Fiscal cliff to impact US growth by 4% if not avoided, Investec

John Stopford, co-head of Fixed Income & Currency at Investec Asset Management, expects the US fiscal cliff to represent a 4% hit to US growth. But, he adds, it is unlikely it will happen.

Are we at the cliff edge?
If the fiscal cliff cannot be avoided it would represent a 4% hit to US growth, which would mean the US goes into a recession next year. Given that the US is one of the few bright spots in the global economy, it would probably mean a global recession.

This is definitely a worst case scenario. In the short-run this could actually be positive for the US dollar simply because in that kind of environment people tend to cut risk positions elsewhere and the dollar typically benefits. It would also arguably in the short term improve the fiscal dynamics of the US, but in a rather messy and rapid way.

How likely is it?
We actually think that the fiscal cliff is unlikely to happen. The good thing about the fiscal cliff is nobody likes it. The problem is one party wants to resolve the problem through spending cuts and the other side wants to do it through a combination of tax rises and spending cuts.

With the fiscal cliff, all the cuts are in places no one likes: the Republicans do not want to see cuts in defence spending; the Democrats do not want to see cuts to entitlement spending. In terms of the tax increases, no one wants to see all of them, although clearly the Democrats would prefer to see them hitting the better-off people, i.e. those earning more than $250,000 a year.

So, we think there is enough about the fiscal cliff that no one likes that will end the stalemate and enable the politicians to ‘cobble something together’. The big risk is that in the short term the politicians are not going to agree anything very soon. It is almost certain that they are going to wait until after the election and it might go quite ‘close to the wire’ in terms of either just before year-end or go beyond the wire and get addressed soon after.

We think the danger is that markets will focus more on this issue heading towards Christmas and for that reason we are more cautious about risk appetite heading towards year-end. We do think, however, that there is enough vested interest for it probably to be avoided and what we will see instead is a more modest fiscal tightening that the US can absorb – something more like 1% of GDP.

What will happen after the fiscal cliff?
Even once the fiscal cliff has been addressed there is a reasonable probability that the US will be downgraded again next year if there are not the beginnings of a longer-term fiscal programme on the table.

In the medium term there is a significant risk that the US continues to push its fiscal problem into the distant future. Ongoing political deadlock, the inability of Republican and Democratic parties to agree a way forward, may restrict a sensible budget policy being enacted. In this case, worries about the US fiscal position will build over the next 3-5 years and markets may begin to pressure policy makers to face up to their profligacy.

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