The fiscal cliff – a $600bn package of automatic tax increases and government spending cuts that had the potential to push the world’s largest economy back into recession – became the biggest risk for asset allocators over the final months of 2012.
Although this risk now seems to have been removed, it looks increasingly likely that the financial health of the US will come ever more into the spotlight in the coming few months and investors will once again find themselves buffeted by uncertainty.
On 2 January, US president Barack Obama signed a deal that eliminated much of the tax side of the fiscal cliff by increasing income taxes levied on wealthier Americans, phasing out some tax deductions and confirming the expiration of payroll tax cuts.
Decisions on the other side of the cliff – which is made up of automatic government spending cuts and contributes much less to the cliff than tax increases – were delayed for another two months.
Stock markets immediately rallied on the news, even though it was widely expected that policymakers would come to a compromise to prevent the US from falling off the cliff. However, investors have started to question how much unfinished business is left over the issue.
Breaking through the debt ceiling
Russ Koesterich, chief investment strategist at BlackRock, warned that “Washington’s fiscal soap opera is far from over” and said investors have to prepare themselves for more volatility in the markets as US policymakers turn to the question of how to deal with the breached debt ceiling.
The US officially passed its borrowing limit on 31 December although the Treasury is able to keep the government running for another six to eight weeks using various accounting tricks. But this still means US policymakers have to lift the debt ceiling, agree large spending cuts or default before the end of February.
Koesterich said: “While a default isn’t a real risk, the upcoming fight over the debt ceiling and budget – like the fight over the fiscal cliff – will likely go down to the last minute and lead to increased market volatility.”
In this environment, Koesterich recommends investments that have the potential to offer some downside protection, suggesting funds focusing on high-quality, international dividend-paying stock funds, global mega caps or minimum volatility products.
A massive problem to solve
While the debt ceiling negotiations don’t have the potential to push the economy back into recession, they will be keenly watched by those that believe $16trn in national debt is simply too much for the US to sustain over the long term.
US tax revenue stands at around $2.4trn a year while the federal budget is $3.5trn, creating a deficit of more than $1trn. Recent budget cuts made by the government amount to just £38.5bn, barely making a dent in the country’s overspend.
Andrew Morris, managing director of Signature, the discretionary arm of Rowan Dartington, suggested the discussion over raising the debt ceiling could be more protracted than that over the fiscal cliff.
“Already politicians on both sides of the political divide are setting out their stalls,” he commented.
“Democrats are saying that spending cuts are off the table in terms of negotiating the debt ceiling. The Republicans are stating that further tax increases will not occur, given that these have already been dealt with.”
More can kicking risks market crisis
Past experience of US debt negotiations and the sheer size of the problem means that an easy solution is unlikely to be found. The uncertainty over how the US slows its growing debt mountain and eventually starts to bring it down will hang over the market for some time to come.
Robert Farago, head of asset allocation at Schroders Private Banking, said: “The fiscal cliff is not a one-off affair. It is a symptom of the need for structural reform of tax and spending policies.
“We are far from confident that politicians will do more than kick the can down the road one more time. This leaves the risk that it will take a market crisis to force more fundamental reform to take place.”
Stock markets have already started to hand back some of their recent gains after the fiscal cliff ‘resolution’ was viewed in a more realistic light. The coming weeks will no doubt see more volatility as policymakers get around the negotiating table once again.
In spite of the uncertainty, the most likely solution will be another increase in the debt ceiling. But this fails to address the fundamental problem of the US’ unsustainable debt path.
For now, the dollar’s status as the world’s reserve currency offers the US some insulation from the consequences of sitting on too much debt but, with the growing economic power of China, this cannot last forever.
The new year started with joy over developments on the US fiscal cliff. But unless real progress is made is addressing the debt mountain, how the US deals with $16trn of debt will become a risk that stalks financial markets for many years to come.
