Clime Investment Management has reviewed this year’s major concerns and has analyzed how deep or enduring they actually are in the article below:-
1. The US Fiscal Cliff
With about 30 days to go before the legislated tax cuts and spending end, this unresolved issue should be hitting the “red alert” stage. Recent reports from the US suggest that rational debate is now occurring between the Democrats and Republicans. The convincing re-election of President Obama was a wake up call to the Republican party which now realises that it must appeal to a broader cross-section of the US community. Simply looking after the rich and ignoring the wealth divide will not return them to the Presidency.
It is well reported and well predicted that in the absence of a compromise, there would be a 3% negative hit to US GDP. This would result in a double dip recession.
Figure 1. Components of the Fiscal Cliff Sources: CBO, EFIC
We have noted before that the US Government has not posted a fiscal surplus in the last 12 years. The fiscal deficit deteriorated rapidly into the GFC and the subsequent US recession of 2008. The actual deficit in 2008/09 peaked at 13% of GDP. Since then the deficit has been improving and the fiscal cliff (if not compromised) is projected to bring the deficit down to about 4% of GDP in 2013 (i.e. $600 billion). A compromise is expected to see the deficit move to about $800 billion in 2013.
Figure 2. US fiscal deficit scenarios Sources: IMF, Congressional Budget Office
So what is the compromise likely to be? Negotiators are examining ideas that would allow the effective tax rate to rise for the wealthy without technically raising the top tax rate of 35%. Importantly these proposals may allow both parties to claim they stood their ground.
One suggestion is to tax the entire salary earned by those making more than a certain level — $400,000 or so — at the top rate of 35%, rather than allowing them to pay lower rates before they reach the target (tax brackets). That idea could be combined with the reinstatement of tax code provisions that once prevented the rich from taking personal exemptions or itemising deductions. Those rules were eliminated by the tax cut of 2001.
The US tax brackets (for couples) range from:
- The first $17,400 of adjusted gross income is taxed at 10 %.
- Above that level and up to $70,700, income is taxed at 15%.
- Income between $70,701 and $142,700 is taxed at 25%.
- Then up to $217,450 is taxed at 28%.
- The next bracket up to $388,350 for couples is taxed at 33%.
- The top bracket hits adjusted gross incomes only above $388,350.
Warren Buffett weighed into the tax argument to counter claims that rich investors or entrepreneurs would pull back if capital gains and investment taxes were increased. Buffett said he’s never seen that happen even when capital gains taxes were above 25 per cent early in his investing career. “Let’s forget about the rich and ultra-rich going on strike and stuffing their ample funds under their mattresses if – gasp – capital gains rates and ordinary income rates are increased,” Buffett said. “The ultra-rich, including me, will forever pursue investment opportunities.”
Buffett reiterated his call for a minimum tax of 30 per cent on income between $US1 million and $US10 million, and a 35 per cent rate for income above that.
Whether Buffett’s solution is adopted is not really relevant but he did succinctly counter the fear campaign that taxing the rich would affect the recovery of the US economy. It won’t. Our view is there will be a compromise and the US recovery will continue through 2013.
2. Compromising Greek Debt
The seemingly endless meetings of European Finance Ministers finally produced a “result of sorts” in dealing with Greece’s debt crisis.
The deal involves three key ingredients. First, the Greek government has passed a further series of austerity measures which compensate for the slippage in budget targets set in debt restructuring of March 2012. Second, and in recognition of the latest budget package, the Eurozone has allowed Greece two years of extra grace (now 2016 rather than 2014) to achieve a 4.5% budget surplus (before interest costs) in common with the extensions recently agreed with other indebted countries in the Eurozone. Third, the Eurozone has embarked on the process of official debt forgiveness through the acceptance of zero or extremely low interest rates on the debt, and the extension of maturity.
In addition, the European Central Bank and national central banks will repatriate to Greece the “profits” on their holdings of Greek government bonds. And the European Financial Stability Facility is effectively making money available to Greece on favourable terms to buy back outstanding debt at a rumoured price of 35 per cent of face value, a little higher than the price at which the debt has been trading in recent days.
As a result of these various restructures and proposals, the projected debt/GDP ratio will fall from around 175 per cent in 2016 to less than 110 per cent by 2022. This projection still depends on the optimistic assumptions that the primary budget surplus can be held indefinitely at 4.5 per cent of GDP, while nominal GDP growth rebounds to more than 4 per cent per annum.
On reflection the last year has been a process of consuming time whereby Germany, France, the ECB and the IMF have allowed Greece to muddle along and see out another year whilst patiently waiting for a more enduring solution to the twin threats of a growing debt mountain and a shrinking economy. Markets waited patiently and nothing much happened. We suspect 2013 will be a re run of 2012.
Figure 3. Greek Government Debt Sources: IMF, Zerohedge, European Commission, Greek Ministry of Finance
The proposed restructure is quite convoluted and is hung up on the politics of Germany where Chancellor Angela Merkel is campaigning for a third term next year on the pledge that Greece won’t cost German taxpayers an additional cent.
But in reviewing the restructure we believe that the IMF and ECB have needed to focus on the short term cost of Greek debt rather than the actual amount of it. The forecast debt reductions are years away when the current market participants will have long forgotten today’s events.
This view is formed because of the previously agreed compromises that limited the interest paid by Greece on its debt to a percentage of GDP. For the next few years, Greece is committed and limited to interest payments of about 5.5% of GDP. At this level, the Greek government would actually spend less on interest than it did during the first few years after it joined the euro. In the 2001 fiscal year, the payments on government debt were about 7% of GDP.
By 2014, Greece’s interest burden is forecast to increase to about 6% of GDP due to its soft (official) loans from the European Central Bank (ECB) and European Commission. This level of debt service would only bring it in line with that those of Italy and Ireland, even though the debt to GDP ratio of both those countries is much lower than Greece’s. The reason is simple: the Irish and Italian governments pay market interest rates of about 4.5% (average), compared with the 3% that Greece pays on its, mostly official, debt.
So what matters more for Greece: a debt to GDP ratio nearing 200% or an interest burden of “only” 5-6% of GDP? The answer depends on the maturity of the debt. For the next few years Greece will not be in a position to repay much principal. Nor will it be able to refinance any debt in the market. The official creditors have decided to be patient (no choice here) and have extended the duration of their low-interest loans.
So the extension of debt at low cost appears a reasonable solution that meets the political imperatives across Europe. It helps Chancellor Merkel declare that Germany has not had to wear a loss even though it is wearing significant opportunity costs. Other countries such as Ireland and Portugal will get a similar reprieve as a reward for their support. Ultimately Spain and Italy may get a similar support mechanism if the European economy does not recover.
Another issue to consider is the likely recovery of Greece. The structural reforms being undertaken have flattened the economy in the short term, but will improve its longer term outlook. That is the normal economic cycle. Greek GDP has fallen by about 20% from its peak in 2008 and the European Commission estimates the gap between potential and actual GDP is now 14%, meaning substantial growth over the next decade or so is likely. Over the next 10 to 20 years the average growth rate of Greek nominal GDP is likely to be higher than the interest rate the government pays on its debt, satisfying a key condition of debt sustainability.
So just maybe there is a glimmer of hope amongst the wreckage of Greece.
3. The United Kingdom sliding through recession
At the beginning of the year, the United Kingdom was hopeful of some economic recovery due to a sharply depressed currency and the infrastructure spends required for the Olympic Games.
Figure 4. Exchange Rate: GBP/AUD Sources: RBA
Whilst there was an economic uptick in the September quarter, the overall economic trend is not good. The quantitative easing programme of the Bank of England was expanded further and interest rate settings held at multi-century lows. The dramatic growth in the size of the ECB is worrying and suggests that the UK government’s ability to fund itself is at dangerously low levels.
Figure 5. Central Bank Assets Sources: CEIC, EFIC, Central Banks
The UK stock market has lifted slightly his year but trails the uplift in the German market by about 20%.
Most significant from a City of London perspective has been the decline in profitability of UK banks. Their significance has declined rapidly over recent years. In 2008 financial institutions provided 16% of total UK corporation profits. This year it will be below 8% and it continues to decline.
Figure 6. Financial Corporations Sources: CEIC, EFIC
There are thus serious issues for the UK and should Germany press forward in its attempt to make Frankfurt the financial centre of Europe then tax revenue sources will be affected. Whilst the decision by the UK to stay outside the European Union and the euro has been applauded by many, the economic evidence does not support the UK’s decision. For instance the freely floating pound has not shielded the UK economy at all. The UK banking system and the highly indebted British government has few European economic friends, and now it does not have a strong Commonwealth to lean on.
Investors will need to keep a watchful eye on the UK in 2013. We suspect that recent political commentary which threatens to withdraw the UK from the European trade zone represents the cries of a deeply distressed economy and a government bereft of new ideas but seeking relevance.
4. Japan shows no sign of recovery
The world needs to be concerned about the lack of economic recovery in Japan in 2012. Japan’s economy declined again in the September quarter as the post-earthquake construction rebound faded. Over the last 12 years, real GDP growth in Japan has been a pathetic 8%.
Figure 7. Japan GDP Sources: CEIC, EFIC
Weighing on growth is the rapid and poorly reported deterioration in its trade balance. The trade deficit commenced 18 months ago and has worsened due to the world economic slowdown that cut Japanese exports. The maintenance of a strong yen due to Japan’s reticence to tap offshore capital markets is exacerbating the problem.
Figure 8. Japan – Trade Flows and External Surplus Sources: CEIC, EFIC
However, this reticence may soon be replaced by economic reality. The weakness in exports is being matched by increasing imports related to high energy import costs and in particular longer term LNG pricing contracts. Commentators are beginning to suggest that Japan might run a current account deficit in 2015 which would be its first in about 40 years.
Figure 9. Financial Balances and Public Debt Sources: CEIC, OECD
The result of the above factors and the well-known ageing population issue is that Japan’s relevance as an economic engine has rapidly declined. The continuing growth in government debt and massive fiscal deficit shows no sign of abating. However, whilst Japan may finally be forced into world capital markets from 2015 it may take many more years for it to become a financial problem of significance.
Our conclusion is that Japan and the UK are more significant issues than the European debt problems or the US fiscal cliff.