An incomplete solution to the US fiscal cliff
The past few days has seen the Republican-controlled House of Representatives clash with the US Senate in a show of political theatre over the aptly named US ‘fiscal cliff’. However, those who hoped that the American Taxpayer Relief Act would emerge as a robust bi-partisan agreement (sometimes referred to as the ‘Grand Bargain’) to deal with the key structural issues facing the world’s biggest economy have been disappointed.
Our initial conclusion is that the outcome is something of a fudge and far from a complete solution. After a year of delay leading up the US presidential election, we were hopeful that a more comprehensive solution would have been hammered out. On the positive side, what we did see was an avoidance of the worst-case scenario (nothing being accomplished at all) and a grudgingly made small step – an agreement to increase the income tax rate for individuals earning over $400,000 while limiting the impact on middle-class taxpayers.
But, while the resolution averted a raft of automatic spending cuts and significant tax hikes (apart from the expiration of the payroll tax reduction affecting all wage-earners), Congress has once again ducked the difficult decisions regarding the critically important issues of spending cuts, the US debt ceiling and entitlement reform. Essentially, no progress was made on any of those fronts. However, the reckoning will begin anew in less than two months, when the automatic spending cuts for defence and health care, originally scheduled to take effect on January 1, will come into force. Soon after that, the debt ceiling will have to be addressed. As such, the policy backdrop appears destined to be highly-fluid in nature and quite challenging for the markets for at least the next several months.
In our opinion, the initial global stock market bounce we saw in the final days of 2012 and first day of trading in 2013, with the S&P 500 making some of its biggest gains since December 2011, had little to do with stock fundamentals. Rather, it had the hallmarks of a relief rally following the avoidance of a potentially significant crisis that had the potential to shave several points off US Gross Domestic Product and undermine the economic recovery.
Yet again, the US has kicked the can down the road. But it is not much of a road at that, with sequestered defence and health care spending cuts looming in less than 60 days. Negotiations over the debt ceiling and entitlement reform must come to some sort of conclusion by March 28, a process that will almost certainly be highly contentious, given the polarisation in Washington. There is a very real possibility of another US debt downgrade if a compromise cannot be reached.
In terms of economic fundamentals, the picture is considerably brighter. We believe that various important US yardsticks, including employment, housing, vehicle sales and bank lending, are improving. We see a great deal of pent-up demand, particularly with regard to household formation and corporate capital expenditures, which could be unleashed if a sensible solution to the fiscal cliff can be achieved and both consumers and businesses gain confidence in the economy. A healthier housing market creates a ripple effect of positives for employment (it generally takes 4-6 people, with varying skills, to build a house). It also has a salutary effect on consumer confidence, because for the vast majority of people, their home is the most important asset on their balance sheets. Rising home values should buoy consumer confidence, manifesting itself in the form of increased discretionary spending. Furthermore, the equity valuation backdrop remains very compelling, on both an absolute and relative basis. In fact, it is difficult to identify another period in modern history in which stocks have been so attractively priced compared to bonds and other major asset classes.