Avoiding the Fiscal Cliff and Pleasing Financial Markets
We are now firmly in the lame duck session of Congress and financial markets will continue to be wary about lack of progress in postponing the fiscal cliff. Some fiscal policy tightening will happen in 2013. At the moment, markets seem to be discounting tightening of 1% of GDP. This policy outcome would be consistent with a continuation of sluggish growth. Risky assets will be concerned as to whether the resultant growth outcome will be strong enough to sustain corporate profit expectations for 2013. Currently, the bottom-up expectations for S&P500 operating EPS growth is +10%.
What is the best outcome for financial markets? Some commentators mistakenly claim that just avoiding the fiscal cliff will be good for financial markets, because fiscal policy would continue to support aggregate demand. The real issue for financial markets is whether the fiscal cliff is only being avoided by another temporary extension of tax expiration deadlines without serious measures being undertaken, in the interim, to institute long-term fiscal sustainability. Markets will not tolerate these issues simply being kicked down the road. The patience of markets could wear thin if they are not addressed by the mid-term elections in 2014. Gridlock was once seen as bullish for financial markets, because economic management would de facto be passed to the Fed. Now that the Fed is deep into uncharted territory with monetary policy conduct, it is imperative that fiscal policy supports growth, but, at the same, is not foolishly profligate.
US Fiscal Policy: Different Scenarios Explored
The Congressional Budget Office (CBO) estimates that under the full blown fiscal cliff scenario, the federal budget deficit would shrink from -7.0% of GDP in 2012 to just -2.4% in 2014. This constitutes cumulative policy tightening equivalent to 4.6% of GDP. The last time that fiscal policy was tightened by this order of magnitude was in 1969, helping to produce a recession. Under the so-called alternative fiscal scenario where the tax increases and spending cuts are not enacted, the CBO estimates that fiscal tightening is barely noticeable: the budget deficit falls from -7.0% in 2012 to -5.6% in 2014.
Would financial markets tolerate the alternative fiscal scenario? The answer depends whether the private sector’s appetite for US Treasury securities remains elevated. Under the alternative fiscal scenario, government debt held by the public rises from 73% of GDP in 2012 to 82% in 2014. There are tantalising implications for funding costs. Risk aversion on the part of the private sector, along with the invocation of quantitative easing, has helped to produce low sovereign funding costs, despite large budget deficits. If risk aversion prevails in a meaningful manner, then the alternative fiscal scenario need not produce elevated funding costs. In some ways, this scenario would partially replicate the experience of Japan in the post-bubble era. A reduction in risk aversion by the private sector produces a very outcome: rising US interest rates.
Putting the Fiscal Cliff into Historic Context
Both the mainstream and financial media have failed to put the fiscal cliff into proper historic context. This is understandable given the fickleness of modern financial markets. In 1969, the US economy was overheating under the strains of the Vietnam War. Fiscal policy was tightened to prevent further overheating, and the Fed tightened monetary policy. The economy entered recession in late-1969, although it was relatively mild by post-war standards.
The other post-war tightening of fiscal policy similar to the looming fiscal cliff was in 1946-8. The US had been running large deficits during the Second World War. The tightening of fiscal policy between 1946 and 1948 was very significant, equivalent to a massive 12% of GDP. The economy went into recession late-1948. Part of the justification for the tightening of fiscal policy was inflation, following the cessation of price controls in 1946.
The most notorious example of draconian fiscal tightening during peacetime occurred in 1937-8. The tightening was largely due to the inception of the new social security tax. The economy entered a 13-month recession in May 1937. How did US financial assets behave under these previous fiscal tightening episodes?
US Financial Asset Behaviour under Earlier Fiscal Tightening
The previous experiences of severe fiscal tightening have occurred at very different stages of US economic development. The 1937-8 recession is arguably the closest historical comparison to the situation prevailing today: the economy was recovering from a severe contraction that imparted significant psychological scars on the private sector. There are, however, some similarities to the circumstances prevailing in 1948 in terms of the capping of long-term interest rates.
US equities had a tough time during the 1937-8 recession. Between February 1937 and May 1938 the S&P500 fell -45% in both nominal and real terms. Did bonds offer better returns during this period of fiscal tightening? Long-term government bond yields fell from 2.7% to 2.5% between February 1937 and May 1938. Total returns on long-term government bonds were +2.8% in nominal and real terms during this period. Yields were to eventually trough in late-1940 at 2%.
Risky assets fared better in 1948-9 recession. The S&P500 fell “only” -17% between June 1948 and its trough in June 1949. The performance of long-term government bonds over this period was affected by the agreement between the Fed and the US Treasury to impose a cap on US long-term government bond yields at 2.5%. The total returns on US long-term government bonds between June 1948 and June 1949 were +5.2% in nominal and +6.0% real terms.
There are parallels between this period of US financial history and the present situation: quantitative easing by the Fed effectively imposes a cap on long-term interest rates. The capping agreement between the Treasury and the Fed ended in 1950. Under current circumstances, it is unclear when the Fed’s attempt to cap long-term interest rates will officially come to an end. Signs of renewed economic weakness due to fiscal policy tightening will be greeted by further Fed asset purchases.
Although the 1970 recession is classed as being relatively mild, the behaviour of financial markets suggested otherwise. Between December 1968 and June 1970, the S&P500 fell -29% in nominal terms and a whopping -35% in real terms. Inflation had finally started having profound effects on financial asset behaviour around the recession period. The returns on US long-term government bonds during the 1970 recession make sobering reading: yields increased 250 basis points between August 1968 and May 1970. It implies that bond market investors were expecting the Fed to increase short-term interest rates, but the Fed began the rate cutting cycle in August 1969. Total returns on US long-term government bonds between August 1968 and May 1970 in nominal and real terms were -17% and -24%, respectively. The fact that long-term interest rates were rising after the Fed had started cutting short-term interest rates indicated that the Fed had lost a degree of credibility with the bond market.
The Composition of Fiscal Tightening: Critical for Financial Assets?
It is ironic that the 1970 recession, partly the result of fiscal tightening, ushered in an era where there has been a tendency for ever-rising budget deficits. Prior to 1970, deficits averaged a mere -0.8% of GDP, while the post-1970 environment has seen the deficit average -2.8% of GDP. Spending growth has consistently outstripped that of revenue. Will the composition of future fiscal tightening be critical in determining the behaviour of US financial assets?
Equities took a bad hit in 1937-8, 1948-9, and 1968-70 under fiscal tightening. Can the composition of these earlier episodes of fiscal tightening provide clues about future financial asset behaviour? The 1937 tightening was overwhelming due to the inception of the new social security tax as opposed to spending cuts. The new tax effectively sucked aggregate demand out of the economy, helping to produce a recession just 4 years after the Great Depression. The very poor performance of risky assets in 1937-8 was probably accentuated by fears of a possible return to depression.
The 1969 fiscal tightening was more balanced in its composition between higher taxes and lower government spending. The hit to risky assets was largely due to rising inflation in the wake of economic overheating, along with an apparent loss in Fed credibility.
The composition of the 2013 fiscal cliff is overwhelmingly skewed towards revenue increases vis-à-vis spending cuts. The tightening of policy from higher revenues during 2013-4 is equivalent to 3.8% of GDP. This would surpass the 3.2% tightening during 1937-8 recession due to the imposition of social security taxes. There is, therefore, a significant threat to aggregate demand in the economy in 2013 from a drop in after-tax disposable incomes. The implications for risky assets would be felt via negative recalibration of corporate earnings expectations for 2013. Under this scenario, government bonds would be underpinned by further weakening of inflationary pressures and a continuation of asset purchases by the Fed. In short, the liquidity trap would continue, possibly in a more virulent form.
Summary and Conclusions
Financial markets are discounting a 1.0% tightening of fiscal policy, consistent with continued subdued economic growth. Temporary postponement of the fiscal cliff is not necessarily bullish for financial assets. Some measures to institute long-term fiscal sustainability are needed to satisfy financial markets.
The implications of postponing the fiscal cliff on financial markets will depend on the private sector’s appetite for embracing risk. A higher appetite for risk-taking will result in higher interest rates.
There are three examples where fiscal tightening has produced recessions of varying severity. Risky assets performed poorly in the three cases. Meanwhile, US government bonds performed very poorly, along with risky assets, in 1970 when rising inflation was a complicating factor.
The current environment is analogous to 1937-8: the economy was improving after vicious contraction. The fiscal cliff will tighten policy overwhelmingly via higher taxes, thereby undermining aggregate demand. This would negatively impact corporate earnings expectations for 2013, presenting headwinds for risky assets. The backdrop for US long-term government bonds is more benign under the fiscal cliff scenario, helped by additional Fed asset purchases and weakening inflationary pressures.
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