The US - always on the brink

Add that to sequester spending cuts, and the prospect of tightening monetary policy, and the US - even though its economy is seemingly recovering nicely at present - faces plenty of challenges in 2014.

Budget and debt

That a great nation appears ready to inflict economic wounds upon itself is baffling enough. Stranger still are the reasons - a desire by the few, apparently, to deny healthcare to the many. Here in the UK - where healthcare provision is generally universal, based on need and free at the point of use - President Barack Obama’s plan to extend decent healthcare to the millions of Americans who currently can't afford it appears uncontroversial.

Not so in America, though. Indeed, the entire budget stand-off reflected a determination by the right to derail the so called Obamacare legislation - that effort ultimately proved fruitless after Republicans in the Senate were forced to cave on the issue.

Since October's stand-off, progress has been made. A short-term deal crafted at that time got things moving again and paved the way for this month's bipartisan agreement on the budget - which funds the government for the next two years. That has delivered much needed certainty and has been well received on Wall Street. Jamie Dimon, chief executive of JP Morgan Chase, for instance, hailed the agreement as a "big deal" because it demonstrated that US lawmakers were no longer prepared to shoot themselves in the foot.

But Mr Dimon's relief could yet be premature. To begin with, the scope of the agreement is modest. It sets government spending in 2014 at just $45bn (£28bn) higher than would have been the case under planned automatic sequester budget cuts, while 2015’s spending limit is just $18bn higher. That does little to eat into total planned sequester spending cuts, enacted in March and designed to cut more than $1.2 trillion in spending over the next decade - so the deal carries virtually no fiscal stimulus. The deal leaves a lot of business undone, too. It fails, for example, to extend federal jobless benefits which expire for 1.3m long-term unemployed on 31 December. And, crucially, the deal doesn't raise the debt ceiling - leaving open the prospect for more political brinkmanship early next year as the US attempts to avoid a possible debt default.

Indeed, an extension to America's $16.7 trillion debt limit expires on 7 February and it's already being mooted that Republicans could be contemplating a new fight with President Obama over this issue. Republican members of Congress will meet in January to discuss what possible concessions could be sought from the White House in exchange for lifting the debt ceiling. That said, failing to agree by February doesn't automatically mean default. The US Treasury has powers to pursue "extraordinary measures" - essentially, accounting tactics - that could allow it to get through until April should a permanent deal on the debt ceiling fail to get done, while a report from the Congressional Budget Office suggests that tax receipts in mid-April could even see the US manage to cope until June.

Inevitably, the uncertainty hanging over the debt ceiling won't do the US economic recovery any favours. "A failure to promptly raise the debt ceiling could also adversely affect financial markets and economic activity, with spillovers to the rest of the world," noted the IMF in its October World Economic Outlook report. But with the proximity of mid-term congressional elections in November 2014, procrastinating for too long on this issue may not be so likely. In an election year, Republicans will probably want to avoid being blamed by the electorate for taking a stance that's perceived to damage the US economy.

But the US recovery does seem to be coming along nicely - despite the best (or worst) efforts of the country's political class. Assuming the debt stand-off issue is also resolved, the IMF estimates that the US economy will grow by 2.6 per cent during 2014 - compared with just 1 per cent for the eurozone and 1.9 per cent for the UK. "Recent indicators suggest that the underlying [US] recovery is gaining ground, supported by a rebound in the housing market and higher household net worth," points out the IMF.

What's more, the US unemployment rate has continued to fall - from its peak of 10 per cent in 2009 to 7.3 per cent now. And that's despite the budget sequestration measures - although those cuts are described by the IMF as "excessively rapid and ill designed" and "expected to subtract between 1.5 and 1.75 percentage points from growth in 2013".

Tapering fears

With sequester cuts curtailing growth and with debt ceiling uncertainty to plague progress, too, then a supportive monetary policy has been seen as essential. Yet it's here that the US faces possibly its greatest longer-term uncertainties.

The US Federal Reserve Bank is engaged in an $85bn-a-month asset purchase quantitative easing (QE) scheme - in order to provide an economic stimulus, the Fed is effectively doing the electronic equivalent of printing money, and on a vast scale. The problem is that, even though the economy is recovering, such progress still doesn't look sufficient to explain the pace of US equity market recovery during 2013.

Since the hefty outflows seen in 2011 and 2012, mutual fund specialist Lipper reckons a net $285bn has been invested in US equity mutual funds and exchange traded funds during 2013 - that's the best year since its records began in 1992. Moreover, during this year the S&P 500 has risen over 20 per cent to about the 1800 mark. The Dow Jones Industrial Average, meanwhile, has nearly reached 16000 mark - after having passed 15000 only in October - and is up roughly 20 per cent since the start of the year. And the Nasdaq Composite has surpassed the 4000 mark - a level not seen since the heady excesses of 2000's dot-com period.

The worry is that this impressive demand for equities is actually significantly driven by the low interest rates and easy money conditions created by the Fed - not by the modest economic recovery that’s underway. Yet the fact that the US economy is recovering at all has also led the Fed to signal (back in May, initially) that it could start to reduce - or 'taper' - its QE scheme. RBC Capital Markets strategist Michael Cloherty reckons that the Fed will begin to taper in April - although the next Federal Open Market Committee is this week as we go to press and it’s not impossible that the decision to taper could be taken then.

Even the expectation of tapering has had a significant impact. "By August, US 10-year yields had risen by more than 80 basis points, and many emerging markets experienced capital outflows, higher bond yields, and lower equity prices," points out the IMF. So once monetary policy actually begins to be tightened, there's a very real danger that investors could bolt - they could fear that an unsustainable bubble has been created that's out of line with economic fundamentals. It's not impossible, therefore, that 2014 could see a major US equity market correction. Of course, that's far from certain and it's not as if the Fed is going to abandon all stimulus efforts overnight.

Fed Chairman Ben Bernanke has been signalling that interest rates are likely to "remain near zero for a considerable time after asset purchases end". There's also the Fed's unemployment rate threshold to consider - currently that must fall to 6.5 per cent before a rate increase can be considered, but it's been mooted that the threshold could be lowered. So serious monetary policy tightening could yet be made conditional on a far stronger recovery than we're seeing in the US at the moment.

It's also anticipated that Janet Yellen - who looks set to take over as Fed chair after Mr Bernanke's term ends on 31 January - will be in no hurry to tighten monetary policy, either. Indeed, earlier this year she expressed the view that "it's appropriate for progress in the labor market to take center stage in the conduct of monetary policy" - hardly the sentiments of a monetary policy hawk. Moreover, after markets have already adjusted to expectations of tapering, the IMF thinks that actual tapering - once begun - "will further tighten conditions only modestly".

Neither does Wall Street sound overly worried. JPMorgan's chief US equity strategist, Adam Parker - formerly one of Wall Street’s biggest bears - now sounds decidedly bullish about 2014, for example. He reckons that the Fed will be able to adequately distinguish between tapering and tightening and that "the lack of a credible bear case in earnings could drive further [valuation] expansion". Mr Parker is even predicting that the S&P 500 will reach 2014 by end-2014 - a full 12 per cent higher than it is now.