The weakness in the US share market in the early part of the month can be attributed to the post-election focus on the fiscal cliff. If you haven’t heard this term, you haven’t been paying attention. It refers to the sudden, and large, tightening of fiscal policy that will occur, by accident more than design, in early 2013.
There are three elements to the fiscal cliff. First, certain stimulatory policies put in place by the Obama administration—notably a cut in payroll taxes and higher unemployment benefits are set to expire, and are likely to do so no matter what.
Second, in late-2011, Congress did something quite strange. Earlier that year, it had passed an increase in the Federal government debt ceiling—the maximum debt that the US Government is allowed to issue. At the time, it was obvious that it would be necessary to raise the ceiling again (because the Government is still running a deficit), probably in early-2013. In order to minimize the frequency of such future raisings, Congress set itself the task of coming up with a medium-term deficit reduction plan. And, in order to concentrate on the task, the legislators decided that, if they failed to come up with a plan, then there would be automatic swingeing cuts in spending as of early 2013. No plan was forthcoming, so hello spending cuts.
Third, and most importantly, the tax cuts legislated during the Bush presidency in 2001 and 2003 are set to expire. Who cuts taxes and puts a use-by date on those cuts? The Americans. These tax cuts were directed disproportionately towards the top end. In addition, the Alternative Minimum Tax is due to go up. This is an interesting concept, designed to limit the ability of (mainly wealthy) Americans, to reduce their gross income massively by means of deductions. It’s quite complicated if you want to know more go to Wikipedia.
The chart below shows the relative importance of these elements in the fiscal cliff, with increased taxes being clearly the biggest part. Most estimates put the total size of the cliff at $607 billion, around 4% of GDP. The chart seems to suggest that the size is closer to 3%, but this is because the fiscal year begins in October, and it will be one-quarter over before the cliff arrives. Take an economy growing at 2% and take 4% out of it, and you are almost certainly back in recession.
Obviously this cannot be allowed to happen, and so it won’t be. Congress will negotiate a significantly smaller tightening. The problem is that the Obama administration wants to raise taxes on the wealthy, while the Republicans would like any tightening to be by way of spending cuts. So there will be some eyeballing, and the issue may not be fully resolved until early in the New Year. At worst, there will be a fiscal escarpment on 1 January. Of course, as long as sentiment waxes and wanes about the resolution of this issue, markets will remain volatile.
Source: RBA Statement on Monetary Policy, November 2012.
With respect to the other two major international issues (China and Europe), there was little change during the month. If anything, the European situation continued to improve. Greece’s lenders agreed on a plan for the next tranche, and long-term interest rates continued to fall, thus taking further pressure off borrowing costs.
The Australian Situation
Having surprised most Australian economists by cutting rates in early-October, the RBA then surprised the same people by not cutting in November. And yet, the same issues that led to the cut in October are still there. Employment growth continues to be weak (just 0.6% in the past year) and the unemployment rate, while low, has been rising. It currently stands at 5.4%. Just as importantly, it is becoming progressively more obvious that the end of the mining capital spending boom is nigh. Capital spending plans data released on 29 November made this abundantly clear. It thus appears most likely that the RBA will continue to cut, and it would not surprise to see a reduction in the cash rate on 4 December. If not then, then early next year.
A Look Ahead to 2013
It will again be a challenging year. At some stage, and it now appears that it will be earlier rather than later, the mining investment boom will peak, and the source of about half of Australia’s growth in recent years will contribute nothing, or even become a drag. This does not necessarily have to lead to a slump, however. Low interest rates will help other sectors, particularly non-mining construction, which should emerge from the doldrums. It’s hard to see the exchange rate not falling once the peak of the mining boom is clear to everyone, so this will help also. And, of course, mining exports will pick up we haven’t been doing all of the capital spending just for the thrill of it! A growth pothole is likely, however.
The share market no longer looks as cheap as it was, but it is still on the cheap side and can thus make further gains. My current targets for end-June 2013 and end-December are 4850 and 5100 respectively. The index currently sits at 4506.
Chris Caton
Chief Economist