Waiting for the cliff to bite Wall Street

The veteran economist Al Wojnilower believes global markets are underestimating the adverse effect of the looming austerity in the US – the so-called fiscal cliff. I have been following Wojnilower for decades and he is rarely wrong on major calls, so if he is right markets face a bumpy start to 2013.

Let me share with you the Wojnilower warning by quoting extracts from his quarterly bulletin. You will not find it pleasant reading.

"Most of the public remains blissfully unaware of the scale of the problem. They will be aghast when, soon after year-end, they experience reduced take-home pay and higher tax bills, as well as unforeseen job losses at the many entities, both public and private, that depend, both directly and indirectly, on federal funding and contracts.

"Monetary policy has been hard at work to produce sharply lower long-term interest rates, an easing of credit availability, and a recovery in home and stock prices. In recent months (some three years after the end of the Great Recession), households have finally responded by stepping up sharply their purchases of homes, autos, and other durable goods. The increased spending has reduced the rate of personal saving to near its pre-recession lows. Saving will narrow further as unanticipated tax increases bite into incomes until households are forced to curtail their outlays once again, bringing on a new recession.

"The improvement in business due to the increased buoyancy of the household sector has been partly offset by reductions in military and state and local government outlays. But more ominous is the fact that business capital investment, which had earlier sustained the economy by rising at double-digit rates, is now actually shrinking – notwithstanding record profit margins and the low credit spreads brought about by Federal Reserve policy. The decline reflects mounting fear that the impending setbacks to household incomes will halt or reverse the upward momentum in consumer spending, which is the chief source of business revenues. The indifference of elected officials to such a disastrous reversal is yet another reason for the widespread loss of confidence in governmental competence.

"The current prospect is that government borrowing will be reduced more rapidly in coming years, as additional revenues are raised from households in ways that compel consumers to curtail their borrowing and spending. This in turn is liable to provoke businesses also to tighten their belts. The result will be that total credit, debt, and incomes grow more slowly, or even shrink. So will GDP. If the shrinkage in incomes and GDP is substantial, the federal budget deficits that we are trying to reduce may actually get larger.

"Perhaps, as has happened in recent years, last-minute political agreements will be adopted and offer hope that, after a modest fiscal shock had been absorbed, GDP growth might reach 2.5 per cent later in 2013 (compared to less than 2 per cent this year) and continue to accelerate.

"Unfortunately, no such 'token' agreement is likely, since President Obama is himself an austerity advocate; he just wants to "distribute” the austerity in different ways than the Republican opposition. An agreement to raise revenues and lower spending along "Simpson-Bowles” lines, the most probable sort of compromise (if there is a compromise), likely would lead to years of GDP growth limited to about 1.5 per cent or less, as domestic business investment continues to languish. Business invests when the economy is expected to grow, not when it is condemned to austerity.

"Conceivably, no compromise will be reached at all, mainly because of deadlock on the issue of extending the debt ceiling. Unless the ceiling is abolished, or raised in unassailable fashion for a number of years, any agreement will be worthless. The administration could not accept an agreement that was hostage to renegotiation every few months to avoid a government shutdown. And without an agreement, the economy would topple over the fiscal cliff into a recession that has no visible means of exit. Business capital spending geared to the future would collapse.

"Awareness of these dangers is bound to have a major effect on the Federal Reserve's policy decisions.

"This suggests that, absent a benign fiscal agreement, high quality bond yields may well decline even further. Meanwhile, the cost-of-living index will be sustained by the increasing prices of utilities, transit, education, and medical care, as governmental supports are reduced."

The US is far from the only country where the economy is being held hostage to politics. But Wojnilower's warning reveals the possibility that markets could face a rockier start to the next year than many investors expect. Meanwhile, Australia has its own issues of political deadlock to address.