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The US must get its house in order

Political stalemate in Washington has already had a profound effect on economic behaviour, and the path to growth is littered with banana skins.
December 21, 2012

Like a juggernaut dangerously out of control, the American economy is heading for the fiscal cliff at blistering speed. Bickering politicians still fighting over the wheel risk sending us all over the edge, and none of the Federal Reserve's fiscal tools can save us.

Bush-era tax breaks end this month and automatic spending cuts worth $1.2 trillion (£749bn) over the next 10 years begin on 1 January. Estimates vary, but analysts at Deutsche Bank put the damage at around $650bn, or more than 4 per cent of GDP. A shock of that size risks plunging America into recession and everyone else with it.

If it happened, next year would be horrendous. A full cliff dive would likely cause the fragile US economy to shrink by around 2 per cent in 2013 and push the unemployment rate into double digits. And credit rating downgrades have already been threatened if Congress fails to do a deal. Last time that happened - in August 2011 - the S&P 500 slumped 20 per cent.

"How the cliff challenge is handled means the difference between, at one extreme, pushing the economy into a severe recession, and at the other inducing a robust recovery," warns Deutsche Bank. Getting the right outcome depends on a so-called 'grand bargain', where both Democrats and Republicans agree on a sensible package of spending cuts and tax reform.

A first drop in business investment since the start of 2011 clearly reflects fiscal fears. It could be months before a significant uptick and growth will suffer in the meantime. "Unless there is a sizeable improvement, the trend growth rate of the US is likely to be below most expectations," warns financial consultancy Smithers & Co.

There's horse trading behind the scenes and some progress is being made, but President Obama's idea of taxing the rich is not popular with Republicans and negotiations will go down to the wire. But there's another problem. The US will hit its credit limit - the debt ceiling - within days. Obama wants a deal on this, too, which, curiously, is how this all began.

 

 

Presidential cycle

In the summer of 2011, with America having exhausted its borrowing authority, the president signed the Budget Control Act into law. It raised the national debt limit to $16.4bn, but came with the caveat that Congress must cut the budget by $1.2 trillion. If it failed, automatic spending cuts - half from defence and half from elsewhere - would kick in, so-called sequestration.

Legal and financial tools can buy time and help the Treasury avoid running out of cash, perhaps until "early in 2013", it says. But that only delays the inevitable, so, if a deal isn't done soon, expect more fireworks on Capitol Hill within days of Mr Obama being sworn in. And his inauguration on 21 January could have serious consequences for share prices, too.

"Presidential elections every four years have a profound impact on the economy and the stock market," writes Yale Hirsch in his Stock Trader's Almanac. "Wars, recessions and bear markets tend to start or occur in the first half of the term and bull markets, in the latter half."

 

 

Analysts at JPMorgan have run the numbers too and concur that, since 1928, equity markets have done "relatively poorly" at the beginning of a term and far better at the end.

According to their research, the median performance for the S&P 500 was a 3 per cent gain in a post-election year and just 1 per cent in year two. However, it jumped to 17 per cent in year three and 9 per cent at the end of the term. Despite the omens, JPMorgan thinks equities will still end the year higher but, given the recent re-rating, it reckons there will be a "better entry point" in the first half of next year. We think the company's right.

By then, the US could be staring up from the bottom of a cliff. If not, it will probably have agreed a mix of spending cuts and revenue increases, mostly via limits on tax deductions. That would certainly please financial markets. After outperforming Europe by 7 per cent during the first half of 2012, the S&P 500 is now no healthier than sickly continental bourses. A resolution would cure that.

"Avoiding the cliff and making rapid progress toward a grand bargain to resolve the unsustainable US fiscal position beyond would mean a surge in the stock market and private spending, moving growth above 3 per cent even with some fiscal drag," predicts Deutsche Bank. That's a long shot, for sure, but even an agreement on a framework for debt reduction with a promise of resolution would boost equities by as much as 10 per cent, the broker says.

Wall Street is agreed that getting back on a secure footing would put the US economy on track for growth of about 2 per cent in 2013. True, that’s not blowing the lights out, but it's better than Europe, and the other advanced economies which the International Monetary Fund (IMF) expects to grow by just 1.5 per cent next year.

 

 

Central banks are stimulating

With Mr Obama busy fighting Republicans in Washington, Federal Reserve chairman Ben Bernanke's ultra-loose monetary policy provides the life support still needed to keep the American economy alive. The Fed is buying up $40bn of mortgage-backed securities a month under QE3 and an extra $45bn of longer-term treasuries, too - QE4 if you like - now that Operation Twist is over, which should keep stock markets ticking over.

Chicago Fed president Charles Evans reckons QE will have to run through 2013 to have any significant impact on the job market. There's already a commitment to a zero-rate policy until the middle of 2015 and unemployment must fall below 6.5 per cent before there's a change of minds - it's currently nearer 8 per cent. Economists go further, predicting the latest round of QE will run deep into 2014 and top $1 trillion.

Realistically, though, hard-won gains on global stock markets are unlikely to survive the early part of 2013. Fourth-quarter earnings season could serve up a few shocks as the true scale of Hurricane Sandy and the corporate spending hiatus emerge. Profit margins, already cyclically high, appear vulnerable and companies will have to cope with a less generous dollop of federal spending, too.

 

 

Indeed, S&P 500 earnings growth slowed from 15 per cent in 2011 and 9 per cent at the beginning of this year to just 2 per cent during the third quarter. Of course, any shock could tip the profits cycle into recession, but investors willing to ride out the inevitable volatility and earmark cash for US equities may reap rewards.

"If we don't go off a cliff and get a political deal with clarity, we see a 'goldilocks' scenario with a minimum of 5 per cent earnings growth in 2013," predicts Joanna Shatney, head of large-cap equities at Schroders in New York. "We're not uber bullish, but where else are you going to put your money?" She has a point.

Much of the growth is tipped to come through in the second half when comparisons get easier, but getting a decent return on bonds is difficult now and the S&P 500 is trading on less than 13 times forward earnings. That’s toward the bottom end of its 20-year range and well below the average. Housing, usually a good barometer of the economy, offers hope, too.

A home for your money

According to the Case Shiller Index, US house prices have been steadily rising since April and confidence among housebuilders is at a six-year high. Housing starts in October ran at their highest rate since the summer of 2008 and economists at Goldman Sachs expect 20 per cent growth in 2013. But opinion is divided.

 

 

US housing stocks are expensive, according to Nomura, but European plays such as Electrolux, Phillips and CRH have yet to reflect the upturn. Ms Shatney disagrees. "Homebuilders have doubled, but we're not worried about near-term valuations. This is a five-year up-cycle," she says. Either way, it probably pays to look further afield and Goldman Sachs has some interesting ideas.

After making $4bn selling subprime mortgage contracts during the financial crisis, the 'Vampire Squid' now thinks predictions of mass mortgage default are overdone, so buy ABX index contracts. "They are clearly sensitive to further home price strength and may also provide a 'call option' on shifts in housing policy to help underwater borrowers," it says. Any increase in refinancing volumes will help the domestic banks like Wells Fargo, too. Who'd bet against them?

Real estate makes up a quarter of US household assets and almost half of all bank loans and leases are taken out to buy property.

And be in no doubt what impact a recovery in property prices will have on the American consumer. Their spending accounts for about 70 per cent of economic activity in the US, and keeps the world's largest economy breathing.

That confidence looks fragile right now - and indeed one fund manager we spoke to suggested that the housing market recovery was being driven by commercial 'vulture' buyers rather than private purchasers.

But if Washington can cure its political paralysis, confidence will improve and companies will start investing again, too. That two-pronged attack will inject a bit of urgency back into the economy and modest returns into investors' pockets.