US Equities: Storm clouds gather over US economy
Shaniel Ramjee worries that markets are misreading the seriousness of the US fiscal position - a situation complicated by a looming budget cut of $1.2bn
Sentiment towards the US equity market has improved considerably in recent months. Given the extent of the change to consensus, we believe it's prudent to examine the risk to these views.
Most market participants describe the outlook for the US economy as moderate, sub-trend or just plain positive. We would agree, and when other major economies are shrouded in questions about growth there is some comfort in that description.
The US banking system is gradually repairing itself. Credit creation, while slow, is not contracting. Employment is slowly increasing. And the consumer has not entirely disappeared.
We have, however, identified a major headwind for the US economy: the potential for fiscal contraction. The combination of a US presidential election and a ‘lame duck' Congress session until late January does not make for an easy policy-making environment, in our view. Mix in early signs of deterioration in US tax receipts, and we believe there are risks to the consensus that are not yet fully recognised in the market.
Let's start by looking at the dynamics of what will occur later this year if Congress doesn't intervene. The Payroll Tax Cut and Unemployment Insurance are set to expire at the end of the year and represent approximately 1% of US GDP in aggregate. We expect these programmes to be extended in the short term, particularly as we head towards the start of an election campaign. The more contentious Bush administration tax cuts will expire on 31 December and represent approximately 1.6% of GDP.
Here, we expect some conflict: the Democrats favour extending the cuts to lower income recipients, while Republicans would prefer the cuts be extended to all.
We see a possibility that agreement can be reached to mitigate some of the negative tax drag, but the fissure between the parties on the issue of tax and fiscal policy makes it unlikely they will agree on anything significant.
The biggest headwind for the US economy, however, is likely to be the automatic federal budget reductions of around $1.2bn that will come into force on 1 January, 2013.
Budget Control Act
These reductions are the product of the Budget Control Act 2011, passed as the administration's spending plans repeatedly came up against the US debt ceiling.
Under the terms of the Act, the United States Congress Joint Select Committee on Deficit Reduction was tasked with proposing deficit reductions of approximately $1.5 trillion to be voted on by 23 December, 2011. The group failed to meet their objective.
Given last year's backlash against raising the debt ceiling limit, the subsequent inability of the politicians to come to an agreement, and the extent to which we believe the US fiscal position will be a hotly debated election issue, we find it hard to see House and Senate members will take time from the campaign trail to agree on a series of cuts that 12 people weren't able to accomplish without the pressure of an imminent election.
We currently expect the US economy to grow by approximately 2.5% in real terms in 2013. If fiscal tightening materialises as expected, and we conservatively quantify it at, say, 1.5-2.0% of GDP, the projected growth rate of the US economy may not be sufficient to meet consensus expectations for corporate earnings growth.
Falling tax receipts
The US Federal Government derives approximately 41% of its revenue from individual income tax. Focusing on the year-on-year change in the six-month moving average, a strong upswing in tax receipts since 2009 is discernible, yet individual income tax growth has decelerated over the past few months.
While it is possible for the individual tax take to rise if the payroll and Bush tax cuts expire, the deficit reduction mechanisms are likely to reduce outlays to the economy and, hence, have a negative impact on income growth.
Investors focused on the debt debacle in Europe may have been tempted to view the US through rose-tinted glasses. We believe there is a risk of complacency.
The US has not begun to address its debt issues meaningfully. Given the potential for continued gridlock in policy formation, the timing and effect of automatic fiscal tightening measures on the pace of economic recovery in the US may not be ideal.
If these risks become more likely and investors' expectations about US growth deteriorate, or we see economic actors begin to rein back their activity, asset markets are likely to experience volatility as expectations adjust downwards.
Curiously, this may provide the opportunity for those in favour of further easing further at the Federal Reserve to do so, in anticipation of fiscal contraction. However, we may need to live through the fear of US austerity in order to get more respite from monetary policy.
Shaniel Ramjee is multi-asset investment manager at Baring Asset Management