The US fiscal cliff, eurozone debt, China, corporate earnings, and fixed income are the five key themes for investors in 2013, say Léon Cornelissen, chief economist, and Ronald Doeswijk, chief strategist at Robeco.
The largest risk in the US as 2012 comes to a close is that irresponsible politicians allow the economy to fall off the fiscal cliff. This will involve the simultaneous expiry of tax breaks with the introduction of tax increases and spending cuts-the combined hit on the economy would be more than $600bn-at the end of 2012 unless Congress can act beforehand.
Failure to do so could have grave consequences. Allowing these automatic conditions to click in would probably result not only in higher unemployment and falling tax revenues but also a return to recession for the world’s largest economy during 2013.
Yet Robeco Chief Economist Léon Cornelissen isn’t overly concerned. “We don’t worry too much about the fiscal cliff,” he says. That’s because he expects a deal to be pushed through before it is too late. “Some compromise will be found,” he says. “Just don’t expect too much.”
Cornelissen believes that once the fiscal cliff has been by-passed, the US government will try to lower the budget deficit by 1.0 percentage point, which would take it to under 6%. Fiscal consolidation cannot be put on hold for ever. Trying is one thing, succeeding is another. “Given the political deadlock, it remains to be seen whether the deficit will actually be lowered from the current level next year,” observes Cornelissen. Moreover, the US’s debt ratio will increase above 110% GDP in 2014.
Even if the budget deficit is successfully pared back, Cornelissen points out that it will still be too high. This matters because failing to tackle it properly could provoke the ratings agencies to downgrade the US credit rating. S&P stripped the US of its triple-A rating in summer 2011, while Moody’s and Fitch both still give it their top rankings. “A downgrade in 2013 is a serious possibility,” he reckons, suggesting that reductions by all three agencies are likely.
How can a downgrade be avoided? Cornelissen says it would require Congress to hammer out a serious medium-term deal. But he doesn’t think that will happen. “With a divided Congress and a pragmatic, uninterested president, a multi-year program to bring the deficit down to say 3-4% of GDP is unlikely, especially given the dovish Federal Reserve,” he contends.
Bi-partisan intransigence aside, one reason for that laid-back approach may be the memory of what happened when the S&P downgraded the US by one notch in August 2011. Despite the US being thus deemed riskier, US Treasuries rallied as investors sought out safe-haven assets. As such, Cornelissen does not think that a downgrade would be a particular shock for investors. “What it could do, however, is focus attention on the fact that, on average, Europe is doing better than the US and Japan in its debtreduction efforts,” he argues.
This was a point made by ECB president Mario Draghi after the central bank council’s November meeting. He said that the euro area as a whole and the individual countries have “a fundamental position which is way more balanced than the US”. Draghi went on to identify a current account that is basically in balance; relatively low corporate and household debt; declining unit labor costs; and “amazing” fiscal consolidation across the shared-currency region.
Still, the backdrop against which the fiscal cliff story is playing out is of a gradually improving US economy. “The housing market is steadily improving, as is the labor market,” says Cornelissen. Moreover, the Fed has reiterated its determination to stay behind the curve. It will thus keep its aggressive monetary policy in place for all of 2013. In fact, Cornelissen feels that with the fiscal cliff out of the way, the US economy will surprise on the upside. “Consensus growth expectations for 2013 will steadily rise to 3%,” he says. That compares with 2% for the whole year now. Moreover, he adds, “inflation will not be a problem.”