Why Can’t We Be Friends?

Why Can’t We Be Friends?

Julia Coronado - Market Economics
US Daily Spotlight | 19 Nov 2012 00:15 |

Last week ended on a hopeful note as Democratic and Republican Congressional leaders met at the White House with President Obama and emerged from their meeting promising they would reach a fiscal compromise “before Christmas”. There is still much political wood to be chopped to reach agreement, and it is certain to be a bumpy road. Nevertheless, we feel reasonably confident that the parameters of a deal are well within sight, and the political incentives on both sides are for a smooth outcome.

We also published our refreshed global quarterly forecast last week. Our global growth outlook is little changed, and we continue to expect a modest pick-up in activity in 2013. We marked down our expectations for Europe, but raised our forecasts for China and Mexico. In the US, we continue to look for a better performance in 2013, with growth of 2.5% q4/q4 in 2013, after a 1.5% q4/q4 performance in 2012, and 2.0% in 2011.

Weakness in business investment was the main driver for the slowdown between 2011 and 2012, and we look for a resumption of momentum in capital spending to drive 0.8pp of the 1.0pp pick-up in 2012. We attribute the malaise in investment mainly to the downswing in the global manufacturing cycle this year, as well as uncertainties posed by the election. With a gradual pick-up in global activity, a resolution of the election and expected progress on the fiscal cliff, we think firms will bring forward projects that had been shelved in 2012 as next year progresses. We also look for the housing recovery to continue and contribute the remaining 0.2pp of the acceleration in growth.

Meanwhile, consumers have been remarkably steady, if unspectacular, in their spending. While they express greater confidence, perhaps in part because their home values have stabilized, they have not matched this with increased spending. Rather, we think consumers have adjusted to the new normal and feel confidence in their more thrifty habits. We expect this to continue as any boost to spending from improving balance sheets will be offset by rising tax liabilities.

We have lowered our forecast for GDP growth in Q4 to 1.0% q/q saar from 1.2%, as incoming data suggest that Hurricane Sandy will take a bigger bite out of near-term activity. Also, the build-up of business inventories in Q3 suggests some paring back in Q4. Resumption of hurricane-delayed activity will lift growth to 2.0% in Q1 2013.

This moderate, but relatively rosy, outlook is predicated on the somewhat startling assumption that we will see improved behaviour from our elected officials. On this front, we would say so far, so good. The rhetoric from key leaders on both sides of the aisle has been reasonably positive and oriented towards compromise. The message after the While House meeting on Friday was that they aim to have a deal done in mid-December, and the deal will involve agreement on the broad parameters of a medium-term fiscal reform with an initial downpayment in 2013. Moderating the spending cuts scheduled to take place in 2013 is fairly straightforward. The difficulties will come on the tax side. We do not know to what degree the Democrats will insist on increased tax rates rather than accept just increased tax revenues. A sensible, small downpayment could involve letting the Bush tax cuts expire, but only for households making more than USD 500k or USD 1mn, rather than the president’s current proposal of a USD 250k threshold.

The sweet tone of recent discussions will inevitably sour to some degree. And, there continues to be chatter, particularly amongst Democrats, that if the Republicans do not agree to increased tax rates, they will allow the US to go over the cliff temporarily to force their hand. But, financial markets are growing impatient and will prevent such brinksmanship from coming to pass. Already the S&P 500 has fallen 5% since the election, and 7% form its peak after the announcement of open-ended QE in September. With year-end looming, sensitivities to risks are running high. If investors start to sense that negotiations are breaking down, it would be perfectly conceivable for equity markets to erase their remaining 8% gain for the year within the next several weeks – hardly the holiday gift legislators will want to deliver to their constituents. The US may very well be developing a European dynamic when it come to fiscal policy making – it may take market crises to make progress.