Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 27 September 2012 at 11:32 GMT

Is the US too close to the fiscal cliff?

Chief Economist & CIO / Saxo Bank

If the United States Congress and President Obama don't come up with a deal before the end of 2012, the US will face a "fiscal cliff" on January 1, 2013. The fiscal cliff is the combination of tax cuts expiring, jobless benefits being lowered, higher personal income taxes, and mandatory spending cuts that will come into force automatically. This is a situation created last year when the Congress failed to find a long-term deal on or a solution to the US budget deficit.

Federal Reserve Chairman Ben Bernanke, of all people, has been instrumental in postponing much-needed reform on the fiscal side of the US by providing unlimited money at zero interest rates to banks and indirectly governments, which has meant it has been possible to delay indefinitely the last sales day for actual reforms. We know how much politicians across the world hate it when they have to deal in reality and not in promises. The fiscal cliff is real and maybe too real for comfort.

US is funding itself cheaply

In a normal business cycle, government bonds will yield something like inflation plus a risk premium. The US yield right now would be expected to be inflation (2.1%) + risk premium (0.5-1.0%) = 2.6%-3.1%.  Instead, the US government is funding itself at 1.60% ! The US has been to able to “afford” to postpone action as it continues to grow its economy in excess of its funding rate – i.e.: growth is 2.0%, funding is 1.6%, making the budget deficit stable. That’s the end of the good news.

The bad news is that Federal Reserve is in a panic over this fiscal cliff. Why else would Federal Reserve go all in with even more easy money when the stock market is reaching 2007 highs and the housing market looks to be stabilizing?  

The reason: Because Federal Reserve is seriously concerned that Congress will fail to find a compromise ahead of the year-end deadline.

No incentive to compromise

The two sides have, from a game theory perspective, no incentive to compromise:

The GOP, Grand Old Party, would like to see more spending cuts combined with lower taxes, while the Democratic Party wants to tax more. Ironically, they both get something if nothing happens between now and year-end, but there is a price.

The downside risk of the fiscal cliff is a negative 3.5-4.0% GDP impact on growth in 2013. The US economy is growing at a 2.0-2.5% pace, meaning that if nothing happens the US will be in recession by 2013. Of course,the  market is looking at the best-case scenario where some of these taxes up and down will be removed, lowered or rescheduled, the classic extend-and-pretend, but even the most optimistic political observer believes we will end with a deal which will be negative on growth.

Why is it important?

Why is a percent up or down in US GDP important for us market people?

Elementary, my dear Watson:  It is estimated that 1 percent growth will create/reduce corporate earnings by 5-7 US Dollars for a S&P 500 company. This needs to be multiplied by the price we pay for this profit. The P/E is roughly 15, meaning that for every one percent up or down in growth S&P fundamental value will increase/decrease by: 75-105 S&P points. (5 USD x 15 = 75, 7 USD x 15 = 105). So, simply put, if the worst case scenario is 5% negative growth then the “price” becomes minus 525 S&P points (or from 1435 to 910 by end of 2013!) . I guess I have your attention now!

This price, however, is only “money” – the real economy will lose another 2 percentage point of growth due to higher taxes, lower payroll benefits et al, (austerity = lower growth), and the re-elected President Obama will need to find another 800,000 jobs lost due to this strong medicine.

Historical parallell

It’s interesting that that we have a historic parallel, as US President Franklin Delano Roosevelt faced the same challenge in 1937. After his expansionary New Deal program in the 1930s, there was a need for “fiscal prudence”. FDR ended up hiking taxes so much that the market fell 50%  (See chart below).

Fiscal Cliff


Back in the 1930s it was also “unusual times”  for policy makers. Is it me or does there seems be more unusual times than normal times these days? Yes, it is illogical and for good reasons. We can’t solve a solvency issue (debt) by issuing more debt, and we can’t tax ourselves to prosperity.

The solution: more micro

The solution to the fiscal cliff, Europe debt crisis and China’s slowdown is the same. We need more micro!

More open markets, more competition, more reforms, lower taxes and incentives to activate record-high private savings away from dead government bonds to risk capital in the shape of jobs, innovators, entrepreneurs. The micro economy is the private individuals who will survive any crisis by being prudent and logical, and the millions of businesses which each day open their doors to be profitable and productive. The macro is compounding all the mistakes of believing in extending and pretending.

A deal, and a bad one

My conclusion is that the US is unlikely to address the fiscal situation in earnest this time, despite the gravity of the situation. The political situation is simply too complicated. There will be a deal, probably a bad one for the long-term, but one which kicks the can down the road, and one which at best will ‘only’  cost 1% of GDP.

This is exactly why we are very conservative on the stock market and risk for the balance of 2012. Fourth quarter is normally the strongest part of the season, and all conventional wisdom says the market is even better in an election year, but never before has there been a fiscal cliff on the other side of the election. The election is anyway almost a done deal: it’s Obama’s to lose, rather than Mitt Romney’s to win.

The market has, as always, discounted all the good things about Q4 ahead of time, neglecting in the process to understand how the micro economy will suffer from inaction. Maybe it is time to pay the bill for years of doing nothing? 

MarketShark MarketShark
Steen, the US budget cannot be put to rights before there is a serious look at entitlement reform. Romney was correct in his inelegant statement that a huge percentage of Americans are receiving regular flows of goods and services from the Federal government, and they will vote to protect those cash flows. What do they care if the money is all borrowed? Obamacare will only make the situation worse when it comes into effect in 2014.
dominom dominom
Maybe a look from abroad. In Slovakia we do have social benefits and "free" healthcare, "free" education yet the biggest issue is costs for all state employees and ineffectivity of the state sector. We receive a lot from the state (and yes some too much) but in the US you get much, much less than we do and yet your deficit is climbing much more than ours. I therefore assume that the biggest problem in the US is not elementary care for citizens but rather areas like defense (or offense?), administration, NASA, but again it is the choice of voters...
Cyprustrader Cyprustrader
Great work once agina from Steen Jakobsen! Regarding the fiscal cliff, Aswath Damodaran made some interesting comments:


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