FYI | Oct 16 2012
By Andrew Nelson
There has been increasing talk in the market and in our service about the US economy heading towards a "fiscal cliff", with the current presidential election seen by many as the lynch pin. Yet many still ask: what is this so-called fiscal cliff, why is it so important to global markets and what happens if the US, like Thelma and Louise, drives right over the edge?
First, let’s start off with a definition. The “fiscal cliff” is a term of phrase coined by US Federal Reserve Board Chairman Ben Bernanke and it refers to the prospect of automatic, year-end US Government spending cuts and tax increases.
The reason we fear the approach of the fiscal cliff is due to the current political situation in Washington. Democrat President Obama has proposed several budgets, but has been blocked at every turn by a Republican-dominated House of Representatives. Unlike Australia, where a government’s failure to pass a budget results in a speedy election, a blocked budget in the US means the US Government stops writing cheques until something has been passed.
It is hoped that the upcoming election in November will provide the US a chief executive and house majority of the same party. That way, Washington avoids at least another two years of political stalemate, with there being a good chance that some sort of budget will be approved. Put more implicitly, one party winning the presidency and lower house will remove uncertainty, and we all know markets hate uncertainty. Given the odds are on the Republicans keeping their majority in the lower house, US markets are firmly behind a Romney victory. There are also myriad political, economic and philosophical rationales for this preference as well, but we’ll not delve into them here.
A new paper from BlackRock Investment Institute, entitled US Election Cliffhangers, takes a look at some of the most likely scenarios for the November 6 US election, and the findings are quite sobering.
The first and main problem BlackRock sees is a “dangerous disconnect” between professional investors and Washington experts. The company recently sat down with a number of Washington insiders and the consensus is that political dysfunction will indeed push the nation off the cliff. However, it is believed the drop will be a short and sharp one, ultimately providing politicians the necessary impetus for compromise and a budget deal by the third quarter of 2013.
On the other hand, BlackRock notes most financial experts believe that an eleventh hour rescue will allow the US to avoid a recession. The problem is: with the S&P 500 near record highs already, it is thought that markets haven’t as yet begun to price in the fiscal cliff, assuming QE3 will somehow drown out other factors.
Such a disconnect between political and market pundits, especially when the US economic recovery is losing steam and undergoing an election that is becoming increasingly bitter and partisan, is quite a scary scenario, says BlackRock. To that end, the US investment house has plotted out three possible fiscal cliff scenarios: a sky dive, a bungee jump or a hard stop.
BlackRock’s sky dive scenario posits that a second term for President Barack Obama could result in a sky dive off the fiscal cliff, and if the chute doesn’t open, there’s a good chance of some real physical damage on landing. While it’s possible a deal on income tax could be struck in January, there would probably still be yet another ugly fight about raising the debt ceiling not too far down the track.
BlackRock suggests the markets wouldn’t like this outcome very much, as it would do little to address already high levels of anxiety and uncertainty that would likely spill over into 2013 if the two parties are unable to put their country first and refuse to compromise. Under this scenario, Fed policy would remain on centre court.
However, given the expectations for sound fiscal policy are sub-zero at the moment, there’s a good chance if a deal were struck that, the upside surprise could ignite a risk rally.
The bungee jump scenario predicts that a victory by contender Mitt Romney with Republicans maintaining control over congress would see a decelerating drop off the cliff, but one with a well-broadcast plan to get back up. Under this scenario, tax increases would be reversed retroactively and the debt ceiling would be raised ahead of a full budget deal.
This is what the market wants at the moment and BlackRock thinks such an eventuality would be greeted with euphoria, at least initially. However, given the people we’re dealing with here, there’s also a good chance of later disappointment if no real progress is made to address structural budget issues. BlackRock doesn’t address the likelihood of such a disappointment, but a quick trawl through historical US debt levels shows that the Democrats actually have a better track record in managing and reducing federal budget deficits in the modern era. One also has to ask the question: can one party really make the tough calls, which would include cutting benefits, without the political cover of compromise?
Lastly, we’ve got the hard stop, or a screeching halt just before the edge of the cliff. Under this scenario, lawmakers would compromise, agreeing on some spending cuts with plans to then hammer out some sort of budget deal in the North American summer of 2013. BlackRock thinks this is the outcome to fear most, as it could also bring with it market panic, public distrust and disgust with Washington’s inability to get anything done. In other words, a much longer run of uncertainty.
One thing that is certain; doing nothing is not an option. That is unless playing Russian roulette with a gun full of bullets is an option. The US is running a massive budget deficit which has created a mountain of debt that will likely hinder growth for decades. This needs to be turned around and BlackRock thinks there will need to be at least an outline of a comprehensive budget deal to turn things around.
No matter which scenario wins out, BlackRock notes, like it or not, the US government will have to increase revenues to make a dent in the deficit. That means changes to the tax code, which will simply never get done.
On the flip side of raising income is reducing spending, even on benefits. Right now, Social Security and healthcare spending currently soak up around two-thirds of US government revenues, claims BlackRock. This number will only grow in the years ahead given an aging population.
Simply put, BlackRock believes the US is well down the wrong fiscal path. While it is pretty easy to change course through a combination of tax give-backs and spending cuts from a mathematical perspective. It looks nigh on impossible from a political perspective unless American politicians rediscover the art of compromise. And it needs to happen now.
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