WITH the leadership transition in China now completed and Greece’s position in the eurozone finally assured, at least in the near-term, the “Fiscal Cliff” issue in the US is set to stand out as the key focus for financial markets between now and year-end.
Indeed, there is plenty at stake – the failure of Republicans and Democrats to compromise on a deal would almost certainly send the US economy back into recession next year, which would have inevitable and significant repercussions worldwide.
Global equity markets have expressed their worry, with recent weakness apparent, although they remain over 10% higher on a total return basis in the year-to-date.
Overall, we remain hopeful that US policymakers will find a resolution and that this will allow investors to focus on what we see as a fairly encouraging macroeconomic outlook for 2013, which should ultimately prove positive for “risk assets”.
There is no question that the level of systemic risk posed by the eurozone crisis has fallen dramatically since the summer months. Through their OMT – Outright Monetary Transactions programme – the European Central Bank has finally taken on the role of lender of last resort for troubled nations, which has helped to bring government bond yields lower in countries such as Spain and Italy.
Policymakers have also removed the possibility of an immediate Greek exit from the eurozone, by recently agreeing to disburse 44bn euros in much-needed funding. The 500bn euros European Stability Mechanism fund is also now in place and it has been agreed that a move towards a Banking Union should be completed by the end of next year.
Overall, it seems that Europeans have now convinced the markets that they understand the risks associated with the debt crisis and are willing to act accordingly.
Nevertheless, the macroeconomic and fiscal outlook for the region continues to remain somewhat of a concern and this is likely to remain the case going into 2013. The eurozone economy fell back into recession in the third quarter of this year, unemployment is at a record high (11.7%) and political risks remain high – indeed, with regards to the latter, there has been increasing discontent from various Spanish regions towards Madrid (including Catalonia, the most significant Spanish region by GDP) and Italy goes to the polls next spring.
Despite heightened political uncertainty in the US over the last few months, due to the Presidential polls and the “Fiscal Cliff” issue, economic news from the US has remained encouraging – for example, third quarter GDP rose by 2.7%, the fastest pace since the last quarter of 2011.
The labour market also continues to improve – the unemployment rate has now fallen to 7.9%, which is close to multi-year lows and recent data suggests that this is now being driven by job creation, rather than a decline in the overall workforce.
The housing market, the initial cause of the credit-crunch, also appears to have turned a corner – record low mortgage rates, a significant fall in inventory levels (back to the long-term average), rising employment levels and improving credit conditions, have all provided support to house prices, which are 5-10% higher on an annualised basis. Rising house prices will help to bring a number of individuals out of negative equity (about 25% of US homeowners are currently in this position), which should qualify them to re-mortgage at lower rates, thus helping to further boost consumption going forwards, ultimately the key driver for the US economy.
We would note that one current area of weakness in the US economy has been business investment, which has steadily declined in recent months. However, it is hoped that this trend could swiftly reverse next year, once the “Fiscal Cliff” is resolved, which would further support growth.
Meanwhile, monetary policy in the US is likely to remain extremely accommodative, with another round of Quantitative Easing likely before year-end, to replace “Operation Twist”.
On the political front however, the policy outlook is far less clear, despite the recent re-appointment of President Obama. Indeed, the threat of another recession is very real in the US if the Democrats (who control the Senate) and the Republicans (who control the House of Representatives) fail to steer clear of the “Fiscal Cliff” by year-end, which could result in a potential fiscal contraction in 2013 of about 4.5% of GDP.
Although we believe that some form of compromise will be formed (both parties agree that some re-assessment of planned spending cuts is needed and that the potentially expiring tax benefits, to a certain degree, will need to be extended), it is difficult to predict the composition of the fiscal package which could emerge, although we anticipate that the level of austerity next year will ultimately be more than manageable for the economy.
Some fears of a slowdown in China have proven to some extent justified, with the economy this year set to grow at its slowest rate since 1999.
Nevertheless, although the economy has clearly slowed, China is still very likely to remain the key driver for global growth going forwards.