The US Fiscal 'Moment': Cliff, Slope, Or Wile E. Coyote?
The overhwelming majority of investors seem to believe that some compromise will be reached to resolve the looming fiscal drag, and as we noted here, this fact is more than priced into markets. As Barclays notes however, a big deal that encompasses entitlement and tax reform is very unlikely before year-end. Hence, if the ‘cliff’ is avoided, it will be because Congress extends all expiring provisions for some time while it works on a bigger deal. Such an 'extension/compromise' move would not reduce investor uncertainty if it were only for a few months; bond markets would simply start counting down to the new date. More importantly, the discussion about the fiscal cliff misses a broader point: the US will probably have significant fiscal tightening over the next decade that is a drag on medium-term growth. Yet more investors dismiss last year's reaction to the debt-ceiling debate - a 17% decline in 2 weeks - as any kind of precedent, claiming (falsely) that this was more due to European financial difficulties. We expect fiscal issues to be the defining drivers of the next several quarters and as BofAML notes, Washington's view of this 'process' as a 'slope' combined with the dangerously negative election campaign (which will need a 180-degree reversal for any compromise) means the likelihood of a Wile E. Coyote Moment is considerably higher than most expect.
The S&P 500 plunged by 17% between July 25th and August 8th and between the fiscal cliff, the debt ceiling, and the election - uncertainty remains high...
but this was not about Europe (as many prefer to believe) as this chart from Goldman shows
"...positive developments by the ECB narrowed the spread between Spanish and German ten-year bond yields by roughly 100bp (from 380 bp to 290 bp) while S&P 500 fell by 11% during those days, including nearly 7% the day after S&P lowered the US credit rating."
and what of compromise or small adjustments?
Via BofAML's Ethan Harris: A Wile E. Coyote moment
One of the best known moments in US cartoon history is when Wile E. Coyote accidentally runs off a cliff. Initially he remains suspended in air – and for a moment starts to believe he will be okay – but then plunges to the canyon floor.
Some in Washington are now contemplating a Wile E. Coyote moment around the fiscal cliff. In their view, the cliff is a fiscal “slope”, or “hill.” They say, going over the cliff initially has very little impact on the economy. The IRS could decide not to change tax withholding tables. The Alternative Minimum Tax doesn’t need to be paid immediately. Government agencies could spend down their cash balances. Households could draw down their savings. And even if policy does tighten, the fiscal cliff cuts spending and raises taxes by only about $2 billion per day and people will “know” politicians are bluffing. So what’s the harm?
In our view, this is a very dangerous way to look at the cliff. After a highly negative election campaign, both parties will need to do a painful 180-degree turn and negotiate a series of compromises. If politicians believe going over the cliff has no real consequences, then they will have little incentive to negotiate as the cliff approaches. Moreover, if the laws of gravity are suspended for weeks or months, why not keep debating after going over the cliff? In our view the end game – the ultimate game of brinkmanship – is a plunge in confidence and markets, and significant damage to the economy. We also believe the Wile E. Coyote moment won’t last long; by the time we go over the cliff, the dysfunctional debate in Washington will have already softened up the markets and the economy.
This reminds us of Summer 2011
A popular view last summer was that a temporary suspension of 25% of government outlays or a few missed Treasury debt payments was a reasonable price to pay to get a sensible deficit reduction plan. That didn’t work out so well. Despite a last minute deal, this brinkmanship contributed to a weak stock market, a downgrade of the US credit and then a large 6.66% one-day plunge in the market. In the end, the “sensible deficit reduction plan” that emerged was to add $110bn in across-the-board spending cuts to the fiscal cliff.
We can only wonder what would have happened to the markets and economy last summer if they had not reached a last-minute deal. Unfortunately, there is a growing risk that we could complete that experiment in January. Keep in mind that the stakes are much bigger this time. Last summer they had only the debt ceiling to deal with. This time there is the debt ceiling, the Alternative Minimum Tax ($120bn), tax extenders ($20bn), the Medicare doc fix ($20bn), the payroll tax cut ($120bn), extended unemployment benefits ($40bn), the sequester ($110bn), the Bush tax cuts ($180bn), Obama Care taxes ($20bn) and a number of other expiring programs ($90bn). Two billion dollars per day may not sound like much, but it is more than 4.5% of daily GDP.
Negotiations should occur before the cliff
Some of the arguments for going over the cliff are well intended: we do not want to rush into a bad deal. However, if the US is to avoid a major shock to the economy and markets, we think such negotiations should occur before the cliff arrives or after extending the cliff. The process matters as much as the outcome.
Using the cliff as a motivating mechanism would be a major mistake, in our view.