Finance Focus

Keith Wade Chief Economist

Schroders

James Bilson Economist

Schroders

US teetering on the FISCAL CLIFF USA

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”.

T

he 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 lapsing of the Bush tax cuts, worth around $220bn. Failure to find a resolution, leading to hitting the full cliff, would almost certainly be enough to drive the US economy back into recession.

The results of the election maintained the status quo, with President Obama retaining the White House, Democrats holding the Senate and the Republicans the House of Representatives. The key swing states, such as Ohio, Nevada, Colorado, Iowa, Wisconsin, Virginia and likely (at time of writing) Florida were all carried by Obama; generally

more comfortably than opinion polls had predicted. Unlike the 2010 mid-term elections, where Democrats lost the House and the “tea party” movement became an influential wing of the Republican movement, the 2012 elections do not appear to have favoured the more conservative branch of the Republican Party. Instead, the results of November 6th suggest a rejection of the more extreme elements of the political right and a mandate for moderate positions and sensible discussion by policymakers on both sides.

Congress now reconvenes on 13th November to attempt to thrash out a deal on the fiscal cliff, just six weeks before it 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. Though the current congress is one of the least productive in history, due to the ideological chasm separating the two parties, with electioneering out of the way we expect progress to be made to avert hitting the entire cliff.

Neither party has a clear mandate to avoid compromise and fail to find a resolution before January 1st, and importantly neither do they have much incentive. Not only would the economy likely be plunged back into recession, reflecting ill on both sides, but the

scale of automatic consolidation would be anathema to both parties, with respect to defence spending and tax increases for Republicans and entitlement spending for Democrats. We thus believe a compromise can be found which is more favourable for both parties than the alternative of hitting the cliff.

Although we expect common sense to prevail and a resolution to be found, uncertainty surrounding the size, and composition, of US fiscal consolidation could dampen investor appetite for risk assets, particularly equities, and create volatility as we head towards the end of 2012. With little indication so far of how any resolution would look, 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. Though we don’t expect it, 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.