The US election result means the country’s unsustainable fiscal arithmetic is back on the agenda.
The US will have the same public-debt-to-GDP ratio as Italy within five years, unless Obama 2 and the Republican-controlled House of Representatives can agree on how to fix the fiscal cliff and eventually the long-term expansion of mandatory spending programmes.
It is not beyond the wit of man to come up with a clever long-term fiscal programme that could reduce US gross public debt from the more than 100% of GDP it is today. However, as 90% to 100% of US fiscal spending now goes on mandatory entitlement programmes and interest, any cuts will hurt the common man.
Moreover, the more the US budget deficit is cut next year, the more likely is a recession. And that will make debt higher as a proportion of GDP in the short term. The less it is cut, the more unsustainable the debt becomes in the long term.
The bottom line is that the US needs an 8% of GDP swing in its primary budget balance to make its public debt ratio sustainable in the long run. That won’t happen under Obama 2, unless a sovereign debt crisis makes it necessary to act. This means uncertainty and continued deleveraging of private-sector debt will weigh on growth. Real GDP growth will be 2% next year at best and could even be negative in the first quarter of 2013.
Japan is back in recession and growth potential from here also depends on political developments. An election has been called for December 16. This will probably deliver a Liberal Democrat-led government. This new government will act to devalue the yen, boost government spending and insist on further monetary expansion under a new Bank of Japan governor. The risk is that, if handled badly, a yen devaluation coupled with fiscal profligacy might launch the inevitable Japanese government bond crisis.
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Europe too has slipped back into recession. And political paralysis is preventing action to turn economies around. The European Central Bank is sitting on its hands waiting for politicians to sort out the fiscal crises in Greece and Spain. In Italy too there is paralysis, as the country gears up for elections next spring. Ironically, although the politicians of the US, Europe and Japan are dithering, global growth next year might be better than expected. That’s because China will be recovering within its much-reduced corridor of trend growth of 6% to 9%. This will lift much of Asia and, with it, global manufacturing output, which I expect to out-swing GDP by two to three percentage points.
Other emerging markets such as Brazil are likely to be in a confirmed cyclical upswing. And countries such as the Philippines, Poland and Turkey will re-emerge as reform-driven growth stories, rather than as victims of the next bout of risk-off and credit contraction. These are stellar emerging market stories.
The US will still manage 2% growth after a shaky first quarter. Europe’s economy will probably bottom out, partly because austerity programmes will chop about 1% less off GDP next year than this year. And once things bottom out, the bedrock of wealth and income in Europe of those who are employed will start to filter through to spending.
In this environment, global industrial output growth could be north of 5% to 6% – compared with 3% for world GDP. This will be as a result of a reversal of the inventory cycle, which hit output this year, as well as from the waning effects of Europe’s contraction.
And that level of growth in manufacturing production is when excess inventories of industrial commodities start to fall. That’s mildly positive for equities, particularly cyclicals and emerging markets.
Like Goldilocks’ porridge – growth is warm enough to reduce defaults and produce cashflow to service debt, but not too hot to spark inflation and a massive bond sell-off.