On both sides of the Atlantic, we have finally come to the point where if we continue on our present respective paths the outcome is not likely to be pleasant. In the United States the wake-up call was the failure of the Congressional Super Committee to come up with a credible plan to reduce the US budget deficit by $1.2 trillion over 10 years. In Europe it was the rise in the cost of raising government funds in Italy and Spain, culminating in November with the lack of bids for part of an auction of German debt and a sudden rise in interest rates there. Finally it appeared that doing nothing and muddling through were incompatible. The verdict was delivered in both the European and American stock markets by a resumption of the free fall in equity prices that we experienced in August and September.
The failure of the Super Committee was part of the pattern of dysfunctional government that began last summer with the downgrade of US government debt and the battle in Congress over raising the debt ceiling. At that time political lines were drawn, with the Republicans not wanting to increase revenues and the Democrats wanting to limit entitlement reductions. A compromise seemed unlikely even then, and perhaps it was wishful thinking to hope that the Super Committee would come up with a workable plan to reduce the deficit. Nothing major seems to happen in Washington until a crisis is upon us and we weren’t at that point yet.
Now few observers expect anything constructive to take place until the national elections a year from now and many, including myself, wonder if we can really wait that long. I also question whether we can narrow the budget gap without raising some revenues. Tax revenues have declined from 18 per cent of gross domestic product for most of the past 60 years to 15 per cent now. Declining revenues account for about 40 per cent of the increase in the budget deficit since 2007. The recession and slow recovery account for some of this shortfall, but tax relief has been an important contributor to the problem. The tax preferences enacted during the last Bush administration expire at the end of 2012. If they are not extended, important additional revenue would be collected, but the absence of these benefits could severely impact the growth of the economy.
At this point both parties are saying that the American people will decide which direction the country should move in when they vote for president in November, but the budget issue is likely to be a major campaign topic and should dominate the dialogue in Congress for all of next year. In addition to the expiration of the Bush tax preferences, the automatic spending cuts in defense and healthcare will also go into effect at the beginning of 2013 as a result of the failure of the Super Committee to come up with a definitive plan for deficit reduction. If anticipatory action is not taken on both these programs, the post-election period is likely to be a lively one for policy makers as they confront these major tax and budget issues, no matter who is elected. The expiration of the Bush tax cuts and the automatic reduction in entitlements and defence occurring at the same time may force legislators to take action before the election. We may get a preview of the willingness to compromise as legislators confront the imminent expiration of the payroll tax cut.
The irony is that the dysfunctionality in Washington which is discouraging investors is occurring at a time when the US economy is showing some signs of improvement. By now almost all of the Standard & Poor's 500 companies have reported, with 70 per cent beating analysts’ estimates. The GDP for the third quarter has been revised downward from 2.5 per cent to 2 per cent as a result of inventory adjustments, but estimates for the fourth quarter are as high as 3 per cent. I'm not getting my hopes up; I still think real growth over the intermediate term will be between 2 per cent and 3 per cent, but at least we have moved away from the recession fears of last summer.
Among the indicators showing a positive trend are the regional reports of the various Federal Reserve banks, the unemployment rate, bank lending, durable goods orders, layoff announcements, railcar loading and consumer sentiment. The general tone of the housing market suggests that conditions are not getting worse. I have thought for a while that housing is in a bottoming process. With a heavy overhang of unsold homes I do not expect a surge in housing starts any time soon, but at least the process of drawing down the inventory seems to have begun. I continue to believe that a program of government incentives to improve American infrastructure is needed and would go a long way toward putting unemployed construction workers back on the job. Early signs of retail sales in the all-important post-Thanksgiving period are favourable and consistent with my growth forecast.
Ultimately I believe Congress will have to pass legislation that will include entitlement cuts, some revenue increases and perhaps a few measures designed to reduce unemployment. Such a program will require the political parties to compromise and soften their differences. That seems unlikely now based on the current rhetoric and partisan hostility, but I think that is where we are headed. Democratic agreement to extend some of the Bush tax cuts may prove the key bargaining chip that gets the Republicans to agree to revenue increases in other areas of the tax code.
Aside from what is happening or not happening in Washington the fundamental background for US equities in terms of earnings and the economy is reasonably positive. Investors, however, are closely following events in Europe and are becoming increasingly anxious. If Europe slips into recession, which still seems likely at this point, notwithstanding the agreement outlined at last week’s summit, that is bound to have a negative impact on the US economy and its financial markets as it has in the past. Just as we are facing an impasse in the United States over the deficit, European policy makers have still made relatively little progress on the impasse over their sovereign debt problems, and the decision to hand control of financial regulation to the European Union will take considerable time to implement.
The ECB and its principal backer, Germany, have been buying debt in the open market in an attempt to defer the crisis point from occurring, and the ECB has now agreed to act as an agent for the EFSF. Meanwhile, implementation of the European Stability Mechanism, with a lending capacity of €500 billion, has been pushed forward to July 2012. But the countries unable to meet their obligations, like Greece, Portugal and Italy, seem unable or unwilling to implement the individual budget reforms necessary to get back on a sound and sustainable path. The trigger point has come in the form of rising interest rates. Greece has long had double-digit rates on its sovereign debt, but this is considered a small enough factor not to be systematically threatening to all of Europe. Spain and Italy are another matter. With 10-year sovereign bonds for those countries approaching or exceeding a 7 per cent yield which is unaffordable over the long run, the crisis is here. Even Germany, whose yields are closer to 2 per cent, had trouble selling all the debt it wanted to bring to market in late November, and economic data in Germany has been softening as well.
Elsewhere, Italy has a total debt of 120 per cent of its GDP and is the third largest debtor nation in the world after the United States and Japan. Its previous Prime Minister, Silvio Berlusconi, valued loyalty over merit and believed, according to a Council on Foreign Relations report, that "the rule of law was only one option among many." Politicians in Italy enjoy high salaries, generous annuities after a few years in parliament, and 600,000 official cars, compared with 75,000 in the United States, a country with five times Italy’s population. The pension system needs reform, the barriers that limit access to professions and trades need to be removed and tax evasion has to be tackled. Italy will not get major aid until Mario Monti proves he can institute reforms, and he is going to have a tough fight with many Berlusconi holdovers in the Italian parliament. I believe a combination of the European Union, the European Financial Stability Facility, the International Monetary Fund and perhaps the central banks of other industrialised countries can provide transitional aid to help the weaker countries during the reform process, but help will not be forthcoming until it is clear that improvements are underway, and there is sure to be a lot of popular resistance to the austerity that will be required.
The long-term solution for Europe has got to be some integrated fiscal entity. Now that eurozone countries have agreed on this, the urgency of the present situation may prompt Europe to act faster on implementing political as well as monetary union. European countries have already surrendered some of their sovereignty through involuntary fiscal tightening in exchange for funds to keep operating and have forced changes in leadership. The debt summit’s outcome is evidence that Europe as a whole does not want to abandon the euro, and I believe they are on a path which will enable it to endure. The continent has invested too much in money and time and the benefits in terms of trade among countries have been huge. In spite of the challenges now facing policymakers a solution must be implemented.
Europe may be providing a warning to the United States. The rise in yields on government debt in the troubled countries is forcing the leadership to take constructive action toward reform. I have long felt that the fact that the United States can borrow money for 10 years at 2-3 per cent is relieving Congress of the pressure to take action on the budget deficit. The reasoning goes that if investors will loan us money at low rates, the situation may not be as bad as the critics say. Only when rates rise to an alarming level will remedial action be taken. With so much fear around the world and the United States viewed as a safe haven with a strong military and a Treasury that can print money, that day may be a long time in coming.
The financial markets yearn for clarity on these issues and as we approach year-end, with some hedge funds closing and other investors wanting greater liquidity, we are again in a situation where there are some impatient sellers and uninspired buyers, which has resulted in the markets drifting lower. On the basis of historical valuations the United States and other markets offer some good opportunities, particularly in high-quality, dividend-paying companies. For investors to act with conviction, however, they will have to believe that policymakers on both sides of the Atlantic will come together to come up with workable solutions to the problems facing them. That has to happen in 2012.
Byron Wien is a senior managing director of The Blackstone Group and vice chairman of Blackstone Advisory Partners LP.