The outcome of this week’s US Presidential election will hopefully provide us with a signal for the direction of economic policy in a number of key areas. The most important of these is the “fiscal cliff” – a potent combination of lower spending and higher taxes which, in the absence of action from the US Congress, will begin early next year, says Percival Stanion (pictured), head of the global multi asset group, Baring Asset Management…
According to estimates by the Congressional Budget Office, without resolution of the fiscal cliff, the US economy could contract by as much as 0.5% in 2013. We believe this figure is actually on the conservative side.
From where we stand, we believe Congress is more likely to address the prospect of higher taxes-lower spending before the year is out, if Gov Romney wins the race to the White House.
However, it is also possible and we argue more probable, that under either outcome Congress will manage to avoid a looming fiscal cliff by 31 December, by most probably reaching an agreement on extending tax cuts. At the time of writing, the election of Gov Mitt Romney as the 45th US president would be a surprise to many, however, it cannot be ruled out given the latest Reuters poll which has the President ahead by just 1% (47% versus 46%).
Looking at the upfront risks if the US legislature fails to act decisively and in good time, the most obvious is the impact on growth, as automatic spending cuts could cost the US between 4-6% of GDP. Automatic cuts of this nature last happened in 1970, the effects of which triggered a sharp recession and market correction. Another risk, that of a second sovereign downgrade for the world’s biggest economy (with all three major rating agencies indicating they will review their rating of US sovereign debt in either 2013 or 2014) depends greatly on whether Congress enacts longer-term fiscal reform which will necessarily lead to a reduction in the debt-GDP ratio over the medium term.
In addition, we believe that the likelihood of an agreement on fiscal reforms is reached by 31 December is lower in an election scenario where we have a Republican Party-controlled Senate but with President Obama retaining office. We believe this type of outcome could make resolution or any sort of agreement, that much harder than a Republican Senate/Romney President verdict.
Turning to the possible implications for monetary policy, this has become an area far more central to political debate than in previous presidential elections. Ben Bernanke’s term as Chairman of the Federal Reserve ends in January 2014 and Gov. Romney has indicated he will not nominate Chairman Bernanke for another term, while President Obama has not said either way. Though the Fed has committed to keeping interest rates at close-to-zero levels until at least mid-2015, the financial markets can typically respond poorly to a lack of clarity on who will eventually direct policy in the future, so this is another risk we are mindful of as we await next Tuesday’s result.