SEB Report: Thoughts On The Fiscal Clilff and The US Elections

Thoughts on the fiscal cliff and US elections
SINCE LAST SUMMER, FISCAL CLIFF ARTICLE NUMBERS HAVE SKYROCKETED. The so-called US fiscal cliff has several dimensions; it is now the biggest concern of investors, even ahead of the European debt situation, exposing the fact that the current Congress is the most polarised in history. How the situation plays out will largely depend on the result of upcoming US elections. While most macroeconomic forecasts operate on the assumption that US legislators can and will continue to kick the can down the road, it stands to reason that if they do not get their fiscal act together soon it will have implications for the countrys debt rating as Moodys recent credit warning attests. However, at the same time, the US is vulnerable to sudden changes in macroeconomic conditions such that excessive nearterm savings i.e. jumping off the cliff will certainly drive its economy back into recession. Put simply, the combination of expenditure cuts and tax hikes proposed totalling USD 600bn in 2013 alone, or 4 per cent of GDP, is more than the US economy can withstand. Indeed, uncertainty regarding the future direction of its fiscal policy has already contributed to the postponement of investment and hiring decisions while business confidence among US chief executives has fallen to its lowest level since 2009 according to Business Roundtable. PARTLY AS AN ANTIDOTE TO THE FISCAL UNCERTAINTY THE FED HAS EASED monetary policy further. However, despite short-term market euphoria, it remains unclear what exactly QE3 will do to support the economy and whether it will be effective. According to Ben Bernanke, the first quantitative easing program was credited with lowering 10-year Treasury yields by between 40 and 110 basis points. The second program may have reduced yields by an additional 15 to 45 basis points. Evidently, the law of diminishing returns applies to these quantitative easing programs. Aggressive stimulus from Washington notwithstanding the economy remains
TUESDAY 2 OCTOBER 2012
vulnerable. The key takeaway is that escape velocity is very hard to achieve when it is deleveraging. Congress finally passed the current debt ceiling bill in August 2011. The political turmoil preceding the decision caused S&P to downgrade its US credit rating. While other major rating agencies have so far kept their fingers off the trigger, the continued absence of a credible plan to tackle the deficit in the longer term may cause Moodys and Fitch to downgrade this time around instead. Just a few weeks ago, Moodys fired a warning shot across the bows of US legislators declaring that their response to the fiscal cliff will determine whether US debt will continue to enjoy its current triple-A rating. Of course, it is possible markets may continue to take a more relaxed view on downgrading US debt. At a time when the quality of most government balance sheets worldwide is deteriorating, the negative effects of another downgrade may not be too severe or to put it differently, double-A may come to be regarded as the new triple-A. Nevertheless, while the economic and market effects of another credit downgrade are debateable, only the most ardent optimist would claim that the economy can handle the tax rises and government spending cuts scheduled to take effect in 2013. Our baseline scenario calls for a compromise involving a total fiscal headwind of around 1.5 per cent of GDP in 2013. The outcome of the elections in November, and in particular the race for president, will ultimately decide whether it will be the Republicans or Democrats who will have to make the biggest sacrifices. PRESIDENT OBAMA IS THE OVERWHELMING FAVOURITE TO WIN THE ELECTION. At the time of writing Intrade puts President Obamas latest re-election odds at 76 per cent. If he is re-elected he will have a mandate to impose tax increases on the wealthiest Americans, more so if he wins a landslide victory. Polls are also suggesting the Congressional balance of power will remain largely unchanged with Republicans controlling the House and Democrats the Senate. If the government remains divided after the election both the Republicans and Democrats will need to compromise and make sacrifices with
This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document Changes may be made to opinions or information contained herein without notice. Any US person wishing to obtain further information about this report should contact the New York branch of the Bank which has distributed this report in the US. Skandinaviska Enskilda Banken AB (publ) is a member of London Stock Exchange. It is regulated by the Securities and Futures Authority for the conduct of investment business in the UK.
Economic Insights
disagreements over tax increases vs. spending cuts as entrenched as ever. The most contentious issues are tax cuts for the wealthiest and reductions in defence spending that are tied to the sequester. On the one hand, if the balance of power remains unchanged in Congress, House Republicans may continue to fight for tax cuts for the wealthiest. However, on the other, they also care about defence spending and may trade fewer such cuts in return for conceding upper income tax hikes favoured by Democrats. If Obama wins the presidency but the Congressional balance of power remains unchanged we regard an agreement before the year-end as 60 per cent likely, increasing to 80 per cent by the end of the first quarter of next year. Alternatively, if Obama wins the presidential election but Republicans take control of both chambers, these percentages fall to 35 per cent and 65 per cent, respectively. CONVERSELY, IF MITT ROMNEY WINS... If the Republicans win the presidential election, the party will be well placed to demand that most of the Bush administrations tax cuts be extended, at least on a temporary basis, especially since customarily Congress raises no budgetary objections during the earliest stages of a new presidency pending the announcement of the incumbents first budget. Moreover, if Romney wins the election it would seem reasonable to expect that Obama will seek to avoid making a huge tax hike his final legacy. JUST TO SUM IT ALL UP our main scenario is that Obama will win the presidency, and the Congressional balance of power will remain unchanged. The discussion above suggests there will be a compromise at the eleventh hour. Congress has now adjourned and will not be back in Washington until after the election. The problem however is that time is short between the election and the end of the year, creating the possibility of a temporary falling off the cliff, especially if the Republicans win both Congressional chambers. Depending on how long the temporary falling off lasts the economy risks being caught in the middle.
MATTIAS BRUR, SEB Economic Research

mattias.bruer@seb.se

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Thoughts on the fiscal cliff and US elections

TUESDAY 2 OCTOBER 2012

MATTIAS BRUR, SEB Economic Research

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