Monday, August 1, 2011

America: Debt Ceiling and Growth

As we expected it would, the debt ceiling extension debate in the US is going right down to the wire. The good news was that stalemate has been achieved. That’s good because after stalemate comes compromise. The messages out of both parties leadership this morning is that a deal is close, although our read is the Democrats are being somewhat more cautious (coy?). And of course party leadership accord does not guarantee House or Senate passage.

The compromise appears to be a two-tranche increase in the debt ceiling totalling $2.4 trillion. The first tranche of around $1 trillion spending cuts would be agreed as part of the deal, with the detail of the second tranche to be agreed later. There appears to be no revenue initiatives in the proposal, making the package more challenging for the Democrats to agree to than the Republicans.

There is still a lot of work to do to get this through. This feels a lot like 2008 waiting for the Troubled Assets Rescue Program (TARP) to get approved. TARP eventually got through, but not without plenty of drama and market volatility. Once agreement on a deal is reached, legislation cannot be passed in time to meet the August 2 deadline. The Senate will use short-term measures to extend the debt-ceiling but this can only buy days rather than weeks or months.

Right here, right now we are actually more concerned about US economic growth than the politics of the debt ceiling. Second quarter GDP growth came in at weaker than expected 1.3% (seasonally adjusted annual rate or saar). Revisions to historical data as a result of annual benchmarking knocked a total of 1% off previous growth estimates.

We have been somewhat downbeat on the US growth outlook right from the start of the recovery. Since the recovery started, the average quarterly growth rate has been 2.5%, well short of a “normal” recovery which would typically see growth rates of around 4%. The theory was that household and finance sector deleveraging initially, then followed by government deleveraging, would keep growth subdued for many years, but the last six months in the US have been weaker than expected. We agree with the Fed’s assessment that some of this current weakness is transitory (Japan earthquake supply disruptions and high commodity prices), but there is more to it than just those factors.

Federal Reserve Chairman Ben Bernanke has said recently that monetary policy is not a panacea. We agree: monetary policy can’t do all the work which is why we still don’t expect QE3. With demand weak, and likely to remain so, a different approach to achieving higher economic growth is required. One of the implications of the revisions down in economic growth is that productivity (a supply side phenomenon) is now lower than previously thought. Instead of debating the debt ceiling, US politicians should be debating a more activist supply-side approach to building stronger US economic growth. The same goes for Europe.

The good news in the US GDP data was continued strength in capital expenditure. That bodes well for future growth. Given the constrained household sector, we continue to look to capex and exports to be the strongest areas of US growth.

Over the last few months we have moved to de-risk our portfolios by reducing our overweight in growth assets. With equities still cheap on most measures, this was against our normal inclination to want to be overweight growth. But with so much to worry about at the moment, it remains the most prudent positioning.