the end of the year – President Obama is in a bind. The sclerosis in the political process will continue to be extraordinary, and to the detriment of the national balance sheet. The biggest anxiety is if creditors to the US take fright, borrowing costs will increase, and the debt spiral will resume. This will have a significant negative impact on global sentiment.
Will US fall off the fiscal cliff?
Beyond this, the US Fed has been compelled to implement quantitative easing (QE), but we are uncertain as to the economic impact. Another bout of QE is all very well, but without a fiscal solution, it is redundant. Markets may move higher, but Fed chairman Ben Bernanke is just pushing on a piece of string if Congress fails to resolve the problem, and that will impact on valuations.
The fiscal cliff
There is only so much macro analysis that can be done. It is not the opinion that is dangerous, rather the weight one puts on that opinion when making investment decisions. A risk-based approach does not, however, necessitate outstanding perceptiveness; it requires us to comprehend which risks worry us the most, and whether market prices most accurately reflect this anxiety.
To this end, the US fiscal cliff is the danger foremost in our minds. Estimates vary, but it may represent a $600bn hit to the US economy, as individual and corporate tax breaks come to the end of their life. This eventuality coincides with the imposition of taxes related to President Obama’s healthcare law, and the spending cuts agreed as part of the fiscal deal signed in 2011.
The prospects of remedial action look dim as the ‘must not cut spending' Democrats diverge ever-further from the ‘never raise taxes' Republicans. It is this political deadlock that has the potential to strangle the weak US recovery. This immovability will then manifest itself catastrophically in the process of ‘sequestration' - a US legal procedure whereby automatic spending cuts are triggered - as spending cuts are felt across all government departments.
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