At Kreab Gavin Anderson we represent Standard Life Investments in Hong Kong. These are very insightful regular columns by their Chief Strategist. I rely on them and hope you find it useful.
9 January 2013
Andrew Milligan, Head of Global Strategy, Standard Life Investments
Financial markets reacted very sharply to the announcement over the New Year holiday that the US was not falling over the ‘fiscal cliff’. Equities surged, while bond markets sold off. There is a danger, though, that investors have bought a piece of fool’s gold; the recent package may not be as positive as initially assumed.
Headlines about the Congressional agreement have focused on the first income, capital gains and dividend tax increases for the wealthiest 1% of the population for 20 years. In reality, there was an important tax increase for over three quarters of all households, through a 2% rise in the payroll tax (from 4.2% to 6.2%) as a tax holiday came to an end. This will affect the first pay checks of 2013, and on its own raises some $130 billion a year. It was no surprise, therefore, that retail stocks lagged behind the stock market rally at the start of 2013. All in all, the fiscal tightening for 2013 is provisionally estimated to be worth some 0.75% of GDP, with more potentially to come. Few economists have raised their US 2013 GDP estimates, which are clustered around 2.0-2.5% p.a.
Early analysis from the Congressional Budget Office (CBO) estimated that the agreement – formally known as the American Taxpayer Relief Act (ATRA) – implied an increase in the cumulative fiscal deficit of some $400 billion between 2013-22. This suggests a grand sum of $8.4 trillion over the coming decade for US and overseas investors, or the Fed, to purchase. US borrowing is set to remain about 3% of GDP a year. The combination of higher supply and the latest Federal Reserve minutes, which suggested QE might end in 2013, have not been supportive for the US Treasury market, where the House View remains Light.
Looking ahead, the backdrop is more worrying. While the tax half of the package has been agreed, three further issues need to be settled by a divided Congress. Firstly, automatic spending cuts, known as sequestration, have only been given a very short stay of execution and the issue will resurface again in two months. Secondly, agreement on an increase for the Federal debt ceiling is still required; various extraordinary measures by the Treasury can only push the debt ceiling limit back towards late February or March. Lastly, Congress has not passed a budget for 2013, so Washington is operating on a six month continuing resolution which also expires in March.
Consequently, it is no surprise that one credit rating agency has already warned that ‘more remains to be done to put US finances onto a sustainable path’. The willingness of Republicans and Democrats to compromise once again has been questioned in the media, with Republicans looking for spending cut concessions. If credit rating agencies place the US on ‘review watch’, that would be a negative for US financial assets.
However, let us not be too negative about the fiscal cliff package. In some respects it was a step forwards. For example, year after year Congress has had difficulty agreeing changes to the Alternative Minimum Tax, a Damocles Sword hanging over parts of the household sector. A patch has been made permanent, while various business taxes have also been settled for the time being.
Looking forward, it will be important to assess the consumer and business confidence reports for January – do they show a surge in optimism, perhaps leading to a reduction in savings and expansion of durables purchases? The most recent small business surveys have been weak, a sign that the drawn out fiscal cliff discussion was having a negative impact on sentiment.
To sum up, the day of reckoning has been postponed, not removed, by the ATRA. The House View remains wary of US assets until there is greater certainty about the second fiscal cliff.